Capital versus Performance Covenants in Debt Contracts Hans B. Christensen and Valeri V. Nikolaev The University of Chicago Booth School of Business 5807 South Woodlawn Avenue Chicago, IL 60637 Abstract: We study the contracting role of financial covenants classified into two types. We argue that capital covenants control agency problems by maintaining sufficient equity capital and hence aligning debtholder-shareholder incentives, whereas performance covenants serve as tripwires that facilitate early transfers of control and renegotiations when performance deteriorates. We find that capital and performance covenants are negatively correlated but are not used interchangeably. Performance covenants are strong predictors of future contract renegotiations, while this is not the case for capital covenants. Further, restrictions on certain managerial actions are less common in conjunction with capital covenants, in line with their incentives alignment effect. We also study how the contracting value of accounting information affects covenant package design. We predict and find that performance covenants are contracted on when accounting information is descriptive of credit quality, while the opposite holds for capital covenants. This relation implies that properties of accounting information have a sizable effect on the design of financial contracts. Keywords: accounting-based covenants, private debt, capital structure JEL Classification: M40 First version: January 2010 This version: October 2010 We thank Ray Ball, Phil Berger, Richard Frankel, Laurence van Lent, Douglas Skinner, and workshop participants at the University of Chicago, London Business School, Tilburg University, Washington University, and the Fourth Interdisciplinary Accounting Conference in Copenhagen for helpful comments. Financial support from the University of Chicago Booth School of Business is gratefully acknowledged.
1. Introduction Covenants, which are designed to reduce the agency costs associated with conflicts of interest between creditors and shareholders, are a key component of debt contracts. The classic view on covenants expressed in Jensen and Meckling (1976) and Smith and Warner (1979) suggests that covenants control the agency costs of debt by giving shareholders incentives to follow a firm value-maximizing policy via restrictions on managerial behavior. More recent theoretical literature views covenants as tripwires that give lenders an option to renegotiate loan terms by threatening default following a decline in economic performance (Berlin and Mester 1992; Rajan and Winton 1995; Gorton and Kahn 2000; Garleanu and Zwiebel 2009). The theoretical papers on covenants typically employ a generic definition of the information signal in terms of which covenants are formulated, and hence largely disregard the fact that, in practice, covenants are formulated in terms of a variety of accounting ratios (Leftwich 1983; Dichev and Skinner 2002). This raises a number of interesting questions about the contracting role of accounting-based covenants. First, are there important distinctions in the monitoring role of different accounting ratios? Second, do covenants that rely on different accounting ratios reduce contracting frictions through different mechanisms? Third, what are the relations among different accounting-based covenants and financial policy choices or non-accounting contract features? And finally, how does the contractibility of accounting information influence covenant package design? In this paper we attempt to shed light on these questions by studying the intensity of accounting-based covenants (so-called financial or maintenance covenants) used in private 1
lending agreements. 1 To characterize the covenants package, we propose a simple classification of these covenants into two broad categories. The first category comprises capital covenants, which rely on information about sources and uses of capital and therefore balance sheet information only. Capital covenants typically control the level of equity or debt in the capital structure directly. The second category consists of performance covenants, which are formulated in terms of current-period efficiency indicators. 2 These covenants rely on income statement (cash flow statement) information alone or combine it with a balance sheet amount (e.g., debt-tocash flow). We argue that the two types of covenants limit debt-related agency problems in different ways. Capital covenants essentially ensure that shareholders have enough money inside the company. Such restrictions are an effective way to control the agency costs of debt (Smith and Warner 1979), as they ensure that shareholder wealth is (sufficiently) sensitive to managerial actions to incentivize shareholders to monitor management. Thus, capital covenants align shareholders' incentives with those of lenders ex ante, in which case there is less need for debtholder interference with managerial actions ex post. In line with this argument, capital covenants are not breached as long as management raises additional equity or cuts back on dividends, which provides incentives to finance investments with equity rather than debt. A cost of using these covenants, however, is that to be effective they have to place stringent constraints 1 Maintenance covenants require borrowers to maintain certain levels of financial ratios at every compliance date. These covenants are different from so-called negative covenants that restrict managerial actions depending on the level of accounting ratios. Such covenants are extensively considered by Smith and Warner (1979). 2 A concurrent working paper by Demerjian (2010) studies how accounting regulation has influenced the use of covenants. The paper refers to capital covenants as "balance sheet covenants" and to performance covenants as "income statement covenants". While such classification also seems appropriate, we do not use these labels for two reasons. First, the classification of some covenants (e.g., debt-to-cash flow or debt-to-ebitda) into balance sheet, income statement, or cash flow statement groups is arbitrary. Second, the labels "capital" and "performance" are more descriptive of the economic nature of these covenants and the underlying mechanism through which they address agency problems (as discussed further in the paper). 2
on the amount of debt in the capital structure. In contrast, we hypothesize that performance covenants are used as tripwires that detect early signals of distress and hence provide lenders an early option to renegotiate the contract or restrict managerial actions after deterioration in credit quality, i.e., ex post (Berlin and Mester 1992; Dichev and Skinner 2002; Garleanu and Zwiebel 2009). Performance covenants generally detect deteriorations in credit quality sooner than capital covenants because they are based on current performance (efficiency) ratios rather than on the stock of past profits and net capital contributions. While this is another effective way to control contracting frictions, compared to capital covenants' ex ante alignment of interests, it requires lenders to monitor the borrower more closely. To examine the differences in the role of the two covenant types, we develop two sets of empirical predictions that we test using data from Dealscan. Our first set of predictions seeks to improve our understanding of the contracting role of the two types of covenants. First, based on our characterization of the two covenant types, we predict that the two types of covenants are not used interchangeably as substitutes. In line with this prediction, we find that performance covenants' and capital covenants' intensities have different determinants and exhibit associations of opposite signs with many firm and contract characteristics. For example, consistent with the idea that capital covenants limit the use of debt, we find that they exhibit a strong negative association with the level of long-term debt, whereas consistent with tripwire covenants improving banks' incentives to monitor the loan (Rajan and Winton 1995), performance covenants are positively correlated with long-term debt. Second, since performance covenants are used as tripwires, we predict that they are positively related to the frequency of contract renegotiations, as a result of which covenants are 3
waived or reset conditional on firms' future performance. In contrast, capital covenants are expected to reduce the need to renegotiate because of debtholder-shareholder incentive alignment effects. We find that, in line with our prediction, performance (capital) covenants exhibit a significantly positive (negative) correlation with renegotiations and the number of covenant amendments. These results extend to a multivariate setting where we find that performance covenants, but not capital covenants, are significant predictors of subsequent renegotiations. Third, we predict that negative covenants such as restrictions on dividends, capital expenditures, and "cash sweeps" are used in conjunction with performance but not capital covenants. This is because when incentives are aligned through capital covenants, demand for negative covenants should be lower. In contrast, performance covenants may occasionally fail to transfer control in a timely fashion and hence negative covenants are needed to prevent shareholders from expropriating wealth from lenders. Our results provide strong empirical support for this prediction. Our second set of predictions seeks to shed light on how the contracting value of accounting information influences covenant package design. We argue that tripwire covenants are only effective at reducing contracting frictions if they transfer control to lenders when credit quality deteriorates (otherwise their use is costly). Thus, our fourth prediction is that performance covenants are used when accounting information is descriptive of credit risk. In contrast, capital covenants are likely to be a more effective mechanism to limit debt-related agency problems when accounting information is a poor indicator of credit quality, for two reasons. First, capital covenants align the incentives of shareholders and lenders ex ante and therefore do not rely on frequent control transfers and renegotiations. Second, aggregation of 4
profits over time, as it occurs in the balance sheet, reduces accounting noise. Using four proxies to measure accounting information's inherent contracting value (similar to Ball et al. 2008), we find that the use of performance (capital) covenants is increasing (decreasing) in the debt contracting value of accounting information, and that the fraction of performance covenants is also positively associated with our contracting value proxies. These results continue to hold when we use timely loss recognition and earnings persistence as alternative contracting value proxies and when we control for the investment opportunity set (Skinner 1993) and other covenant determinants. Taken together, the evidence suggests that performance covenants are chosen over capital covenants when accounting information is a good indicator of credit quality, in line with our predictions. Our fifth and final prediction is an extension of the arguments in Ball et al. (2008). Ball et al. find that credit rating-based pricing grids substitute for accounting-based pricing grids when accounting is uninformative about credit risk. Since the purpose of credit ratings and performance measures is to detect changes in credit quality, in contrast to capital-based measures, we argue that the effect documented in Ball et al. is largely due to substitution between credit ratings and the indicators used by performance covenants but not capital covenants. Our evidence supports this argument. Our study contributes to three threads of the literature. First, we contribute to the literature on creditor control rights and debt contract design (e.g., Dichev and Skinner 2002; Nash et al. 2003; Nini et al. 2007; Chava and Roberts 2008). Smith and Warner (1979) highlight the need to study interrelations between covenants. We propose a simple distinction between two types of financial covenants that is conceptually appealing and turns out to be empirically powerful. In particular, our results support the argument that performance and capital covenants 5
are not substitutes, that is, they reduce contracting frictions through different mechanisms. We thus find that the covenant mix varies meaningfully with different firm characteristics as well as contract characteristics such as leverage and negative covenants. Second, we contribute to the literature on the renegotiation of financial contracts (Roberts and Sufi 2009). Our evidence indicates that contracts with performance covenants are more frequently renegotiated than contracts without performance covenants. This is not the case for capital covenants, however, in line with capital covenants reducing the need for future renegotiations ex ante. Third, we contribute to the literature on how accounting information affects the design of debt contracts (Frankel and Litov 2007; Ball et al. 2008; Bharath et al. 2008; Nikolaev 2010; Costello and Wittenberg-Moerman 2010; Demerjian 2007 and 2010). Specifically, we show that performance covenants are preferred to capital covenants when accounting information provides a good description of credit quality. The remainder of our paper is organized as follows: Section 2 develops our hypotheses; Section 3 discusses our measure of the contracting value of accounting information; Section 4 outlines the sample selection and provides descriptive statistics; Section 5 presents the results; and Section 6 concludes. 2. Background and hypotheses Accounting-based covenants limit contracting inefficiencies. There are many channels through which covenants operate. Covenants can reduce agency problems by restricting managerial actions that potentially hurt debtholders as a company approaches financial distress (Jensen and Meckling 1976; Smith and Warner 1979). Alternatively, covenants can serve as a screening device that helps lenders obtain information about the borrower (Garleanu and Zwiebel 2009). Covenants can further alleviate hold up problems associated with short-term debt 6
(Sharpe 1990; Rajan 1992), improve lenders' incentives to monitor the loan (Rajan and Winton 1995), and provide a valuable option to renegotiate a contract following an adverse event (Berlin and Mester 1992). However, there is a disconnect between theory and practice as the theory is silent with respect to the roles of the different accounting ratios on which covenants are formulated. In this paper we classify covenants into two types to provide early evidence on the contracting role of the two types of accounting indicators used in practice. Before developing our hypotheses in turn below, we begin with a discussion of the classification that we propose. 2.1. Capital versus performance covenants To shed light on the role of accounting-based covenants, we classify covenants into two types: capital covenants and performance covenants. Capital covenants are formulated in terms of accounting information about sources and uses of capital, that is, balance sheet information only. Examples include restrictions on leverage, debt-to-equity, loan-to-value, debt-to-tangible net worth, and current ratios. In contrast, performance covenants consists of those covenants formulated in terms of current-period performance or efficiency ratios. Such covenants include interest coverage, fixed charge coverage, debt-to-earnings, and debt-to-cash flow ratios, as well as earnings (EBITDA) itself (see Appendix A for a complete classification of covenants). A notable distinction between the two types of covenants relates to the fact that capital covenants typically place explicit restrictions on a firm's minimum equity or maximum debt level, for instance, by requiring that the firm maintain certain leverage or net worth thresholds. Shareholders can ensure that such thresholds are respected by contributing additional equity capital or cutting back on dividend payments. Thus, capital covenants are not breached as long as shareholders are willing to participate in the firm's investments with their own capital. In contrast, performance covenants place no direct restrictions on the amount of a firm's debt; 7
instead they require that a minimum performance (profitability) level be maintained. Under performance covenants a company can keep increasing the level of debt in its capital structure as long as its new investments are sufficiently profitable. 3 However, a breach of performance covenants can rarely be avoided simply by contributing equity or cutting dividends. Another distinction between the two covenant types relates to the timeliness of control transfers. Capital covenants are based on a firm's cumulative profitability plus shareholders' net capital contributions, that is, they measure equity holders' capital in the firm including the stock of past undistributed profits. Performance covenants, in contrast, are functions of current-period performance only and thus are informative about changes in the stock of equity capital (profits) net of dividends. To become binding, capital covenants may require a series of losses, while it simply takes a lower level of current-period performance (which need not be a loss) for performance covenants to bind. Thus, performance covenants are usually timelier and more forward-looking indicators of negative trends in credit quality. Further, capital covenants rely on cumulated and aggregated accounting information from the balance sheet. Although this is likely to reduce noise over longer time periods, this comes at the expense of timeliness as current-period performance receives relatively small weight over longer periods. We note that it is rather difficult to draw a sharp line between performance and capital covenants because a firm's level of capital and performance are correlated. For example, if a company underperforms over an extended period its capital will be depleted and control reallocation will take place with capital covenants unless shareholders contribute new equity capital. However, this correlation is expected to prevail only over rather long measurement 3 Capitalizing future profits is generally not allowed under GAAP and thus financing a profitable new project with debt alone will be difficult in the presence of capital structure covenants. 8
horizons. Contracting parties should therefore find the distinction between the two types of covenants relevant. 2.2. Role of capital and performance covenants in limiting contracting frictions The distinctions we outlined above imply that the two types of covenants limit contracting frictions in different ways. Capital covenants require that shareholders maintain enough net assets in the firm (i.e., have enough "money" inside the firm). This ensures that shareholders' wealth is sensitive to opportunistic actions that decrease firm value (i.e., an equity option on the firm's assets is in the money), which in turn reduces shareholders' incentives to expropriate debtholder value and encourages them to monitor management (i.e., aligns the interests of shareholders and lenders). In contrast, instead of directly influencing the level of shareholders' equity and hence aligning incentives, performance covenants lead to more active monitoring by lenders by identifying deteriorations in a firm's performance and facilitating renegotiation. Performance covenants therefore reduce agency problems by reallocating control when debtholder-shareholder conflicts of interest become more severe. Smith and Warner (1979) argue that one of the most effective ways to control debtholdershareholder agency conflicts is to limit the amount of debt in the capital structure to a relatively low level. These authors distinguish four types of agency conflicts between shareholders (and managers' actions on their behalf) and debtholders, namely, (1) conflicts over dividends, (2) claim dilution, (3) asset substitution (Jensen and Meckling 1976), and (4) underinvestment (Myers 1977). To see how capital covenants can reduce agency conflicts, consider each of these problems in turn. First, by imposing a minimum equity constraint, capital covenants directly limit excessive dividend payouts and claim dilution. Next, because asset substitution arises due to shareholders' limited downside risk, which provides shareholders (and ultimately managers) 9
with risk-taking incentives, capital covenants' minimum equity constraint increases shareholders' downside sensitivity and hence helps mitigate asset substitution. Finally, because the underinvestment problem arises when the return on new investments effectively accrues to debtholders rather than shareholders, that is, when equity capital is thin and shareholders hold an out-of-the-money option on the firm's assets, capital covenants' equity requirements help preventing the underinvestment problem as well. Performance covenants can also address the four agency problems above by acting as tripwires that preempt managerial actions by reallocating control to debtholders at risk of expropriation. Control transfers allow debtholders to discipline managerial actions such as dividend payouts, capital expenditures, asset sales, and changes in the debt level (Roberts and Sufi 2009). We argue that capital structure covenants are less able to serve as tripwires as they do not focus on current performance, are less timely, and are easier to avoid. Thus, whereas capital covenants provide ex ante incentives against opportunistic actions, performance covenants limit agency conflicts by transferring control after operating performance deterioration. Based on the above discussion we expect that the two types of covenants are used by companies with different characteristics, such as for example, different investment opportunity sets (Skinner 1993). This implies that the two types of covenants are not direct substitutes. More formally: H1: Capital and performance covenants are used by borrowers with different investment opportunity sets, i.e., they are not substitutes. We state our first hypothesis in general form and discuss specific associations with firm characteristics in the results section. Our alternative hypothesis is that the two types of covenants are substitutes and hence exhibit similar relations with firm characteristics. 10
2.3. The use of negative covenants In addition to financial covenants, credit agreements often contain negative covenants, such as dividend restrictions, capital expenditure restrictions, and cash sweeps (which require remittance of a portion of cash proceeds from asset sales, new debt or equity issuance, etc. to the lender and hence effectively restrict these actions). Negative covenants are an alternative mechanism to control excessive dividend payouts, asset substitution, and claim dilution. We expect demand for negative covenants to be lower when managerial incentives are aligned with those of debtholders via capital covenants. In contrast, negative covenants are vital when performance covenants fail to transfer control in a timely manner and hence the risk of expropriation increases. This leads to the following hypothesis: H2: Dividend restrictions, capital expenditure restrictions, and cash sweeps are used in conjunction with performance covenants but not with capital covenants. 2.4. Frequency of renegotiation Lender monitoring via tripwire covenants is closely related to contract renegotiations. When economic performance deteriorates, tripwire covenants give lenders an option to renegotiate the terms of the loan. Garleanu and Zwiebel (2009), for example, show that under asymmetric information it is optimal to give stronger decision rights to lenders via covenants, which increase the frequency of subsequent renegotiation. We posit that because performance covenants serve as tripwires, the intensity of performance covenants is significantly related to the frequency of contract amendments that lead to covenant modifications. In contrast, because capital covenants are less suitable for active lender monitoring, we do not expect a positive association between capital covenants and contract amendments. Indeed, in the absence of conditioning on performance covenants, capital covenants are likely to reduce the frequency of renegotiation as they align managerial incentives ex ante. Our third hypothesis is thus as 11
follows: H3: Performance covenants are positively related to the frequency of contract amendments, whereas capital covenants do not show a positive relation with contract amendment frequency. 2.5. Accounting-based covenants and the contracting value of accounting information A key role of accounting information in the debt markets is to provide contractible information. Properties of accounting information are likely to be important in determining debt contract design and more specifically the use of accounting-based covenants (Skinner 1993; Frankel and Litov 2007; Bharath et al. 2008; Nikolaev 2010). We argue that performance covenants require accounting information to be a good indicator of credit quality. First, if accounting is not descriptive of credit risk, performance covenants will not effectively control agency problems as they will not transfer control in a timely manner (Type I error). Second, performance covenants will be costly if they transfer control and require renegotiation at times when doing so is unjustified (Beneish and Press 1993) (Type II error). Finally, if accounting information does not easily map into credit scores, monitoring of covenants written in terms of such information (which entails verifying quarterly compliance certificates, understanding covenant violations, and possibly renegotiation) will be relatively costly. In contrast, capital covenants do not require that accounting information explain credit quality. First, capital covenants reduce agency conflicts not by reallocation of control but rather by aligning shareholders' and debtholders' interests and giving shareholders incentives to control managerial actions. Second, accounting noise present in performance measures (e.g., earnings) reverse and wash out over time, and therefore have only a minor effect on capital covenants that rely on cumulative numbers from the balance sheet. However, the use of capital covenants entails a significant cost as they directly limit the use of debt as a mechanism to align incentives. 12
These arguments imply that there exists a tradeoff between capital and performance covenants that is affected by the contracting value of accounting information: when accounting information's ability to explain credit quality increases, performance (capital) covenants become a more (less) appealing contracting mechanism. 4 More formally: H4: The reliance on performance (capital) covenants is positively (negatively) associated with the ability of accounting information to explain credit risk. 2.6. Pricing grids and accounting information Loans frequently rely on pricing grids that make interest payments contingent on accounting indicators or credit ratings (Asquith et al. 2005). Pricing grids based on accounting information can be classified into (1) capital-based pricing grids, which rely on accounting indicators used by capital covenants, and (2) profitability-based grids, which rely on accounting indicators used by performance covenants. 5 Ball et al. (2008) predict and find that rating-based pricing grids substitute for accounting-based grids when the contracting value of accounting information is low. Extending their argument, we argue that rating-based grids substitute only for profitability-based grids and not capital-based grids. To see this, note that ratings are likely used for the same purpose as performance measures: to detect changes in credit quality. Capitalbased pricing grids, on the other hand, are less affected by the contracting value of accounting information since they provide incentives to maintain a sufficient equity cushion rather than detect changes in credit quality. Substitution of profitability-based grids for rating-based grids is 4 Note that this is different from predicting that performance (capital) covenants are used when performance (capital) measures are more informative about credit quality. It is likely that informative performance measures will lead to informative capital ratios and vice versa. Thus, we expect and find that these are highly positively correlated. As a result, it is difficult to separate informativeness effects empirically. 5 Capital indicators include senior leverage and the ratio of debt to tangible net worth; profitability (performance) indicators include the debt service coverage ratio, fixed charge coverage, interest coverage, senior debt to cash flow (EBITDA), and total debt to cash flow (EBITDA); rating measures include commercial paper rating, subordinated debt rating, and senior debt rating. 13
expected in cases where accounting information is a poor indicator of credit risk. As a result, we predict that the use of profitability-based pricing grids, but not capital-based pricing grids, is increasing in the contracting value of accounting information. This leads to our fifth hypothesis: H5: Pricing grids are formulated in terms of performance indicators rather than capital indicators when accounting information is more descriptive of credit risk. 3. Measuring the contracting value of accounting information Accounting information explains credit risk to the extent that it maps into credit scores. To quantify the ability of accounting information to measure default risk we construct four proxies for contracting value. Following Ball et al. (2008), our contracting value proxies are based on industry-level regressions of long-term debt ratings (transformed into numerical scores) on accounting variables. As credit ratings summarize credit risk, R 2 s from these regressions capture the relative ability of accounting information to explain default risk. A low explanatory power would imply the presence of a large information component for the industry that is not easily captured by accounting information (but that is taken into account when determining credit risk). In this case the amount of contractible accounting information available to capture credit risk is limited. In contrast, a high R 2 would imply that accounting benchmarks are sufficient statistics for determining credit scores within a particular industry. We estimate the regressions at the industry level over the period 1988-2008, similar to Ball et al. (2008). Our approach differs from that in Ball et al. (2008) who measure the contracting value by looking at whether changes in accounting earnings explain credit rating downgrades. We do not follow their procedure as our objective is different. The first reason for using levels rather than changes in earnings is that we are interested in using variables actually used in contracts. Contracts are written in terms of performance or capital indicator levels and thus it is interesting 14
to focus on these variables. Moreover, performance indicators already effectively inform us about the changes in shareholder's capital (wealth) and thus differencing capital indicators brings us to performance measures. Specifically, differencing net worth yields current period earnings net of dividends. If the purpose of the analysis is to compare net worth vs. earnings as two contracting alternatives, differencing is misleading. Second, we are not interested in whether changes in accounting variables predict credit rating downgrades per se. 6 Instead, we are interested in determining whether accounting information maps into a credit score, or whether a large amount of other information (captured in residuals) explains credit ratings. Because levels of earnings and capital are likely to be important in determining credit risk, calculating changes would difference out this essential information component. 7 Further, the lack of a credit rating downgrade need not necessarily imply that accounting information is uninformative about credit quality; rather, it may simply suggest relatively stable performance. 8 As a result, it is difficult to evaluate whether accounting information explains (as a sufficient statistic) credit risk by focusing on credit rating downgrades. 9 6 Note that credit rating downgrades following changes in profitability are endogenously related to the use of covenants, as contracts that rely on tight tripwire covenants have a higher probability of a downgrade following a change, which complicates inferences. In contrast, examining the extent to which earnings map into credit risk scores is a non-causal approach that is less subject to this concern. Note that the mapping of earnings into credit scores is unlikely to depend on whether covenants are used or not. 7 While a specification in changes allows one to get closer to a causal relation between accounting variables and credit rating, we are not interested in causal relations per se, but rather the strength of association. 8 Econometrics of panel data suggests that taking differences is likely to exacerbate econometric problems caused by measurement error when there is a lack of within-subject (company) variation in the variables of interest (i.e., subjects are correlated over time) (Hsiao 2003, Section 10.5). 9 As a technical complication, our data do not allow us to construct a quality measure of credit rating downgrades. For example, suppose we observe a credit rating on February 1, 2000, and on April 1, 2002 we observe a lower rating. This could mean that the company was downgraded right before April 1, 2002, or alternatively it could mean that there was an interruption in coverage. 15
Note that private loan covenants are usually not written in terms of credit ratings, and hence they are suitable as benchmarks for measuring the contracting value of accounting information (as this avoid selection issues). While it is beyond the scope of this paper to establish why covenants are not written in terms of credit ratings, several explanations are possible. First, the introduction of conflicts of interest between rating agencies (compensated by the borrower) and debtholders can discourage contracting on ratings. Second, circularity would arise because ratings are determined in part by firms' access to bank financing (Standard&Poor's 2010) and therefore lenders' decisions. For example, S&P could downgrade a company's debt in response to lenders' intention to recall the loan, in which case contracting on ratings makes default a self-fulfilling prophesy, similar to covenants written on credit spreads. It is worth pointing out that whereas the circularity above reduces the usefulness of ratings in contracts, to our knowledge it should not bias the contracting value proxies used in this study. As a robustness check, in Section 5.6 we use credit default spreads instead of credit ratings. We now turn to the construction of our contracting value proxies. 10 Our first proxy for the debt contracting value of accounting information, CV1, is the R 2 from the following industrylevel regression: Rating E E E E E (1) it 0 1 it 2 it 1 3 it 2 4 it 3 5 it 4 it where Rating it is constructed by assigning 1 to companies with the highest credit rating following quarter t, 2 to companies with the second-highest credit rating, and so on, and then taking the natural logarithm. Eit s is earnings before extraordinary items in quarter t s divided by average total assets over the quarter. 10 We use quarterly data as private credit agreements' compliance with accounting-based covenants is often determined on a quarterly basis. 16
Our second contracting value proxy, CV2, is the R 2 from the industry-level regression: Rating Coverage Coverage Coverage it 0 1 it 2 it 1 3 it 2 Coverage Coverage 4 it 3 5 it 4 it (2) where Rating is defined as above and divided by total interest expense). Coverageit s is quarter t s interest coverage (EBITDA Notice that both CV1 and CV2 are formulated in terms of performance indicators that lenders are interested in. One may also measure the extent to which accounting information maps into credit quality based only on balance sheet variables, i.e., capital indicators. Doing so allows us to contrast capital ratios with performance indicators. Our proxy based only on capital indicators, CV3, is the R 2 from the following regression: Rating NetWorth Leverage Tangibility (3) it 0 1 it 2 it 3 it it where Rating is as defined above, by total assets, NetWorthit is the quarter t ratio of book value of equity divided Leverage it is long-term debt divided by total assets in period t, and Tangibility it is capital intensity defined as book value of net property, plant, and equipment divided by total assets. 11 Finally, our all-in contracting value proxy, CV4, is based on the R 2 from the following industry-level regression (here we do not include lags to keep the model parsimonious): Rating E Coverage NetWorth Leverage Tangibility (4) it 0 1 it 2 it 3 it 4 it 5 it it where all variables are as defined previously. Appendix B provides pooled sample estimates for Models (1) through (4). 3.1. Alternative proxies for contracting value 11 While Tangibility is rarely used in credit agreements, it clearly represents a measure of assets-in-place, which is important in lending decisions (Skinner 1993). 17
While there is no consensus in the accounting literature on how to measure accounting quality (Dechow et al. 2009), we use two simple properties of accounting information that likely affect contracting parties' decision on covenants: timely loss recognition and earnings predictability. Apart from being interesting in their own right, timely loss recognition and earnings persistence also help us validate our contracting value proxies described above. 12 Timely loss recognition, or conditional conservatism, plays an important role in debt markets (Watts 2003). In particular, timely loss recognition improves the effectiveness of accounting-based covenants by facilitating transfers of control to debtholders when a company approaches financial distress (Ball and Shivakumar 2005). Thus, timely loss recognition is important for tripwire-type covenants. We measure timely loss recognition, TLR, as the coefficient 3 from the following industry-level regression based on Basu (1997): Et / P t 1 0 1D( R t 0) 2R t 3D( R t 0) R t (5) t where Et / Pt 1 is defined as the ratio of annual earnings before extraordinary items scaled by beginning-of-period market value of common stock, R t is the stock return from CRSP compounded over the 12-month period starting three months after the beginning of the fiscal year (to exclude prior earnings announcement effects), and D(.) is an indicator function. Earnings predictability is also often argued to be an important consideration for lenders and thus is likely to influence the covenants decision. We measure predictability, PRED, as the R 2 from the following industry-level regression (e.g., Dichev and Tang 2009): E E (6) it 0 1 it 1 it 12 Ball et al. (2008) also use timeliness, the R 2 from regressing stock returns on accounting earnings and their changes. They find, however, that timeliness exhibits a negative correlation with timely loss recognition. This is not unexpected given the construction of these two proxies. As a result, and given that the contracting benefit of a higher return-earnings association is unclear, we do not include this measure in our analysis. 18
where Et is annual earnings divided by average total assets. Regressions (5) and (6) are estimated by industry over the period 1988-2008. 4. Sample and summary statistics 4.1. Sample selection We use Dealscan to measure reliance on accounting-based covenants and other loan characteristics. Accounting variables and firm characteristics are collected from Compustat. We merge loans from Dealscan to the fiscal years in which they are issued on Compustat using the Dealscan-Compustat link (August 2010 vintage) constructed and maintained by Michael Roberts and WRDS (see Chava and Roberts 2008). 13 If a loan package has several credit facilities, we aggregate information at the deal (i.e., loan) level. Contracts without covenant information are excluded from the analysis. 14 We capture a contract's reliance on covenants by using covenant intensity, which is the number of covenants in the contract. C-Covenants denotes a count of capital covenants, and P-Covenants denotes a count of performance covenants. The classification of accounting-based covenants into performance covenants (P-Covenants) and capital covenants (C-Covenants) is described in Appendix A. To construct our contracting value proxies we link the S&P Credit Ratings Database to the Compustat quarterly database and use S&P's entity-level long-term credit ratings. Each endof-quarter credit rating is linked to accounting information from the current and preceding quarters. If S&P did not update a firm's credit rating during a particular quarter, we use the most 13 We thank the authors for generously sharing the link information. 14 Approximately 50% of credit agreements in Dealscan are coded as having no covenants. It is highly unlikely that these credit agreements do not employ covenants given that almost all private credit agreements rely on covenants (e.g., Christensen and Nikolaev 2009). The absence of covenant data indicates simply that Dealscan was unable to obtain information on covenants. Thus, we exclude contracts with no covenant information rather than set this number to zero. 19
recent long-term credit rating. S&P Credit Ratings data dates back to the 1920s, but coverage is sparse before 1986. As we further require cash flow statement data, we limit the sample to the period 1988-2008. Over this period S&P rated over 5,500 companies and on average released credit rating (or economic outlook) information 1,900 times per year (this number ranges from about 500 in 1988 to 3,300 in 2008). In general it takes more than a year for S&P to update information about a given company's long-term credit. Contracting value is measured based on SIC industry classification: 3-digit SIC codes are used in cases where more than 25 companies and 250 quarterly observations are available; 3- digit SIC codes that do not meet this requirement are combined and considered at their 2-digit level (all industries are mutually exclusive). This procedure achieves a more balanced distribution of companies across resulting industry groups. We further exclude industry groups with less than 25 companies or 250 quarterly observations to improve the reliability of estimates and avoid overfitting that occurs in small samples. This procedure results in 50 industry groups. We employ the same industry classification procedure when measuring timely loss recognition and earnings predictability. 15 These properties are estimated using the intersection of CRSP and annual Compustat data. We omit 1% of the observations for CRSP and Compustat variables at each tail and restrict the sample to non-negative EBITDA (which is necessary to compute interest coverage). 16 All variables are defined in Appendix C. The final sample size varies from approximately 6,000 to over 10,000 debt contracts depending on data availability for the specific regression. 4.2. Summary statistics 15 The resulting set of industries is larger as we do not require S&P data to be present. 16 The results are not sensitive to this choice. 20
Table 1 presents summary statistics. With a mean (median) market value of assets at $4,553 ($975) million, the average firm in our sample is larger than the average firm on Compustat. Average book-to-market is 0.63, which is similar to the Compustat average. Leverage, as measured by long-term debt divided by book value of assets, is 27%, which is substantially higher than the 17% that corresponds to the population of Compustat firms. The mean contracting value proxies range from 15% in the case of CV1 to 44% in the case of CV4, which implies that a substantial portion of the variation in credit ratings is explained by variation in accounting variables. Half of the sample companies have at least one C-Covenant and two P- Covenants. Table 2, Panel A reports correlations among the contracting value proxies. All CV proxies exhibit high positive correlations with each other. This result is interesting as it shows empirically that profitability indicators' ability to explain credit risk is closely correlated with the ability of balance sheet capital ratios to do so. It is therefore unlikely that the choice of covenants is explained by trading off how well balance sheet vs. income statement variables map into credit risk. In addition, the CV proxies exhibit significant positive correlations with the timely loss recognition (TLR) and predictability (PRED) proxies. For example, the correlation between TLR (PRED) and CV4 is 31% (50%). This result helps validate our contracting value proxies. Table 2, Panel B provides pairwise correlations among covenants based on a more refined classification of the financial covenants into five main groups (detailed in the table header). The five main groups are given by indicator variables for covenants on debt-toprofitability, interest coverage, liquidity (current ratio), leverage, and net worth. Note that interest coverage and debt-to-profitability covenants belong to P-Covenants while liquidity, 21
leverage, and net worth covenants belong to C-Covenants. As expected, performance and capital covenants exhibit positive correlations with other members of their group. However, they exhibit significant negative correlations with members of the other group, which is consistent with covenants across these groups being substitutes. Overall, P-Covenants and C-Covenants exhibit a significantly negative correlation of -0.37. Panel C of Table 2 shows the correlations between financial covenants' intensity and the presence of negative covenants (dividend and capital expenditure restrictions, as well as cash sweeps). We observe significantly positive (negative) correlations between negative covenants and performance (capital) covenants, consistent with H2. Table 3 provides Pearson correlations among firm- and contract-level variables. P- Covenants and C-Covenants exhibit correlations of opposite signs with leverage (0.26 and -0.16, respectively). This evidence is consistent with the idea that capital covenants mitigate agency conflicts by limiting access to debt financing. The covenants mix, P/C CovMix = C- Covenants/(C-Covenants+P-Covenants), also exhibits significant correlations with a number of firm characteristics, including size, leverage, and book-to-market. 5. Results 5.1. Are performance and capital covenants substitutes (H1)? To examine whether performance and capital covenants are substitutes, we regress them on the investment opportunity set (Skinner 1993) and other covenant determinants (Nash et al. 2003; Billett et al. 2007; Chava and Roberts 2008; Chava et al. 2010). Table 4 presents the regression estimates. Models (1) and (2) explain the determinants of performance covenants (P-Covenants) and capital covenants (C-Covenants), respectively. Model (3) explains the covenant mix, P/C-CovMix. We find that only the coefficients on Size, 22
ROA, and Altman's Z-score share the same sign across performance and capital covenants. All other firm characteristics in Models (1) and (2) exhibit opposite signs across the two types of covenants and in many cases are significantly different from zero. Perhaps the most striking finding in the table is that leverage exhibits a strong positive association with P-Covenants, while it exhibits a strong negative association with C-Covenants. This finding confirms the univariate results discussed in Section 4.2. In addition, whereas prior research documents a positive association between the number of accounting covenants and leverage (Press and Weintrop 1990; Duke and Hunt 1990; Skinner 1993; Bradley and Roberts 2004), this relationship does not hold for C-Covenants, further underscoring the difference between C- Covenants and P-Covenants. We do not derive empirical predictions as to how different types of covenants should be related to firm characteristics as the relationship is often an empirical question. However, we offer interpretations for several coefficients of interest. We find that larger (Size) and more mature companies (Age) rely on capital rather than performance covenants, which can be explained by lower information asymmetry in such companies. Consistent with this idea, Garleanu and Zwiebel (2009) show that tripwire-type covenants are used to address contracting frictions due to information asymmetry. We do not have a clear prediction on how growth opportunities are related to the covenant mix. On the one hand, capital covenants allow for greater managerial independence and flexibility, essential for high growth firms. On the other hand, lenders may be reluctant to grant flexibility to such firms due to greater agency problems. Existing empirical evidence on growth options and covenants is mixed. For instance, Bradley and Roberts (2004) find that high growth firms face more covenants, Demiroglu and James (2010) find that high growth firms get more but looser covenants, whereas Skinner (1993) finds 23
that high growth firms face fewer covenants. We find that companies with relatively high growth opportunities (as implied by lower book-to-market, B/M) tend to rely on performance rather than capital covenants. Our evidence complements and potentially helps reconcile the mixed findings of prior literature. In particular, the more intense use of performance covenants among high growth borrowers suggests more direct monitoring by lenders when investment opportunities are greater. We further find that companies with a larger portion of tangible assets (tangibility) rely more on C-Covenants than P-Covenants. Skinner (1993) argues that having assets-in-place helps overcome the asset substitution and underinvestment problems as such assets can be used as collateral and are easier to monitor via covenants. The need for tripwire covenants is thus likely lower. On the other hand, capital covenants are still likely to be useful as they help ensure that the value of the collateral (assets-in-place) exceeds a minimum threshold. In addition, R&D intensive companies (controlling for growth opportunities) and companies with low profits also gravitate towards the use of C-Covenants. This result can be explained intuitively by the lack of meaningful performance indicators in such companies (Demerjian 2007). For example, negative earnings, due say to large R&D expenditures, preclude the interpretation of performance ratios. Finally, consistent with the argument that volatile operations likely make the use of P-Covenants costly due to unwarranted covenant breaches, the standard deviation of returns (StdRet) is negatively associated with P-covenants but positively related to C-Covenants. The results on the determinants of the covenant mix in Model (3) closely mimic those in Models (1) and (2). This result makes P/C-CovMix a convenient summary measure of the type of covenant package used. Overall, the evidence implies that capital and performance covenants are indeed used by companies with different characteristics. This result, in combination with the 24