Debt covenants and renegotiation

Berlin, Mitchell; Mester, Loretta J.

doi:10.1016/1042-9573(92)90005-x

Cited by 345 publications

(168 citation statements)

References 18 publications

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“…Neither of these papers looks at optimal covenant design. Berlin and Mester (1992), Sridhar and Magee (1997) and Gârleanu and Zwiebel (2009) study the relation between optimal covenant design/tightness and renegotiation, which becomes important under information frictions.…”

Section: Literature Reviewmentioning

confidence: 99%

Is Operating Flexibility Harmful Under Debt?

2017

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We study the inefficiencies stemming from a firm's operating flexibility under debt. We find that flexibility in replenishing or liquidating inventory, by providing risk-shifting incentives, could lead to borrowing costs that erase more than one-third of the firm's value. In this context, we examine the effectiveness of practical and widely used covenants in restoring firm value by limiting such risk-shifting behavior. We find that simple financial covenants can fully restore value for a firm that possesses a midseason inventory liquidation option. In the presence of added flexibility in replenishing or partially liquidating inventory, financial covenants fail, but simple borrowing base covenants successfully restore firm value. Explicitly characterizing optimal covenant tightness for all these cases, we find that better market conditions, such as lower inventory depreciation rate, higher gross margins, or increased product demand, are typically associated with tighter covenants. Our results suggest that inventory-heavy firms can reap the full benefits of additional operating flexibility, irrespective of their leverage, by entering simple debt contracts of the type commonly employed in practice. For such contracts to be effective, however, firms with enhanced flexibility and/or operating in better markets must also be willing to abide by more and/or tighter covenants. AbstractWe study the inefficiencies stemming from a firm's operating flexibility under debt. We find that flexibility in replenishing or liquidating inventory, by providing risk shifting incentives, could lead to borrowing costs that erase more than a third of the firm's value. In this context, we examine the effectiveness of practical and widely used covenants in restoring firm value by limiting such risk shifting behavior. We find that simple financial covenants can fully restore value for a firm that possesses a mid-season inventory liquidation option. In the presence of added flexibility in replenishing or partially liquidating inventory, financial covenants fail, but simple borrowing base covenants successfully restore firm value. Explicitly characterizing optimal covenant tightness for all these cases, we find that better market conditions, such as lower inventory depreciation rate, higher gross margins or increased product demand, are typically associated with tighter covenants. Our results suggest that inventory-heavy firms can reap the full benefits of additional operating flexibility, irrespective of their leverage, by entering simple debt contracts of the type commonly employed in practice. For such contracts to be effective, however, firms with enhanced flexibility and/or operating in better markets must also be willing to abide by more and/or tighter covenants.

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Section: Literature Reviewmentioning

confidence: 99%

Is Operating Flexibility Harmful Under Debt?

2017

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“…This problem is particularly relevant for banks because of their high leverage and the relative ease with which they can change the degree of risk of their business activities. This risk-shifting problem between debtholders and shareholders can be mitigated to some extent by including loan covenants in the debt contract (Berlin and Mester, 1992;Chava and Roberts, 2008) or by using short-term debt (Calomiris and Kahn, 1991).…”

Section: Introductionmentioning

confidence: 99%

Incentive-Based Capital Requirements

Eufinger

Gill

2017

Management Science

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This paper proposes a new regulatory approach that implements capital requirements contingent on executive incentive schemes. We argue that excessive risk taking in the financial sector originates from the shareholder moral hazard created by government guarantees rather than from corporate governance failures within banks. The idea behind the proposed regulatory approach is thus that the more the compensation structure decouples the interests of bank managers from those of shareholders by curbing risk-taking incentives, the higher the leverage the bank is permitted to take on. Consequently, the risk-shifting incentives caused by government guarantees and the risk-mitigating incentives created by the compensation structure offset each other such that the manager chooses the socially efficient investment policy. This paper was accepted by Amit Seru, finance.

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“…5 In other legal regimes, however, the only investor protection contract that is enforceable is that which provides rights whenever "assets are sold. "This characterization of legal regimes according to their enforceable contract set is very much in the spirit of Co¤ee 2001, which refers to a "smell test"that courts in common law legal regimes can perform to detect expropriation, unlike civil law legal regimes that cannot.…”

Section: Introductionmentioning

confidence: 99%

Investor Protection and the Coasian View

Bergman

Nicolaievsky

2004

SSRN Journal

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Some legal regimes leave gaps in the protection provided by the law to …rm investors. This paper considers the decision by a …rm to opt out of the law and bridge those gaps using contracts. Examining the charters of a sample of Mexican …rms, we …nd that private …rms often enhance signi…cantly the protection o¤ered by the law to their investors, but public …rms rarely do so. Motivated by these …ndings, we construct a model that endogenizes the degree of investor protection that …rms provide, using as springboard the assumption that legal regimes di¤er in their ability to enforce precisely …ltering contracts, namely, contracts that provide protection only in those cases where expropriation can occur. Our model generates predictions about the types of contracts that would be employed and the levels of investor protection that they would provide across di¤erent legal regimes in both private and in public …rms.We are very grateful to Andrei Shleifer, Jeremy Stein and Philippe Aghion for their detailed suggestions. We are thankful for comments by

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Debt covenants and renegotiation

Cited by 345 publications

References 18 publications

Is Operating Flexibility Harmful Under Debt?

Is Operating Flexibility Harmful Under Debt?

Incentive-Based Capital Requirements

Investor Protection and the Coasian View

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