Do Tighter Loan Covenants Signal Improved Future Corporate Results? The Case of Performance Pricing Covenants

• Author: Mehdi Beyhaghi,Gordon S. Roberts,Aron A. Gottesman,Kamphol Panyagometh
• DOI: http://doi.org/10.1111/fima.12159
• Date: 01 September 2017
• Published date: 01 September 2017

Do Tighter Loan Covenants Signal

Improved Future Corporate Results?

The Case of Performance Pricing

Covenants

Mehdi Beyhaghi, Kamphol Panyagometh, Aron A. Gottesman,

and Gordon S. Roberts∗

Covenants in corporate bonds and loan agreementsmitigate agency conflicts between borrowers

and lenders and may provide a signal of borrower quality to help resolve information asymme-

try. Performance pricing covenants in bank loans specify automatic adjustments to loan spreads

based on borrowers’ subsequent performance.Our covenant signaling framework views interest-

decreasing performance pricing as a tight covenant associated with borrowers’ private informa-

tion on improved future performance accompanied by reduced credit risk. This positive signal is

associated with larger positive loan announcement returns and greater improvements in future

borrower performance. Further, in addition to signaling value, we find that the spread impact of

this class of covenant also depends on its option value and reduction in transactioncosts.

Covenantsin cor porate bonds and loan agreements mitigate agency conflicts betweenbor rowers

and lenders and also provide a signal of borrower quality to help resolveinfor mation asymmetry.

When addressing agency conflicts, creditors play an important role in the corporate governance

of firms experiencing reduced performance short of f inancial distress. Such intervention occurs

through loan covenants that serve to allocate increased control rights to lenders when poor

outcomes occur.

Our paper examines the role of covenantsas a signal of bor rowerquality, prior to any violations.

We focus on performance pricing covenants (PPCs) in bank loans that specify automatic adjust-

ments to the interest-rate spread based on the borrower’s subsequent performance as gauged by

different accounting-based or credit rating–based measures such as the debt-to-earnings before

interest, tax, depreciation, and amortization (EBITDA) ratio or Moody’s rating of the borrower’s

bonds or commercial paper. With a PPC, moderate declines in financial performance do not

trigger covenant violations and renegotiation but rather bring automatic adjustments to the cost

The authors received helpful comments from Raghu Rau (Editor), an anonymous referee, and audiences at Concordia

University, the University of Manitoba, the 2014 MidwestFinance Association in Chicago, the 2013 European Financial

Management Association in Reading, the 2013 European FMA annual meeting in Luxembourg, and the Financial

Management Association 2011 European Conference in Porto. Hussam Alghamdi, Shiu-Yik Au, RuchaDesmukh, Arwa

Najmi, Amit Soni, John Tagawa, and Jie Zhu furnished excellent researchassistance. The Social Sciences and Humanities

Research Council of Canada providedfinancial support for this research.

∗Mehdi Beyhaghi is an Assistant Professorof Finance in the College of Business at the University of Texasin San Antonio,

TX. Kamphol Panyagomethis an Associate Professor of Business Administration at the National Institute of Development

Administration in Bangkok, Thailand. Aron A. Gottesman is a Professor of Finance in the Lubin School of Business,

Pace University in New York, NY.Gordon S. Roberts is the CIBC Professor of Financial Services in the Schulich School

Business, YorkUniversity in Toronto, Canada.

Financial Management •Fall 2017 •pages 593 – 625

594 Financial Management rFall 2017

of debt prior to the “tough principal” role (Freudenberg et al., 2015), which has been the focus of

prior research on covenant violations.

PPCs provide a signal of borrower quality addressing asymmetric information. We distinguish

between interest-decreasing and interest-increasing PPCs and argue that in an environment of

information asymmetry, by accepting loan terms with interest-decreasing PPCs, the borrowersig-

nals that it possesses private information that its financial state will improve. Interest-decreasing

performance pricing is generally a tighter covenant than its interest-increasing counterpart. We

illustrate the distinction with a hypothetical example of a company that borrows at the London

Interbank Offered Rate (LIBOR) plus 100 basis points (bps) and currently has a debt/EBITDA

ratio of 3.0. Using an interest-increasing PPC, the loan spread would increase to 125 bps should

the debt/EBITDA ratio rise to 3.5 and to 150 bps for a ratio of 4.0. Beyond debt/EBITDA of

4.5, the borrower goes into technical default.1This is a relaxed covenant as it gives the company

slack should its debt ratio deteriorate from the current level of 3.0 to 4.5. In contrast, with an

interest-decreasing PPC (tight covenant), borrowing at LIBOR as before, the borrower goes into

technical default if the borrower’s debt/EBITDA ratio rises to 3.5 from the current level of 3.0.

Interest-reducing provisions state that the spread would narrow to 75 bps if the ratio falls to 2.5

and to 50 bps for a ratio of 2.0. The tighter covenant package consisting of a lower same-variable

covenant provision set closer to the current level and an interest-decreasing PPC constitutes a

signal that the firm expects its financial strength to improve. This is a costly signal that cannot be

mimicked by firms with poor prospects as its adoption would incur major costs by increasing the

likelihood of technical default. Such signals are quite common: we find that interest-decreasing

PPCs are roughly twice as prevalent as interest-increasing PPCs.

Recognizing that the presence of interest-decreasing PPC signals positive private borrower

information forms the conceptual foundation for our three hypotheses: First, the announcement

impact of this class of PPC will be more positive than for interest-increasing PPCs for which the

signal is lacking (H1). Second, borrowers with interest-decreasing PPCs will perform better in

the long run as measured by return on assets (ROA) and Altman’s Z-score than borrowers with

interest-increasing PPCs. Further, the selection of a tight PPC is related to improvement in the

credit-metric variables on which the PPCs are written (H2). Third,loans with interest-decreasing

provisions are associated with lower spreads ceteris paribus; however, PPCs’ impact on spreads

is also affected by their option value as posited by Asquith, Beatty, and Weber (2005) (H3).

Our first hypothesis predicts that because it is a tight covenant that sends a positive signal, an

interest-decreasing PPC should be associated with higher announcement returns. We calculate

the market-adjusted cumulative return using stock returns over three trading days centered at the

loan announcement date. We then regress the announcement return on dummy variables for PPC

inclusion in general and the impact of the direction of a PPC. In addition, because the market

learns about different features of a loan agreement at the same time, we also control for other

observable terms of the loan such as spread and size to be able to isolate the impact of a PPC on

announcement returns. Our univariate analysis shows that loans with interest-decreasing PPCs

produce an average three-day market-adjusted announcement return that is 160 bps higher than

those of loans with interest-increasing PPCs, and 170 bps higher than the announcement return

of loans without a PPC. Our regression analysis strongly supports this finding. Consistent across

all models and robust to the choice of control variables, our results show that the presence of

an interest-decreasing PPC in loan agreements is correlated with positive private information.

1Technical default indicates that the borroweris in f inancial trouble and can trigger an increase in a loan’s interest rate,

foreclosure, or other negative events.Beneish and Press (1995) provide evidence that announcements of technical default

are associated with significant stock price declines.

Beyhaghi, et al. rThe Signaling Role of Performance Pricing Covenants 595

Our second hypothesis states that interest-decreasing PPCs are associated with stronger long-

run financial performance. We find that borrowers with any PPC on average enjoy a positive

but economically insignificant improvement in their industry-adjusted ROA one year after loan

initiation. In contrast, this change is a positive 10 bps for borrowers with a decreasing PPC

and a negative 20 bps for borrowers with an increasing PPC. Interest-decreasing PPCs are also

associated with improvement in credit quality as measured by Altman’s Z-score. Our results

(Table IV) show that a borrower with an interest-decreasing PPC has a reduction in its industry-

adjusted leverage ratio by 130 bps relative to borrowers without a PPC. This change is, however,

positive and significant (80 bps) for the holders of interest-increasing PPCs. We also consider the

variables on which the PPCs are written. Besides the leverage ratio that was mentioned before,

debt/EBITDA and credit ratings are the most popular PPC variables, which constitute about

77% of the PPC loans in our sample. We observe a significant relation between the tightness of

covenants at loan origination and future changes in borrowers’ debt/EBITDA and ratings.

To test H3, wer un regressions explaining spreads based on the presence of interest-decreasing

PPC and controlling for borrower and deal characteristics. While interest-decreasing PPCs are

expected to negatively affect loan spreads through a signaling channel, by providing positive

private information about the borrower, an interest-decreasing PPC can also affect a loan spread

through a cost-reduction channel (Asquith et al., 2005). Without an interest-decreasing PPC,

a borrower requires renegotiation to obtain a lower interest rate when there are unanticipated

improvements in the borrower’s performance. An interest-decreasing PPC is valuable to borrow-

ers as it automatically decreases the interest rate on the loan when borrowers’ creditworthiness

improves. Because it reduces borrowers’renegotiation costs, bor rowers must compensate lenders

for provision of interest-decreasing performance pricing. In contrast, an interest-increasing PPC

grants an option to lenders that increases the interest rate on the loan when borrowers’ credit-

worthiness declines prior to default. This option is valuable to lenders, and borrowers must be

compensated for granting it. Therefore, through the cost-reduction (option-value) channel, an

interest-decreasing PPC has a positive impact on loan spread (opposite to the signaling channel’s

impact), and an interest-increasing PPC has a negative impact on spread (there is no signaling

channel for interest-increasing PPC). In our spread analysis, we are able to disentangle the two

channels using three groups of test specifications. These three groups include pooled regressions,

propensity score–matching analysis, and marginal impact analysis with loan packages.

Our empirical results provide strong support for H3. The removal of the signaling channel of

interest-decreasing PPCs inflates loan spreads. Wealso show that the cost-reduction channel has a

positive impact on the spread of loans with interest-decreasing PPCs and has a negativeimpact on

the spread of loans with interest-increasing PPCs. Our pooled regressions provide strong evidence

that PPCs that include an interest-increasing provision carry reduced spreads on the order of 55

to 66 bps depending on the controls included, while there is a small positive significant impact

on spread of a decreasing PPC (5 to 11 bps). This finding shows that the cost-reduction channel

dominates the signaling value after controlling for observable borrower and loan characteristics,

including borrowers’ quality measures of Z-score and credit rating.

In further tests, we employ a probit model of the propensity to include a PPC to address the

self-selection bias that likely arises because firm risk characteristics influence the decision to

introduce performance pricing as well as the choice of design features: interest increasing or

interest decreasing. The results of these refined tests also support our predictions in H3: in the

pooled regressions, compared to loans with no PPC, interest-increasing PPCs have a smaller

spread while interest-decreasing spreads are not significantly different from zero. The results

indicate that the cost-reduction effect cancels the residual signaling value of interest-decreasing

PPCs.