Managerial Optimism and Debt Covenants

• Published date: 01 March 2022
• Author: Jakob Infuehr,Volker Laux
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/1475-679X.12402

DOI: 10.1111/1475-679X.12402

Journal of Accounting Research

Vol. 60 No. 1 March 2022

Printed in U.S.A.

Managerial Optimism and Debt

Covenants

JAKOB INFUEHR ∗AND VOLKER LAUX †

Received 17 March 2020; accepted 23 August 2021

ABSTRACT

This paper studies the effects of managerial optimism on the optimal design

of debt covenants. We find that managers who are more optimistic about the

future success of their investment ideas provide lenders with greater control

rights via tighter covenants. This is optimal for optimistic managers even

though they understand that tighter covenants increase the probability of

covenant violations and lead to excessive lender intervention. The broad rea-

son for this result is that optimists wish to write contracts that repay lenders

more frequently in bad states rather than in good states, and the only way to

achieve this is by granting lenders more control rights. Our model generates

new predictions and offers a novel explanation for the empirical evidence

that covenants in debt contracts are set very tightly and are often violated.

JEL codes: D23, D86, G32, G41

Keywords: managerial optimism; debt contracting; control right allocation;

debt covenants

∗University of Southern Denmark; †University of Texas at Austin

Accepted by Haresh Sapra. We thank two anonymous reviewers, Tim Baldenius, Sunil

Dutta, Ron Dye, Pingyang Gao, Ilan Guttman, Xu Jiang, Christian Laux, and workshop partic-

ipants at Columbia University, Yale University, University of California at Berkeley, Northwest-

ern University, University of Texas at Austin, and the 11th Accounting Research Workshop at

the University of Zurich for their valuable comments.

E-mail: volker.laux@mccombs.utexas.edu

353

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business

354 j. infuehr and v. laux

1. Introduction

Starting a new business venture is risky, requires long working hours,

and involves stress and forgone opportunities (Dunne, Roberts, and

Samuelson [1988]). Hamilton [2000] documents that the median earnings

of entrepreneurs after 10 years are 35% less than those of comparably em-

ployed individuals. And yet, the U.S. Census Bureau tracked over 3 million

business applications in 2019 alone.1

Several studies argue that an important explanation for entrepreneurial

activity is that individuals overestimate the chances that their venture will

succeed.2A large body of survey and empirical evidence supports the no-

tion that entrepreneurs have overly optimistic expectations about their

success.3For example, based on a survey of nearly 3,000 entrepreneurs,

Cooper, Woo, and Dunkelberg [1988] find that 81% of entrepreneurs be-

lieved that their success probability was at least 70%, although less than

50% of entrepreneurs survived for more than five years at that time. One

interpretation of this phenomenon is self-selection: Individuals who forego

other opportunities to start a new venture are typically those who overes-

timate the chances that their venture will succeed (De Meza and Southey

[1996], Van den Steen [2004]).

While the prevalence of entrepreneurial optimism is well documented,

its impact on economic choices is less clear. In this manuscript, we study

how optimism on the part of the entrepreneur affects the allocation of

control rights in debt contracts. Accounting-based covenants transfer con-

trol rights to lenders if accounting signals fall below certain thresholds. A

tighter covenant (i.e., a higher threshold) increases the likelihood that the

lender gains control over the firm, permitting him to take actions against

the entrepreneur’s will, such as liquidating the firm. Our model predicts

that entrepreneurs that exhibit a higher degree of optimism grant lenders

greater control by choosing tighter debt covenants. This is the case even

though the optimistic entrepreneur understands that the lender will use

the acquired control to intervene more frequently. Our model offers a

novel explanation for the empirical observation that covenants in debt

contracts are set tightly and are frequently violated (Dichev and Skinner

[2002], Chava and Roberts [2008], Nini, Smith, and Sufi [2012]).

We consider an entrepreneurwho raises capital from a lender to finance

a project. If the project is continued to completion, it succeeds if the state

1See https://www.census.gov/econ/bfs/data.html.

2See Cooper, Woo, and Dunkelberg [1988], Camerer and Lovallo [1999], Moskowitz and

Vissing-Jorgensen [2002], Hayward, Shepherd, and Griffin [2006], Koellinger, Minniti, and

Schade [2007], Landier and Thesmar [2009], and Åstebro, Nanda, and Weber [2014].

3See Larwood and Whittaker [1977], Cooper, Woo,and Dunkelberg [1988], Busenitz and

Barney [1997], Arabsheibani, Meza, and Pearson [2000], Pinfold [2001], Malmendier and

Tate[2005a], Puri and Robinson [2007], Koellinger, Minniti, and Schade [2007], Landier and

Thesmar [2009], Cassar [2010], Ben-David, Graham, and Harvey [2013], and Dawson et al.

[2014]. See also Gervais [2010] and Åstebro, Nanda, and Weber [2014] for literature reviews.