Debt Covenants and the Value of Commitment

Abstract

In a dynamic setup, the value of a capital structure policy for a firm depends on shareholders’ commitment. We analyze whether debt covenants can be com- mitment devices and their disciplinary effect on firm policies. While renegotiation following covenant violations allows for debt holders’ control and improves the ex post firm value, it weakens commitment on leverage policies and leads to ex ante firm value losses similar to those under no covenants, as well as a rigid debt issuance policy which is unable to respond to productivity shocks. Therefore, frictions that hinder ex post renegotiation are crucial for covenants to be commitment devices. Under commitment, covenants that discipline the leverage improve firm value the most because they restore the flexibility of debt policy. Instead, covenants de- signed to deliver ex post debt protections, like debt and asset sweeps, are less efficient, as they do not affect the dynamics of leverage. An efficient covenant also has a positive effect on investments.