Private Equity and Debt Contract Enforcement: Evidence from Covenant Violations

Abstract

Using the Shared National Credit supervisory data, we find Private Equity (PE) sponsored firms violate loan covenants more often than comparable non-PE firms. However, upon covenant violation, PE-sponsored borrowers experience relatively smaller reductions in credit commitments, suggesting lenders are more lenient with these borrowers. This limited-punishment effect exists in both covenant-heavy and covenant-lite loans but is stronger for banks with relatively higher capital. Limited punishment is driven by repeated deals and sponsor reputation, as well as the higher bargaining power of sponsors in loan renegotiation. Our results indicate sponsors generate financial flexibility by dampening debt contract enforcement for distressed borrowers.