The Impact of Corporate Governance on Covenant Use in Private Debt Contracts

Abstract

This thesis examines the association between corporate governance and the restrictiveness of covenants used in private debt contracts in the U.S. Both corporate governance and covenants have been shown to play a role in mitigating agency problems associated with debt. A complementary relationship may be expected between these two monitoring mechanisms but it is unclear whether corporate governance has any influence on the way covenants are used to mitigate debtholder-shareholder conflicts. Using an agency framework, this thesis argues that debtholders will consider a firm’s corporate governance when estimating its potential agency costs. The central hypothesis is that, ceteris paribus, firms with stronger corporate governance will be perceived by debtholders to be less likely to engage in ex-post opportunistic activities that will expropriate wealth and reduce the value of the claims, thereby reducing the need to use particularly restrictive covenants. The strength of corporate governance will be measured using both a governance index/score as well as firm specific characteristics such as board independence and board expertise. Several measures of covenants restrictiveness will be employed including the number of covenants, a covenant-intensity-index, a covenant slack and contract-specific accounting measurement requirements such as the use of fixed or rolling GAAP. This thesis also explores the relation between corporate governance and performance pricing, a contractual feature that is often included, in addition to covenants, in private debt contracts. Given that performance pricing helps address deterioration in a firm’s future credit quality by directly linking ex-ante pricing of debt with the firm’s ex-post performance, the expectation is it complements the role of covenants, particularly in cases where covenants are less restrictive. Accordingly, it is hypothesised that, ceteris paribus, performance pricing is more likely to be included in the debt contracts of firms with stronger corporate governance. Some preliminary results will be presented at the symposium.