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I investigate whether and how expected future contract renegotiation considerations affect the type of covenants used in ex-ante debt contracts. Using an instrumental variables methodology, I find that when future contract renegotiation costs are expected to be high, debt contracts are less likely to include covenants that restrict the borrower’s financial flexibility. This finding suggests that, when renegotiation costs are high, borrowers and lenders avoid the use of covenants that are more likely to hold up the borrower and force her/him to bypass value-enhancing corporate policies (e.g., investments or the rebalancing of the firm’s capital structure). Consistent with this interpretation, the negative relationship between renegotiation costs and the presence of flexibility-reducing covenants becomes stronger when the borrower has fewer outside options and financial flexibility becomes more valuable. Overall, this study contributes to our understanding of how (1) renegotiation considerations affect the design of debt contracts and (2) covenants are chosen to mitigate renegotiation frictions.

Renegotiation and the Choice of Covenants in Debt Contracts