Tough Love: The Effects of Debt Contract Design on Firms' Performance

Abstract

I investigate whether restrictive loan covenants disrupt or improve firm operating performance. Using an instrumental variables approach to address the endogenous relationship between covenant strictness and firms' efficiency, I find stricter loan covenants cause an increase in profitability and a reduction in operating cost. Stricter covenants improve performance only in firms with poor governance: those without large shareholder ownership, with weaker shareholder rights, facing softer competition in their product market, or with inside director dominated boards. The evidence is consistent with the view that the design of debt contracts can mitigate agency costs in firms that lack alternative governance mechanisms.