Growth Opportunities and Step-Down Performance Sensitive Debt

We investigate the effect of growth opportunities on a firm’s choice of step-down performance sensitive debt (PSD) jointly with leverage and debt maturity. By explicitly linking the interest rate with the borrower’s credit quality via interest-decreasing options, step-down PSD arguably attenuates the negative effect of growth opportunities on leverage. Using a large loan deal sample from the Dealscan dataset over the period between 1990 and 2006, we demonstrate three main findings. First, the negative relation between growth opportunities and leverage is attenuated by both the issuance of step-down PSD and its proportion in the debt structure after controlling for short maturity debt effect. Second, the attenuation effect of step-down PSD is concentrated in loans with high renegotiation cost. Third, firms with higher growth opportunities are more likely to borrow debt with an interest-decreasing provision. Overall the evidence suggests that an interest-decreasing provision can mitigate suboptimal investment incentives for high growth firms.