Executive Summary:
The Importance of Covenants in Corporate Financing Decisions
Key elements of corporate financial policy include the choice of debt level, the maturity structure of debt and the types of restrictive covenants included in the indentures of debt that the firm issues. Beyond this, an important feature of these financial policy choices is that they are jointly determined as a function of firm characteristics and the contracting environment that the firm faces. “The Effect of Growth Opportunities on the Joint Choice of Leverage, Maturity and Covenants” by David Mauer and Tao-Hsien Dolly King of SMU-Cox and Matthew Billet of the University of Iowa sheds new light on the importance of covenants as protective mechanisms for bondholders, but also how they impose restrictions on corporation’s growth opportunities. This analysis—an empirical investigation unexamined to date—is concerned with how a firm’s overall covenant structure relates to its growth opportunities and to its leverage and maturity choices.
Background
The decision to become levered involves a tradeoff between the costs and benefits of debt financing. The long-standing view among finance theorists is that one of the most important costs of debt financing is the potential for conflicts between stockholders and bondholders over the investment and financing policies of the firm. These agency conflicts have the potential to significantly reduce firm value and thereby temper the firm’s use of debt financing. Some of the risks of debt financing can be controlled by the use of short-term debt and covenants*. This is more important for firms having more growth options in their investment opportunity sets, since these types of firms are more likely to face conflicts between stockholders and bondholders.
Given this viewpoint of the theorists and the inherent agency conflicts, important and unanswered questions remain. First, what are the relationships among the financial policy choices of leverage, maturity and covenant structure within a firm? Specifically, how do these choices vary with firm characteristics, and especially growth opportunities? Second, recognizing that the use of short-term debt and covenants are costly mechanisms to control stockholder-bondholder conflicts, are they complements or substitutes? To answer these questions, the authors construct a large panel data set containing information on firms’ overall covenant structure, maturity structure, leverage and other characteristics, for example growth opportunities.
Covenants are important because they effectively restrict the amount of debt financing, which ultimately places restrictions on corporate-wide financing and investment decisions. Covenants are also ‘trip wires’ according to Mauer. By violating a covenant, a firm will be placed in technical bankruptcy. A firm then has to either re-negotiate the issue or go into Chapter 11. Mauer explained, “Many companies go into bankruptcy voluntarily. With a firm’s current need to pay debt obligations, if they are having cash flow difficulties, they could end up triggering one of their covenants. If this happens, a firm winds up in technical bankruptcy—non-voluntarily,” Mauer continued. “Covenants are as important a mechanism as anything else in financial decision-making.”
The Findings
The research documents that the incidence of certain types of covenants has dramatically changed over time. Most notable, the incidence of restrictions on the issuance of secured debt, change of control put provisions (i.e., poison puts), restrictions on the use of proceeds from the sale of assets, and merger restrictions have dramatically increased over the sample period. In the full sample (12,415 bond issues), the most frequent covenants are secured debt restrictions (58%), cross default provisions (66%), asset sale clauses (83%), and merger restrictions (83%). A covenant index was constructed as a measure of the strength of bondholder covenant protection; it serves as one decision variable in a system of equations with leverage and maturity decisions.
Importantly, the authors provide the first evidence that the use of restrictive covenants is systematically related to leverage, maturity and growth opportunities. Other major findings include:
• Consistent with prior studies, the authors find a strong negative relation between leverage and growth opportunities. Importantly, however, the authors establish that at the margin both short-term debt and restrictive covenants ease the negative effect of growth opportunities on leverage.
• Leverage was observed as significantly negatively related to the market-to-book ratio (a proxy for growth opportunities) and short-term debt, i.e., the more levered a firm, the lower the market-to-book ratio and less use of short-term debt. Leverage was significantly positively related to the covenant index. Firms having larger amounts of covenants in their debt issues, in fact have higher levels of debt financing, contrary to what would be assumed.
• The covenant index is significantly positively related to the market-to-book ratio, which is consistent with the view that firms use restrictive covenants to mitigate agency conflicts induced by growth opportunities.
• The liquidity risk of short-term debt has a negative direct effect on leverage and that firms with high growth opportunities use less leverage (consistent with author predictions).
• High growth firms use (or more likely are required by bondholders to use) restrictive covenants to mitigate stockholder-bondholder conflicts over the exercise of growth options, in spite of the fact that covenants have the potential to limit future investment flexibility.
• Finally, and perhaps most interesting, the covenant index and short-term debt are significantly negatively related, which supports the view that they are substitutes in addressing stockholder-bondholder agency conflicts.
More on Covenants
There are three major groups of covenants:
1. Covenants that restrict the payment of dividends;
2. Covenants that limit overall borrowing and the issuance of certain types of debt; and
3. Covenants designed to restrict investment activities.
Covenants designed to restrict one activity (e.g., financing decisions) indirectly restrict other activities (e.g., investment decisions). For example, a restriction on dividend payments indirectly influences investment decisions, because it may prevent the firm from distributing cash to shareholders that otherwise would have been used to finance positive net present value investments. Other covenants, for example restrictions on the amount of debt financing or event-risk covenants designed to protect bondholders from the dilutive effects of highly leveraged transactions, indirectly reduce the incentive to over-invest in risky investments by moderating the default risk of outstanding debt. This inter-relatedness among the activities that covenants restrict, and especially their role in helping to mitigate suboptimal investment decisions, suggests an examination of the relation between growth opportunities and a firm’s overall covenant structure.
Covenants are costly precisely because they restrict future financing and investment decisions. Although firms with high growth opportunities are more likely to face stockholder-bondholder conflicts and thereby benefit the most from restrictive covenants, it is easy to argue that these same firms would desire to preserve future financing and investment flexibility by having few if any restrictive covenants. Conversely, covenants may be relatively cheap for firms with low growth opportunities and therefore be more prevalent in these firms.
Covenant Specifics from the Study
In this study, two fixed income databases were used to analyze more than 30 different types of covenants in 12,415 bond issues by industrial and regulated firms during the period 1960 through first quarter 2003. During the period, there appears to have been a slight decline in the use of dividend restrictions. A noteworthy observation is that there were no poison puts prior to the 1985-89 sub-period. The general consensus is that poison puts were first introduced in 1986 in response to the boom in takeovers and leveraged buyouts in the 1980s, where unprotected bondholders suffered large wealth losses. Results also suggest that covenants tend to be used in groups (i.e., if an issue has one covenant it tends to have other covenants), which is inconsistent with the notion that issuers view dividend, financing and investment covenants as substitutes.
Consistent with intuition, bond issues by regulated issuers generally have fewer restrictive covenants, although not dramatically so. In the sample, 81% of senior debt issues have a covenant restricting the issuance of secured debt, which is the largest percentage having this covenant among all priority categories. As expected, below investment grade (and not-rated) bond issues tend to have a greater incidence of all types of restrictive covenants; perhaps most notable is that 69% of below investment grade issues have poison puts, while only 11% of investment grade issues have poison puts. In contrast with earlier small-sample results, little evidence was found that firms view the conversion feature in convertible debt and restrictive covenants as substitutes. One result indicated that when it is beneficial to include one covenant, it is typically beneficial to include others. More importantly, this hints that there is variability in covenant protection across firms.
Conclusion
Firms use restrictive covenants to control stockholder-bondholder conflicts over the exercise of growth options, and short-term debt and restrictive covenants are substitutes in controlling such conflicts. The liquidity risk of short-term debt has a negative direct effect on leverage and firms with high growth opportunities opt for less leverage. Short-term debt and restrictive covenants help attenuate the negative effect of growth opportunities on leverage. An important by-product of the analysis is that the authors provide the first large-sample evidence on the incidence of restrictive covenants in public debt. The use of one covenant tends to be positively correlated with the use of other covenants, suggesting that issuers view covenants restricting dividend, financing and investment decisions as complements rather than substitutes. The authors document that covenants in public debt vary substantially across bond types, firms, industries, and time.
*Section 2 in the paper discusses the theoretical relationships between growth opportunities and the firm’s choice of leverage, maturity and covenants. Another related research site summary “Dynamic Model Reflects Complexity of Corporate Financing and Investment Decisions” in the finance section provides highlights from a Journal of Financial Economics article by Mauer, Childs, and Ott. It discusses a model for corporations in determining optimal levels of initial debt, debt maturities, flexibility in adjusting debt levels at maturity dates, and asset structures in general.
Summarized by Jennifer Warren
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