The following post comes to us from Hans Christensen and Valeri Nikolaev, both of the Department of Accounting at the University of Chicago.
In the paper, Capital versus Performance Covenants in Debt Contracts, which was recently made publicly available on SSRN, we propose a simple classification of financial covenants into two distinct groups: performance covenants and capital covenants. Performance covenants rely on measures of profitability and efficiency whereas capital covenants rely on information about sources and uses of capital, i.e., balance sheet information. We argue that capital covenants align incentives between borrowers and lenders by limiting the amount of debt in the borrower’s capital structure. In contrast, performance covenants act as tripwires that transfer control to lenders when performance deteriorates and hence incentive conflicts between shareholders and lenders become more acute.