Electronic copy available at: http://ssrn.

com/abstract=1747909
Working Paper No. 11-06
Capital versus Performance Covenants in Debt Contracts


Hans B. Christensen
University of Chicago Booth School of Business

Valeri V. Nikolaev
University of Chicago Booth School of Business






This paper also can be downloaded without charge from the
Social Science Research Network Electronic Paper Collection:
http://ssrn.com/abstract=1747909
Electronic copy available at: http://ssrn.com/abstract=1747909

Capital versus Performance Covenants in Debt Contracts

Hans B. Christensen and Valeri V. Nikolaev
-

The University of Chicago
Booth School of Business
5807 South Woodlawn Avenue
Chicago, IL 60637

Abstract: Building on contract theory, we argue that financial covenants control the conflicts of
interest between lenders and borrowers via two different mechanisms. Capital covenants control
agency problems by aligning debtholder-shareholder interests. Performance covenants serve as
tripwires that limit agency problems via the transfer of control to lenders in states where the
value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose
costly restrictions on the capital structure, while performance covenants require contractible
accounting information to be available. Consistent with these arguments, we find that the use of
performance covenants relative to capital covenants is positively associated with (1) the financial
constraints of the borrower, (2) the extent to which accounting information portrays credit risk,
(3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on
managerial actions. Our findings suggest that accounting-based covenants can improve
contracting efficiency in two different ways.
Keywords: accounting-based covenants, private debt, financial contract design
JEL Classification: M40




First version: January 2010
This version: September 2011

-
We would like to thank an anonymous referee, Ray Ball, Ryan Ball, Mary Barth, William Beaver, Philip Berger,
Robert Bushman, Richard Frankel, Laurence van Lent, Douglas Skinner, Joshua Madsen, Haresh Sapra (the editor),
and workshop participants at the University of Chicago, London Business School, Stanford University, Tilburg
University, Washington University at St. Louis, and the Fourth Interdisciplinary Accounting Conference in
Copenhagen for helpful comments. We also thank Trevor Clark and Peter Notter from Madison Capital Funding for
helpful discussion. Financial support from the University of Chicago Booth School of Business is gratefully
acknowledged.
Electronic copy available at: http://ssrn.com/abstract=1747909
1

1. Introduction
The classic view on debt covenants expressed in Jensen and Meckling (1976) and Smith
and Warner (1979) suggests that covenants control agency problems by restricting managerial
behavior. The more recent analytical literature views covenants as tripwires that give lenders an
option to renegotiate loan terms by threatening default following a decline in economic
performance (Berlin and Mester 1992; Rajan and Winton 1995; Gorton and Kahn 2000;
Garleanu and Zwiebel 2009). Theory typically employs a generic definition of the information
signal in terms of which covenants are formulated. In practice, however, covenants are
formulated in terms of a variety of accounting ratios (Leftwich 1983; Dichev and Skinner 2002).
Little theoretical or empirical work exists on the structure of covenant packages or the tradeoffs
among financial ratios. Consequently, a number of questions remain unanswered. First, what
determines the design of covenant packages? Second, do covenants based on different
accounting ratios reduce agency costs through different mechanisms? Third, how do the
properties of the accounting system influence the choice of covenants?
In this paper, we shed light on these questions by analyzing the structure of covenant
packages in private lending agreements. We draw upon theory developed by Aghion and Bolton
(1992), who argue that, in a world with agency conflicts, financial contracts exploit two
mechanisms. First, a contract can align the interests of the contracting parties ex ante such that
there is little disagreement about the desired action ex post. Second, when interest alignment is
difficult to achieve, a contract can reallocate decision rights ex post, such that the party in control
decides on the action taken. The optimal contract trades off ex ante interest alignment against ex
post control transfers.
We hypothesize that the role of capital covenants (C-covenants) in private debt contracts
is to align ex ante debtholder-shareholder interests by requiring that shareholders maintain
2

enough capital inside the company. C-covenants, by definition, rely on information about
sources and uses of capital (i.e., balance sheet information only) and thus directly restrict the
level of debt in a firm's capital structure. C-covenants are an effective way to control the agency
costs of debt because they make the value of shareholder stakes sensitive to managerial actions
and reduce the need for debtholder interference with managerial actions. In line with this
argument, C-covenants need not be breached when performance deteriorates, as long as
shareholders participate with sufficient capital (e.g., contribute additional equity or reduce
distributions). However, C-covenants require stringent constraints placed on the capital structure
and so they are not suitable for all firms ex ante.
In contrast, we hypothesize that performance covenants (P-covenants) act as tripwires
that facilitate the contingent allocation of control to lenders, providing them with an option to
restrict managerial actions in states characterized by poor economic performance (Berlin and
Mester 1992; Dichev and Skinner 2002; Garleanu and Zwiebel 2009). P-covenants rely on
current-period profitability and efficiency indicators formulated in terms of income statement
(cash flow statement) information alone or in combination with balance sheet data (e.g., debt-to-
cash flow ratio). P-covenants are more suitable as tripwires than C-covenants because they are
likely to be more timely indicators of distress. Hence, P-covenants allow early lender
interference with managerial actions as a way to control agency problems. This mechanism,
however, relies on more frequent transfers of control, which are costly if the accounting
information is not sufficiently correlated with the state of nature (Aghion and Bolton 1992;
Gigler, Kanodia, Sapra, and Venugopalan 2009).
We develop four theory-based empirical predictions to test the arguments above. The
choice between P- and C-covenants boils down to a cost-benefit analysis of the two underlying
3

mechanisms through which contracts address the agency problems. On the one hand, the use of
C-covenants requires a substantial portion of equity capital to be effective and therefore limits
financial flexibility, which is problematic for financially constrained borrowers. Theory suggests
that stringent capital requirements may force financially constrained borrowers to forgo certain
profitable projects (Aghion and Bolton 1992). Hence, we predict that (1) the use of P-covenants
relative to C-covenants increases as borrowers become more financially constrained. On the
other hand, the use of P-covenants can also be costly because unwarranted control transfers open
the way to rent seeking. Unwarranted control transfers increase as accounting information
becomes less informative of the state of nature (i.e., contractible). Thus, we predict that (2) the
use of C-covenants relative to P-covenants increases as the contractibility of accounting
information declines. Further, if P-covenants are indeed used as tripwires, we predict that (3)
they are positively related to the frequency of contract renegotiations that waive or reset
covenants. In contrast, C-covenants are not expected to affect the likelihood of renegotiations
because they align debtholder-shareholder interests. Finally, restrictions on specific managerial
actions (i.e., negative covenants), in theory, are less likely when a contract aligns interests, while
they are likely to complement contracts relying on ex post control allocation (Aghion and Bolton
1992). As a result, we predict that (4) the use of C-covenants (P-covenants) is inversely
(positively) related to the use of negative covenants.
We find the following results, using data from lending agreements provided by Dealscan.
First, consistent with our prediction, we find that the use of P-covenants increases relative to C-
covenants as borrowers become more financially constrained. In contrast, consistent with our
second prediction, the use of C-covenants relative to P-covenants increases as the contractibility
of accounting information declines a finding that is somewhat at odds with the argument that
4

C-covenants are crowded out as accounting information becomes less useful for contracting
purposes (Demerjian 2011).
1
These results are robust to various measures of financial
constraints (Whited and Wu 2006, Kaplan and Zingales 1997, and Cleary 1999), to multiple
measures of contractibility, and to controlling for the investment opportunity set (Skinner 1993)
and covenant determinants. Third, in line with their role as tripwires, we find that P-covenants
predict future contract renegotiations. Namely, P-covenants, but not C-covenants, exhibit a
significantly positive relation to the likelihood of contract amendments. Fourth, we find that
negative covenants that restrict managerial actions are typically used in combination with P-
covenants that reallocate control, in line with contracting theory.
Overall, our evidence suggests that covenant packages employ two broad contracting
mechanisms, as proposed in Aghion and Bolton (1992). The first mechanism relies on transfers
of control and therefore requires that accounting information is contractible. This mechanism
relies on P-covenants, complemented by restrictions on specific managerial actions (negative
covenants), and is used by financially constrained borrowers with contractible accounting
information. For example, companies from the airline industry exhibit relatively heavy reliance
on P-covenants. This is in line with our expectations, as airlines are often financially
constrained, while they are likely to have contractible accounting information due to a short
product cycle. The second mechanism aligns debtholder-shareholder interests via C-covenants
that place restrictions on the capital structure and do not require negative covenants. Companies
use these covenants when incentive alignment is easier to achieve because of fewer financial
constraints and when accounting information has low contractibility. For example, companies
with greater subjectivity in performance measurement (for example due to a long product cycle)

1
More specifically, the use of C-covenants declines in the contractibility of both income statement information
(proxy C1 and C2) and balance sheet information (proxy C3); we also find that contractibility of income statement
and balance sheet information exhibit strong positive correlation (see sub-sections 5.1. and 5.3.).
5

are more likely to use C-covenants. Indeed, companies in the construction industry exhibit
relatively heavy reliance on C-covenants. Our evidence suggests that firms trade off the two
mechanisms when choosing the covenant package.
We also provide two additional sets of analyses. First, we examine the implications of
accounting information contractibility for the design of performance pricing. Ball et al. (2008)
demonstrate that credit rating-based performance pricing grids are chosen over accounting-based
performance pricing grids when accounting information is a poor predictor of credit risk
deteriorations. We refine their analysis by hypothesizing that capital indicators penalize the use
of debt in the capital structure and hence are less dependent on the ability of accounting
information to explain credit risk. Therefore, as the contractibility of accounting information
varies, we expect to observe a substitution effect between performance-based and rating-based
pricing grids but not between capital-based and rating-based pricing grids. Our results support
this prediction.
Second, we examine changes in the contracting practices leading up to and following the
credit crisis of 2008/2009. The credit crisis can be viewed as an unanticipated event leading to a
large adverse change in economic fundamentals. In line with findings in Demerjian (2011), we
document a downward trend in the frequency of C-covenants from 1996 to 2007. Interestingly,
we find a substantial reversal in the trend for C-covenants during 2008-2010. Although it is
outside the scope of this paper to identify what caused the reversal in C-covenants, the results
suggest that more weight is placed on interest alignment following the financial crisis.
This study contributes to the literature on creditor control rights and debt contract design
(e.g., Dichev and Skinner 2002; Nash et al. 2003; Frankel and Litov 2007; Nini et al. 2007;
Frankel et al. 2008; Ball et al. 2008; Bharah et al. 2008; Chava and Roberts 2008; Nikolaev
6

2010; Costello and Wittenberg-Moerman 2010; Demerjian 2010, 2011). Despite much interest
in debt contract design, Skinner (2011) argues that we still have limited knowledge of the
economic forces that shape it. We show that there are important distinctions in how P- and C-
covenants address the agency problems and that the choice between P- and C-covenants is
consistent with the theory in Aghion and Bolton (1992). This further sheds light on ways in
which accounting improves contracting efficiency (Watts and Zimmerman 1986). Contracts
either align interests between shareholders (and managers acting on their behalf) and lenders
using C-covenants or rely on ex post control transfers using P-covenants. Importantly, the
contractibility of accounting information and financial constraints affect the choice between the
contracting mechanisms.
Our paper is related to Demerjian (2010, 2011) who studies the use of balance sheet vs.
income statement covenants.
2
However, Demerjians approach and research questions are
fundamentally different from ours. Demerjian (2010) recognizes that agency problems influence
the choice of covenants, however, advocates an alternative explanation for their use. Namely, he
explains the use of covenants by uncertainty regarding credit risk per se. In contrast, agency
conflicts are the key determinant of covenant use in contract theory. Hence, our focus is on the
role of P- and C-covenants in limiting agency costs. Nevertheless, we control for potentially
confounding effects due to uncertainty. Demerjian (2011) examines how changes in accounting
regulation towards fair value accounting and the balance sheet perspective affect the choice
between covenants through time. While Demerjians hypothesis does not explain the post-crisis

2
While this classification is also appropriate, we do not use these labels for two reasons. First, the classification of
some covenants (e.g., debt-to-cash flow or debt-to-EBITDA) into balance sheet, income statement, or cash flow
statement groups is somewhat arbitrary. Second, for the purpose of our study, the labels "capital" and
"performance" are more descriptive of the economic nature of these covenants and the underlying mechanisms
through which they address agency problems.

7

increase in C-covenants (which we find), we include year fixed effects to control for changes in
accounting regulation.
3

Section 2 presents the theoretical underpinnings and develops empirical predictions;
Section 3 explains the measurement of key variables; Section 4 describes the sample selection
and provides descriptive statistics; Section 5 presents the main results; Section 6 discusses
additional implications of our analysis; and Section 7 summarizes the main results and
concludes.
2. Theory and Empirical Predictions
This section begins with a discussion of theory that posits two distinct contracting
mechanisms. Subsequently, we discuss how these mechanisms relate to financial covenants.
Finally, we derive four empirical predictions.
2.1. Contract Theory: Alternative Contracting Mechanisms
Our analysis builds on security design theory developed by Aghion and Bolton (1992).
The theory builds on the idea that contracts are incomplete because future states of nature are not
contractible. The authors model a wealth-constrained entrepreneur (manager) who approaches
an investor to raise financing for an investment project. The project return is a function of the
action taken by the entrepreneur after observing the state of nature in the interim period. The
entrepreneur enjoys private benefits of control and, as a result, conflicts of interest arise between
the investor and the entrepreneur over the future action. Contractual incompleteness makes it
impossible to specify different actions in future states and thus opens scope for wealth
expropriation. The authors show that solving this problem contractually raises issues of control
allocation. Namely, the degree of contractual incompleteness can be reduced by making control

3
In untabulated results, we control for Demerjians (2011) volatility ratio, a proxy for balance sheet focus, and our
conclusions are unchanged.
8

contingent on an accounting signal correlated with the state of nature. Thus, the optimal contract
involves a share of monetary return for the manager and a control allocation rule.
The analysis in Aghion and Bolton shows that two types of control allocations can be
efficient: unilateral and contingent control allocations. Under unilateral control, the entrepreneur
(or in some instances the investor), retains control over the business. In contrast, contingent
allocation assigns control (to the party vulnerable to expropriation) based on the realization of a
short-term performance signal. One important insight from the model is that entrepreneur
control is both feasible and efficient when the entrepreneurs and investors objectives are
aligned ex ante. If the objectives are not aligned, the entrepreneur can benefit from behaving
opportunistically in some states and expropriating investors wealth (by taking all returns). This
behavior increases the cost of external finance and reduces the investors incentives to finance
the project (leading to inefficiency).
Aghion and Bolton show that one approach to solving this problem is to align the
interests of the entrepreneur with those of the investor. To achieve this alignment, the initial
contract should give the entrepreneur a sufficient share of monetary return such that the efficient
action is chosen in every state. However, this solution is costly because investor compensation
(after compensating the entrepreneur) is often not sufficient for them to provide financing. Thus,
when the entrepreneur is financially constrained and is unable to participate with a sufficient
share of the upfront investment, some projects are not feasible, despite their positive expected
return.
An alternative approach to addressing the misalignment of interests is to create a contract
with contingent control allocation. Specifically, the investor obtains control when accounting
information indicates a state where the entrepreneur is likely to take a suboptimal action (and
9

extract rents from investors). The downside of this type of arrangement, however, is that
accounting information measures the state of nature imperfectly, and unwarranted control
reallocations are costly because they lead to either opportunistic behavior (rent extraction) or
suboptimal liquidation.
2.2. P- versus C-covenants and Agency Costs
While the theory in Aghion and Bolton (1992) does not consider distinctions among
financial covenants, we argue that the two contracting mechanisms in their study, ex ante interest
alignment versus ex post control allocation, underlie the distinctions between capital and
performance covenants. However, before describing the mechanisms in detail, we first define
the two covenant types more rigorously. We define C-covenants as covenants formulated in
terms of information about sources and uses of capital, that is, balance sheet information only.
These covenants include requirements to maintain certain levels of leverage, debt-to-equity,
loan-to-value, debt-to-tangible net worth, and current ratios (including variations of these ratios).
In contrast, we define P-covenants as covenants formulated in terms of current-period
performance or efficiency ratios. They include interest coverage, fixed charge coverage, debt-to-
earnings, and debt-to-cash flow ratios as well as earnings (cash flow) itself. See Appendix A for
the complete classification of covenants.
2.2.1. Covenants and ex ante Interest Alignment
We argue that alignment of interests between shareholders (represented by managers) and
debtholders is best achieved via C-covenants, which require that shareholders maintain enough
money inside the firm (in other words, require shareholders to have skin in the game). The
maintenance of equity capital ensures that shareholders' wealth is sensitive to opportunistic
actions that decrease firm value. This in turn aligns the interests of shareholders with those of
10

debtholders and encourages shareholders to monitor managements actions. To see how C-

covenants reduce incentives to expropriate debtholders wealth, consider the main agency
problems associated with debt: asset substitution (Jensen and Meckling 1976), debt overhang
(Myers 1977), and (3) claim dilution (Smith and Warner 1979). Asset substitution arises when
shareholders equity is relatively thin and shareholders are effectively holding a close to out-of-
the-money call option on the firms assets, which provides risk-taking incentives. A requirement
to maintain a certain level of equity capital ensures that the option is sufficiently in-the-money,
which increases shareholders downside risk and alleviates asset substitution. Debt overhang
arises when shareholders fail to undertake profitable investments, which, intuitively, also occurs
because shareholders hold close to out-of-the-money call options on the firms assets. Thus, the
return on new investments effectively accrues to debtholders. This problem declines as the
amount of shareholders capital increases. Finally, claim dilution, which occurs when the
borrower issues new debt without contributing more equity capital, is directly restricted by a
constraint on leverage. In contrast, P-covenants have substantially weaker interest alignment
effects because a company subject to such covenants can reduce the level of equity as long as its
new investments are sufficiently profitable.
4

2.2.2. Covenants and Contingent Control Allocation
We argue that contingent control transfers are best achieved via P-covenants because
they are generally timelier and more forward looking than C-covenants. Note that P-covenants
are functions of current-period performance and are informative about changes in the stock of
equity capital (profits) net of dividends. In contrast, C-covenants are based on a firm's
cumulative past profitability plus net capital contributions. Although aggregation of past profits

4
GAAP generally does not allow capitalization of future profits. Thus, financing a profitable new project with debt
alone will be difficult in the presence of capital covenants.

11

is likely to reduce idiosyncratic economic shocks and accounting noise over time, this reduction
comes at the expense of timeliness (as current-period performance receives relatively little
weight). For example, to become binding, C-covenants may require a series of losses and
shareholders' reluctance to maintain enough capital, while only a lower level of current-period
performance (which need not be a loss) is necessary for P-covenants to bind. Thus, we argue
that P-covenants address agency problems by acting as tripwires, or timely indicators of adverse
performance, that preempt suboptimal managerial actions by reallocating control to debtholders
when they are at risk of expropriation. Consequently, these covenants represent a different way
to control the contracting frictions.
5

2.3. Empirical Predictions
The theory suggests that companies trade off the costs of interest alignment with the costs
of contingent control allocation. In Aghion and Bolton, the costs of interest alignment come in
the form of a financing constraint that limits the feasibility of certain profitable projects. This
limitation occurs because the interest alignment for such projects is only feasible for relatively
low amounts of debt financing (and thus relatively high share of return given to the
entrepreneur). A financially constrained entrepreneur simply cannot offer lenders a contract that
would cover the cost of external financing while at the same time aligning the entrepreneurs
incentives, suggesting that financially constrained companies will find this contracting
mechanism less attractive. In contrast, the theory suggests that in such circumstances, it is more
efficient to rely on contingent control allocation. Based on this discussion, we predict the
following:

5
It is difficult to draw a sharp line between P- and C-covenants because a firm's level of capital and performance are
related. For example, underperformance over an extended period depletes capital. However, this correlation
prevails only over long measurement horizons. Thus, contracting parties concerned with ex ante monitoring via
interest alignment vs. ex post monitoring via timely control transfers will likely find the distinction between the two
covenant types to be important.
12

H1: Financially constrained firms rely more on performance covenants than on capital
covenants.
Contingent control allocation, however, can be rather costly because it requires a
contractible accounting signal, which exhibits considerable correlation with the state of nature.
In the absence of such correlation, contingent control allocations are inefficient because they
introduce costly (type I and type II) errors that lead to rent extraction. While the state of nature
is unobservable to the researcher, it directly maps into credit risk. Therefore, from an empirical
standpoint, performance covenants require an accounting signal to exhibit high correlation with
credit risk. Intuitively, if this is not the case, performance covenants are ineffective tripwires. In
contrast, capital covenants control the agency conflicts by aligning shareholder-debtholder
interests via sufficient equity interest and do not require accounting information to explain credit
quality. Moreover, the accounting noise present in performance measures (e.g., earnings)
reverses over time and therefore has less of an effect on capital ratios relying on cumulative
balance sheet information. Therefore, our second hypothesis is as follows:
H2: The reliance on performance (capital) covenants is positively (negatively) associated
with the ability of accounting information to explain credit risk (i.e., contractibility).
Our next prediction concerns contract renegotiations. While covenants transfer control to
lenders in certain states of the world, in practice, this situation leads to renegotiations because
lenders are less capable managers of a firms assets (e.g., Huberman and Kahn 1988). If P- and
C-covenants had the same objective, their tightness would likely be set such that the probability
of a violation or a renegotiation was the same. However, the differences in the roles of P- and C-
covenants have implications for the expected frequency of renegotiations. Indeed, control
transfers and lender monitoring via tripwire covenants is closely linked to contract renegotiations
(Berlin and Mester 1992; Garleanu and Zwiebel 2009). In contrast, alignment of interests
reduces the need for future contract renegotiations (Aghion and Bolton 1992). If C-covenants
13

align incentives while P-covenants serve as tripwires, we expect the following:

H3: Performance covenants, but not capital covenants, are positively related to the
frequency of contract amendments.
Finally, Aghion and Bolton (1992) also consider an extension of their model in which
certain actions by the entrepreneur can be restricted contractually (e.g., mergers, new financing,
or capital expenditures). They show that it is optimal to use action restrictions in conjunction
with control allocation between the two parties. Namely, contingent control allocation without
action restrictions provides greater opportunities for the entrepreneur to extract rents and, in turn,
makes it harder to raise financing ex ante. Thus, our last hypothesis is as follows:
H4: Negative covenants are used in contracts with performance covenants, but not with
capital covenants.
6


3. Measuring Financial Constraints and Contractibility

3.1. Financial Constraints

Testing our first prediction requires a measure of financial constraints. Following
extensive literature in finance, we define financial constraints as frictions that prevent a company
from undertaking certain profitable investment projects, which would be financed if internal
funds were available (e.g., Kaplan and Zingales 1997; Cleary 1999). We use three measures of
financing constraints based on prior studies: (1) the measure proposed by Whited and Wu
(2006), denoted F-Constraint-WW; (2) the measure developed by Kaplan and Zingales (1997) as
implemented by Lamont et al. (2001), denoted F-Constraint-KZ; and (3) the measure developed
by Cleary (1999), denoted F-Constraint-CL. These measures, computed as of the end of the
fiscal year before debt issuance, exhibit significant positive correlations with each other. To
reduce noise and achieve better comparability across measures, we sort the observations on each

6
This prediction does not imply that C-covenants and negative covenants are substitutes because restricting
managerial actions does not necessarily align debtholder-shareholder interests.
14

measure into three equally sized groups and use the resulting ranks in the analysis. To preserve
space, we present the details regarding the construction of each measure in Appendix B.
3.2. Contractibility of Accounting Information
Our second prediction requires us to quantify the inherent ability of accounting information
to measure the state of nature, which we define as accounting information contractibility. We
construct several proxies for the contractibility. Our approach builds on early literature that
evaluated the usefulness of accounting data in credit administration by measuring the power of
accounting ratios to explain credit ratings (Horrigan 1966, West 1970, and Kaplan and Urwitz
1979) and, more recently, estimation of the contracting value of accounting information (Ball et
al. 2008). Thus, we base our contractibility proxies on the explanatory power, pseudo R
2
, from
industry-level ordered logit regressions of long-term debt ratings on accounting variables.
7
A
low explanatory power implies the presence of a large information component for the industry
that accounting information does not capture but that affects credit risk. In this case, the
contractibility of accounting information is limited. In contrast, a high pseudo R
2
implies that
accounting benchmarks are close to being sufficient statistics for credit risk within a particular
industry, which suggests high contractibility.
We estimate four contractibility measures. The first two measures (C1 and C2) rely on
income statement information (performance indicators) return on assets and interest coverage
ratio. The third measure (C3) relies on debt-to-total assets a capital ratio. The fourth
contractibility measure (C4) is all-inclusive: it relies on the ratios used to construct the first three
measures. Finally, as an alternative to the contractibility proxies, we estimate timely loss

7
As discussed in Appendix B, there is no consensus on the most appropriate measure of fit in non-linear models.
We use Cox-Snell pseudo R
2
. As a robustness check, we repeat the analysis using R
2
from OLS regressions (where
we assign numerical values to credit ratings). We find that the results are similar to those presented in the paper and
our conclusions are unchanged.
15

recognition (TLR) within industries. TLR arguably facilitates control transfers to lenders (Ball
and Shivakumar 2005). To preserve space, we present the details of the construction of
contractibility measures and discuss key distinctions from Ball et al. (2008) in Appendix B.
4. Sample and Summary Statistics
We use Dealscan to measure reliance on accounting-based covenants and other loan
characteristics. We collect accounting variables from Compustat, and stock return data from
CRSP. We merge loans from Dealscan to Compustat using the Roberts Dealscan-Compustat
link (August 2010 vintage, see Chava and Roberts 2008). If a loan package has several credit
facilities, we aggregate information at the deal (i.e., loan) level. We exclude contracts without
covenant information from the analysis.
8
We measure a contract's reliance on covenants by
using the intensity of P- and C-covenants, which is the number of covenants of each type in the
contract. Because we are interested in understanding when one contracting mechanism
dominates the other and because the mechanisms need not be mutually exclusive, we need a
proxy for the extent to which a contract relies on C-covenants vs. P-covenants. We
operationalize this proxy by measuring the covenant mix: P/P+C ratio = P-covenants/(P-
covenants+C-covenants).
9
In section 5.6, we consider an alternative measure that summarizes
the covenant package.

8
Approximately 50% of credit agreements in Dealscan lack covenant information. It is highly unlikely that these
credit agreements do not employ covenants given that almost all private credit agreements rely on covenants (e.g.,
Christensen and Nikolaev 2011 who examine debt contracts taken from SEC filings). The absence of covenant data
is therefore likely to indicate that Dealscan was unable to obtain information on covenants. Accordingly, we
exclude contracts with no covenant information (rather than set their number to zero).

9
An advantage of the P/P+C ratio is that it captures variation in the covenant packages of firms that rely on both P-
and C-covenants, something that a discrete classification of contracts would not achieve. However, as a robustness
check, we use a discrete classification where we measure the mix of covenants by assigning the value of 0 to
contracts with C-covenants only, 1 to contracts with P-covenants only, and 0.5 to contracts that use both types of
covenants. The results are similar to those reported in our tables. Furthermore, in section 5.6.1, we present the
results where we use a common factor retained from the factor analysis of individual covenants rather than their
counts.

16

Table 1 presents the summary and correlation statistics for our main sample (additional
descriptive statistics accompany individual tests). With a mean (median) market value of assets
at $4,719 ($1,073) million, the average firm in our sample is larger than the average firm on
Compustat.
5. Results
We begin this section with a brief description of the summary statistics on covenant
packages. Subsequently, we present the empirical tests of the four predictions derived in Section
2.3. Finally, we offer several robustness checks.
5.1. Correlation among Covenants
Table 2 provides summary statistics with respect to financial covenants. Panel A
indicates that half of the sample companies have at least one C-covenant and two P-covenants.
Panel B provides Pearson correlations among individual covenant types. The five covenant
types are given by indicator variables for the presence of at least one debt-to-profitability (cash
flow or EBITDA) covenant, interest coverage covenant, liquidity covenant (current ratio),
leverage covenant, and net worth covenant. Note that interest coverage and debt-to-profitability
covenants belong to P-covenants, while liquidity, leverage, and net worth covenants belong to C-
covenants. As expected, P- and C-covenants exhibit positive correlations with other members of
their group. However, they exhibit significant negative correlations with members of the other
group. Overall, P-covenants and C-covenants exhibit a significant correlation of -0.37, which
under the null hypothesis implies either that P- and C-covenants are used interchangeably by the
same firm or, alternatively, that their purpose differs and they are used in different contracting
environments. Our analysis in Sections 5 distinguishes between these two explanations. Finally,
many contracts rely on both P- and C-covenants, which implies that the contracting parties often
17

care about both ex ante interest alignment and ex post control transfers. However, the negative
correlation between P- and C-covenants suggests that one of these mechanisms typically
dominates.
5.2. Do Financial Constraints Shape the Covenants Package?
In this subsection, we test our first hypothesis (H1), which suggests that financially
constrained firms are more likely to rely on performance covenants than on capital covenants.
We regress the covenant mix, P/P+C ratio, on the proxies of financial constraints while
controlling for the investment opportunity set (Skinner 1993) and covenant determinants
identified in prior studies (Nash et al. 2003; Billett et al. 2007; Chava and Roberts 2008; Chava
et al. 2010). Table 3 presents the results. In Model (1), we use several individual firm
characteristics that prior studies used as proxies for financial constraints (e.g., Fazzari, Hubbard,
and Petersen 1988). Namely, more mature (Age), dividend-paying firms are less likely to be
financially constrained, whereas high-leverage firms are expected to be more financially
constrained. Models (2), (3), and (4) rely on more comprehensive financial constraint measures
based on prior studies by Whited and Wu (2006), Kaplan and Zingales (1997), and Cleary
(1999), respectively (see Section 3.1. for details). We find that older, dividend-paying firms and
firms with lower leverage rely relatively more on C-covenants than P-covenants. Further, all
three financial constraints proxies exhibit positive and statistically significant coefficients. This
implies that firms rely on P-covenants in their covenants packages relatively more as they
become more financially constrained. Overall, the evidence supports our first hypothesis.
We do not derive empirical predictions regarding the relation between the covenant mix
and the control variables because it is often an empirical question. However, we offer
interpretations for several coefficients of interest. First, prior evidence on the relation between
18

covenants and the investment opportunity set is mixed. For instance, whereas Bradley and
Roberts (2004) and Demiroglu and James (2010) find that high-growth firms face more
covenants, Skinner (1993) finds that high-growth firms face fewer covenants. Prior studies do
not distinguish between P- and C-covenants, which may explain the mixed results. Indeed, we
find that companies with relatively high growth opportunities (as implied by lower book-to-
market, B/M) tend to rely on P-covenants rather than C-covenants. This result is consistent with
the cost of capital structure constraints increasing with growth opportunities.
We further find that companies with a larger portion of tangible assets (tangibility) rely
more on C- than on P-covenants. Skinner (1993) argues that having assets-in-place helps to
overcome the asset substitution and underinvestment problems because such assets can be used
as collateral and are easier to monitor via covenants. The need for tripwire covenants is
therefore likely to be lower. Nevertheless, C-covenants are likely to be useful because they
ensure that the value of the collateral (assets-in-place) exceeds a minimum threshold. Finally,
the covenant mix exhibits a positive association with loan Deal size and Maturity, which is
consistent with the coefficient on Leverage. Additionally, tripwire covenants make debt maturity
conditional on performance and hence are likely to be more valuable in contracts with longer
maturity. Overall, the covenant mix exhibits meaningful associations with a number of firm and
loan characteristics. This result suggests that the two types of covenants are used in different
situations rather than interchangeably.
5.3. Does Accounting Information Affect the Choice of Covenant Package?
To the extent that accounting information is an imperfect measure of the state of nature,
control may not be reallocated when the borrower has incentives to expropriate from lenders. In
this subsection, we test our second hypothesis (H2), which predicts that lower levels of
19

accounting information contractibility are associated with greater reliance on interest alignment,
that is, the use of C-covenants rather than P-covenants. Recall that we define contractibility as
pseudo-R
2
measuring the strength of association between credit risk categories and accounting
variables by industry (see Section 3.2. and Appendix B). Table 4 provides descriptive statistics
for the four contractibility proxies. Panel A indicates that the variation in accounting variables
explains a substantial portion of the variation in credit ratings: contractibility proxies are on
average between 19% (in the case of C3) and 35% (in the case of C4), with their minimum value
equal to 1% and their maximum value equal to 79%. Panel B shows that all contractibility
proxies exhibit high positive correlations with each other. This implies that the ability of income
statement indicators to explain credit risk is closely correlated with the ability of balance sheet
ratios to do so (it is therefore unlikely that covenant use is explained by trading off balance sheet
vs. income statement informativeness). In addition, the C1 and C2 proxies exhibit substantial
positive correlations with TLR.
Table 4, Panel C presents correlations of the contractibility proxies with P-covenants, C-
covenants, and the covenant mix. The correlations between P-covenants and the individual
proxies (C1 through C4) and TLR are all positive and statistically significant. These results are
consistent with our prediction that the use of P-covenants increases with the contractibility of
accounting information. For C-covenants, the findings inversely mirror the evidence for P-
covenants. Proxies C1 through C4 and TLR all exhibit significantly negative associations with
C-covenants. Notice that the extent to which balance sheet (capital) ratios explain credit quality
(C3) is negatively related to the use of C-covenants. This finding can be explained by the high
positive correlation of C3 with C1 and C2. As predicted, the results suggest that companies
retreat to C-covenants when accounting information does not capture the default risk.
20

Next, we perform multivariate tests by regressing the covenant mix on the contractibility
proxies C1-C4 and TLR. We also include industry-level proxies for the volatility of earnings and
cash flows as additional control variables.
10
Table 5 presents the results of this analysis. We
find that the P/P+C ratio exhibits a significant positive association with the contractibility
proxies and TLR, controlling for firm, industry, and contract characteristics. This finding
supports our prediction that firms move towards the use P-covenants and away from C-
covenants when accounting information scores high on contractibility.
Our results so far suggest that the choice of covenants is determined by the trade-off of
constraints on the capital structure that limit financial flexibility (introduced by C-covenants)
against the need for contractible information (introduced by P-covenants). This finding confirms
our prior result that the two types of covenants are used in different circumstances and hence are
not direct substitutes. This result also implies that empirical studies should be careful when
pooling (counting) P- and C-covenants to form one covenant intensity measure. This is because
covenants are not directly comparable due to differences in their economic role and due to
differences in their associations with firm characteristics and information environment.
5.4. Do Covenants Explain Contract Renegotiations?
Here, we test the third prediction (H3), that lender monitoring via P-covenants (but not
C-covenants) explains contract renegotiations. As a proxy for contract renegotiations, we use
either an indicator for the presence of at least one amendment (Amendment) or a count of
amendments (#Amendments) to a specific lending agreement on Dealscan. To increase the
likelihood that amendments are related to the renegotiation of covenants (which is of interest

10
We include industry volatility of earnings and cash flows because volatility of accounting variables may correlate
with our industry-level contractibility proxies. We also performed a robustness check where we controlled for firm-
level earnings volatility measured over the prior 20 quarters, which did not materially affect the estimated
coefficients.
21

here), we require that the amendment description contains the words "covenant", "definition", or
"provision".
11
Table 6 presents the results of this analysis. In Panel A, we present univariate
correlations between amendment frequency and the two covenant types. Both the amendment
indicator, Amendment, and the number of covenant amendments, #Amendments, exhibit a
positive correlation with P-covenants and P/P+C ratio, while they both show a negative
correlation with C-covenants.
Table 6, Panel B presents the results of a multivariate analysis of amendment frequency
controlling for a number of firm and loan characteristics. Models (1)-(3) present the estimates of
logit regressions where the dependent variable is Amendment. Models (4)-(6) present the results
of Poisson regression where the dependent variable is the count of covenant amendments (#
Amendments). The results are consistent across both types of analysis. We find that P-covenants
are a significant positive predictor of deal amendments, while C-covenants exhibit an
insignificantly negative association. The evidence supports our prediction that P-covenants act
as tripwires that transfer control to lenders. The insignificant coefficient on C-covenants is also
expected because, conditional on the use of tripwires, C-covenants are not expected to lead to
renegotiations because they align interests ex ante. Note that the loan characteristics predict
associations with amendment frequency. For example, maturity is positively associated with the
likelihood of contract amendments. This is expected, as the scope for renegotiation is more
likely to arise as time progresses.
12

11
Note that Dealscan typically records as amendments those contract modifications that require a positive vote from
the required lenders, while those modifications that require unanimous consent (e.g., changes to maturity) appear as
new loans.

12
It is worth contrasting our results with prior evidence. Previous studies report that violations of C-covenants are
more frequent than violations of P-covenants (Beneish and Press 1993; Chen and Wei 1993; Sweeney 1994), which
seems to contrast with P-covenants serving as tripwires. Several explanations are possible. First, many contract
amendments are not the result of covenant violations but of covenant modifications. Second, the violations analyzed
in prior studies represent more serious breaches that remain unresolved as of the reporting date. In contrast, a
22

5.5. How are Negative Covenants and Financial Covenants Combined?

Table 7 provides evidence on the association between the use of negative covenants and
reliance on P- vs. C-covenants. According to our fourth prediction (H4), negative covenants are
used in contracts with P-covenants but not with C-covenants. We examine three types of
negative covenants: dividend restrictions (dividend covenant), capital expenditure restrictions
(capex covenant), and the presence of cash sweeps (cash sweep). Panel A reports pairwise
correlations between P-, C-, and negative covenants. As expected, we observe significantly
positive (negative) correlations between P-covenants (C-covenants) and each negative covenant
type (consistent with Nini, Smith, and Sufi 2009).
Panel B of Table 7 presents the results of Poisson regressions in which the number of
negative covenants is regressed on P- and C-covenants, controlling for firm and loan
characteristics. We find that P-covenants and negative covenants are significantly positively
related. In contrast, C-covenants and negative covenants are significantly negatively related.
The results continue to hold when P-covenants and C-covenants are included simultaneously.
Overall, the evidence supports our prediction that restrictions on actions are used when relying
on P-covenants but not C-covenants. Intuitively, when interests are aligned, the need to limit
managerial actions does not arise and hence negative covenants are less likely.
5.6. Robustness Tests

typical P-covenant violation is expected to be less serious and hence to be renegotiated quickly (perhaps even before
the actual violation), in which case it may not be disclosed. Finally, dramatic changes have taken place in the
market for syndicated lending over the last two decades, and it is not clear to what extent tripwire-type covenants
were popular in the past. Indeed, the evidence in Figure 1, Panel B (discussed in Section 6.2) is suggestive of an
increased popularity of P-covenants. To shed some light on this issue, we examine a subset of violations based on a
recent sample constructed by Roberts and Sufi (2009). We focus on 1,000 first-time covenant violations and search
annual reports for disclosure of the covenant type violated (in more than 50% of the cases that we examined, the
type of covenant in violation is not disclosed). In contrast to prior studies, we find that during this recent period, the
first-disclosed covenant violation is twice as likely to be a result of a P-covenant violation as a C-covenant violation.
Note that these data are still likely to understate the violation of P-covenants because disclosed breaches are more
likely to be material. Nevertheless, the evidence is in line with our arguments.

23

In this section, we describe two robustness checks. First, we explore ways to measure the
reliance on covenants of each type without relying on their counts. Second, we use spreads on
credit default swaps as an alternative measure of credit risk.
5.6.1. Factor Analysis as a Way to Characterize the Covenant Package
While relying on covenant counts is a simple and intuitive way to summarize the
covenant package, we acknowledge that this may not be the best approach. As one alternative,
we use a more data-driven approach by performing factor analysis and retaining common
factors.
13
Specifically, we look for common factors among eight indicator variables (one for
each type of covenant): interest coverage covenant, debt/profitability covenant, leverage
covenant, liquidity covenant, net-worth covenant, dividend covenant, capex covenant, and cash
sweep covenant. This approach allows considering negative covenants simultaneously with
financial covenants. Another advantage of this approach (as compared to counts) is that it does
not assume that going from 0 to 1 covenant and from 1 to 2 covenants is the same. Instead, this
approach addresses how different covenants are used together by relying on correlations among
individual covenants to detect the presence of a common underlying factor(s). Hence, factor
scores can be used as a convenient way to summarize multidimensional covenant packages.
The results of factor analysis are presented in Panel A of Table 8. The panel shows that
the first factor explains 78% of the systematic variation among covenants. Examination of the
scree plot and the fact that all other factors have eigenvalues below one suggest the presence of
only one factor. Panel B of Table 8 presents the correlation between the first factor score and

13
Another alternative would be to classify contracts into three groups: C-covenants or P-covenants only and
contracts in-between. Based on descriptive statistics, we find that firms with P-covenants only are more
financially constrained and have more contractible accounting information than firms with C-covenants only; the
firms with both P- and C-covenants typically fall in between in terms of their contractibility and financial constraint
proxies. We replicate the results reported in the paper using ordered logit where the dependent variable comprises
the three groups. Our results are robust to this approach, but we do not present them here for brevity.
24

different types of covenants. We find that the first factor is negatively correlated with the three
indicators that comprise C-covenants, whereas it is positively correlated with the two indicators
that constitute P-covenants and the three negative covenant indicators. In other words, higher
factor score values indicate reliance on P-covenants and negative covenants, while lower values
indicate reliance on C-covenants. These results are consistent with two ways of designing
contracts that rely on two different contracting mechanisms: one mainly relies on P-covenants
and negative covenants and the other mainly relies on C-covenants.
Table 8, Panel C uses the factor score to replicate the analysis in Sections 5.2. and 5.3.
When we use the factor score as the dependent variable and re-estimate the models in Table 5,
we find a significantly positive correlation between the factor score and the proxies for financial
constraints and contractibility. These results suggest that financial constraints and contractibility
make the reliance on P-covenants preferable to C-covenants. Finally, in Table 8, Panel D we
replicate the analysis from Section 5.4. on the frequency of contract amendments. When we
regress the amendment indicator (Amendment) and the number of amendments (#Amendments)
on the factor score and the same control variables as in Table 6, we find that, consistent with our
prior results, contracts with P-covenants exhibit more frequent amendments than contracts with
C-covenants. Overall, the results in Table 8 confirm the conclusions from the main analysis
presented earlier.
5.6.2. Credit Default Swap Spreads as a Measure of Credit Risk
We rely on credit ratings to measure credit risk when estimating information
contractibility. Although ratings have been used in similar ways in other studies (e.g., Ball et al.
2008), they are known to lack timeliness. As an alternative to credit ratings, we use credit
default swap spreads provided by Markit to measure credit risk. Over the 2001-2009 period,
25

Markit covered approximately 1,700 U.S. companies. We were able to hand-match 1,200 of
these firms to Compustat and a further 960 of these firms to Dealscan. Individual firm time
series are generally limited to two or three years of data, which precludes firm-level analysis.
We therefore estimate the contractibility proxies at the industry level, using a procedure
analogous to that described in Appendix B. Further requiring a minimum number of
observations within an industry substantially limits the number of available observations.
Nevertheless, all results presented in this paper are confirmed and remain statistically significant
(although t-statistics are lower given the smaller sample).
6. Additional Analysis
In this section, we provide two sets of analyses that explore additional implications of our
main findings. First, we refine the analysis in Ball et al. (2008) on the choice of performance
pricing grids. Second, we study time series variation in the frequency of P- and C-covenants
around the time of the financial crisis.
6.1. Performance Pricing
Loans frequently rely on "pricing grids" that make the interest rate contingent on
accounting ratios or credit ratings (Asquith et al. 2005). We classify pricing grids into (1)
capital-based pricing grids (C-grid), which rely on capital-based accounting indicators used by
C-covenants, (2) profitability-based grids (P-grid), which rely on accounting indicators used by
P-covenants, and (3) grids based on credit ratings (Rating-grid).
14

Ball et al. (2008) demonstrate that credit rating-based performance pricing grids are
chosen over accounting-based performance pricing grids when accounting information is a poor

14
Capital indicators include senior leverage and the ratio of debt to tangible net worth; profitability (performance)
indicators include the debt service coverage ratio, fixed charge coverage, interest coverage, ratio of senior debt to
cash flow (EBITDA), and ratio of total debt to cash flow (EBITDA); and rating measures include commercial paper
rating, subordinated debt rating, and senior debt rating.

26

predictor of credit risk deteriorations. However, Ball et al. (2008) do not distinguish between C-
and P-grids in their analysis. C-grids penalize the use of debt in the capital structure and we
therefore expect them to have similar interest-aligning effects as the C-covenants described in
Section 2. As a result, C-grids are less dependent on the contractibility of accounting
information than P-grids. Therefore, as the contractibility of accounting information varies, we
expect to observe a substitution effect between performance-based and rating-based pricing grids
but not between capital-based and rating-based pricing grids.
Table 9, Panel A presents correlations among the different pricing grid types. We find
that the indicators for Rating-grid, P-grid, and C-grid exhibit negative pairwise correlations.
Further, we find high positive correlations between the type of pricing grid and the same type of
covenant (which suggests their complementarities; see Dichev et al. 2002). The presence of a
Rating-grid correlates negatively with all four contractibility proxies (this result strengthens the
validity of our contractibility proxies because we expect the use of credit ratings when
accounting information is a poor summary measure of credit risk). Finally, notice that the
inclusion of a Rating-grid exhibits a sizable negative correlation of -0.39 with P-covenants but
not with C-covenants, for which the correlation is 0.05. To the extent that the use of a Rating-
grid indicates low contractibility of accounting information, as suggested by Ball et al. (2008),
the negative correlation between Rating-grid and P-covenants supports that P-covenants are used
when accounting information is descriptive of credit quality.
Table 9, Panel B presents the results of a multinomial logit regression that explains the
use of pricing grids. We choose Rating-grid as the baseline category. The coefficient on C1
shows how the choice of P- and C-grids, relative to Rating-grid, is associated with contractibility
of accounting information (for brevity, we only report results on contractibility proxy C1). In
27

line with Ball et al. (2008), we find that the likelihood of a P-grid is increasing, relative to
Rating-grid, in the contractibility of accounting information. However, we find no significant
increase in C-grid relative to Rating-grid as the contractibility of accounting information
increases. This result is in line with the prediction that credit ratings substitute for performance
indicators when the ability of accounting information to describe credit risk declines.
6.2. Covenants Before and After the Credit Crisis
In this section, we examine over-time variation in covenants during the 1993-2010 period
(for all Dealscan loans with available covenant information). Of particular interest to us is the
credit crisis of 2008-2009, which can be viewed as an unanticipated event leading to an
unprecedented adverse change to economic fundamentals. While high growth and borrower-
favorable credit-market conditions characterized the period before the crisis, the opposite holds
in the period following the onset of the crisis (FED 2011). Lack of incentive alignment was
arguably an important contributor to the causes of the crisis (e.g., Kashyap, Rajan and Stein
2008) and, therefore, reliance on mechanisms that align the interests between borrowers and
lenders is expected to increase subsequent to the crisis.
Figure 1 depicts the frequency of P- and C-covenants annually from 1993 to 2010. We
find a steady decline in C-covenants from 1996 to 2007. This evidence is consistent with
Demerjian (2011), who argues that C-covenants became less popular due to accounting
standards, which reduce the usefulness of the balance sheet for contracting. However, we find a
strong reversal in the C-covenants trend from 2008 to 2010 (in fact, the frequency of C-
covenants is higher in 2010 than in 1998). There are also fluctuations in the frequency of P-
covenants, but no clear trends are apparent over the sample period. The sharp increase in C-
covenants from 2008 to 2010 suggests that interest alignment, as a contracting mechanism,
28

becomes more important following the credit crisis. Consistent with the idea that lenders
demand more skin in the game, the market for leveraged financing (loans financing leveraged-
buyouts, mergers and acquisitions, and share repurchases) declined by 84% during the crisis
(Ivashina and Scharfstein 2010).
15
However, we caution that the types of firms raising debt are
systematically different before and after the beginning of the crisis, and, hence, it is difficult to
establish what caused the reversal in the C-covenants trend from 2008. We leave this question
for future research.
7. Conclusion
We study the ways in which financial covenants control the conflicts of interest between
lenders and borrowers. We argue that splitting financial covenants into performance and capital
covenants is central to understanding how accounting is used to control agency problems. P-
covenants rely on measures of profitability and efficiency, whereas C-covenants rely on
information about sources and uses of capital (i.e., balance sheet information). We argue that C-
covenants align interests between borrowers and lenders by restricting the borrower's capital
structure. In contrast, P-covenants act as tripwires that transfer control to lenders when
performance deteriorates and the conflicts of interest between shareholders and lenders become
acute. This characterization of covenants is in line with contracting theory in Aghion and Bolton
(1992), on the basis of which we develop and test a series of predictions.
We find that P- and C-covenants are negatively correlated and that the choice between
these covenant types reflects trading off their costs. First, the use of P-covenants relative to C-
covenants increases with the financial constraints of the borrower, consistent with the prediction

15
One potential explanation for the increase in C-covenants since 2007 is a reduction in the contractibility of
accounting information during the financial crisis. To test whether this is indeed the case, we estimate contractibility
annually throughout the sample period. In unreported tests, we find a weak upward trend in contractibility after the
onset of the crisis, which suggests that a reduction in contractibility does not explain the upward trend in C-
covenants after 2007.
29

that capital structure restrictions are costly for financially constrained firms. Second, the use of
P-covenants relative to C-covenants decreases as the contractibility of accounting information
declines. This is also expected because unwarranted control transfers are costly. Third,
consistent with our overall prediction that P-covenants act as tripwires whereas C-covenants do
not, we find that P-covenants are significant predictors of contract renegotiations. Finally, we
find that P-covenants are used in conjunction with negative covenants that place direct
restrictions on certain managerial actions, whereas C-covenants are not, in line with C-
covenants interest alignment effects.
Taken together, the findings support the hypothesis that accounting information can be
used to either align interests between lenders and shareholders (C-covenants) or to facilitate state
contingent control allocation (P-covenants), in line with contracting theory. Future research
should benefit from considering these differences in the contracting roles of covenants.
However, the results should to be interpreted with caution because firm and contract
characteristics are endogenous.


30

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33

Appendix A: Covenant Classification

Performance-covenants: (1) Cash interest coverage ratio; (2) Debt service coverage ratio; (3) Level of
EBITDA; (4) Fixed charge coverage ratio; (5) Interest coverage ratio; (6) Ratio of debt to EBITDA; and
(7) Ratio of senior debt to EBITDA.
Capital-covenants: (1) Quick ratio*; (2) Current ratio*; (3) Debt-to-equity ratio; (4) Loan-to-value ratio;
(5) Ratio of debt to tangible net worth; (6) Leverage ratio; (7) Senior leverage ratio; and (8) Net worth
requirement.
*Note that the classification of Current and Quick ratios as capital covenants is conceptually appropriate
as they require a company to maintain enough short-term assets to cover short-term liabilities, while, for
example, leverage ratio typically concerns both short and long-term assets and liabilities.

Appendix B: Measuring Financial Constraints and Contractibility
Financial Constraint Measures
We use three measures of financing constraints: (1) the measure proposed by Whited and Wu
(2006), (2) the measure developed by Kaplan and Zingales (1998) as implemented by Lamont et al.
(2001), and (3) the measure developed by Cleary (1999). We measure all proxies at the end of the fiscal
year before debt issuance. To reduce noise and achieve better comparability across measures, we rank
observations into three groups. We assign 1 to the least constrained group, 3 to the most constrained
group, and 2 to the middle of the distribution. We discuss the three measures in more detail next.
(1) Whited and Wu (2006) construct an index of a firms external finance constraints based on a
standard intertemporal investment model augmented to account for financial frictions. They estimate the
Euler equation and model the shadow price of relaxing the financing constraint as a function of firm-
characteristics. Their financial constraint index is as follows:
0.091* 0.062* 0.021* 0.044*
0.102* 0.035*
it it it it
it it
F - Constraint -WW CF DIVPOS TLTD LNTA
ISG SG
= +
+ +
(WW)
where CF is the ratio of cash flow to total assets; DIVPOS is an indicator that takes the value of one if the
firm pays cash dividends; TLTD is the ratio of the long-term debt to total assets; LNTA is the natural log
of total assets; ISG is the firms 3-digit industry sales growth; and SG is firm sales growth. See Whited
and Wu (2006) for additional details.
(2) Kaplan and Zingales (1997) construct a direct measure of financial constraints for a relatively
small sample of companies. To do so, they examine detailed data sources that include MD&A discussion
from 10-K filings, public news data, etc. The constructed financial constraint rankings exhibit
associations with a number of firm-specific characteristics and thus allow extrapolation of the financial
constraints measure to a broader sample. Based on this idea, Lamont et al. (2001) implement the Kaplan-
Zingales financial constraints index for the Compustat population based on the following model:
1.002* / 0.28* 3.139* /
39.368* / 1.315* /
it it it it
it it
F - Constraint - KZ CashFlow K Q Debt TotalCapital
Dividends K Cash K
= + +

(KZ)
where CashFlow/K is earnings before extraordinary items plus depreciation divided by the net value of
property, plant and equipment (PPE); Q is Tobins Q measured as the market value of equity plus the
book value of debt divided by long-term debt plus equity; Debt/TotalCapital is long-term debt divided by
the sum of long-term debt and equity; Dividends/K is common plus preferred dividends divided by net
PPE; and Cash/K is cash plus cash equivalents divided by net PPE. See Lamont et al. (2001) for
additional details.
(3) Cleary (1999) follows Kaplan and Zingales (1997) but develops a classification methodology
that does not rely on hand-collected data. Instead, this approach employs discriminant analysis to
34

discriminate between companies that increased dividend payouts and those that cut dividends. We
estimate the model proposed by Cleary (1999) using logistic regression (logistic regression does not rely
on the assumption that all explanatory variables are normally distributed) and then interpolate the model
to a broader population of companies. The financial constraint index here is given by the following
equation:
0.0432* 0.0011* 0.0039* / 3.3525*
0.5723* 0.6067*
it it it it it
it
F - Constraint - CL Current FCCov Slack K NI
SalesGrowth Debt
= +
+
(CL)
where Current is the ratio of current assets to current liabilities; FCCov is fixed charge coverage
measured as pre-tax income less interest divided by the sum of interest and preferred dividends; NI is net
income margin calculated as income before extraordinary items divided by sales revenue; Sales growth is
annual growth in sales revenue; Slack/K = (cash + 0.5*inventory + 0.70*accounts receivable short term
loans)/net PPE; and Debt is long-term debt divided by total assets.
Contractibility of Accounting Information
This section explains how we construct the four contractibility measures (C1 C4) and timely loss
recognition (TLR). We define the contractibility of accounting information as its ability to capture and
explain credit risk (i.e., the inverse of noise in the signal). We base our contractibility proxies on the
explanatory power (Cox-Snell pseudo R
2
) from industry-level regressions of long-term debt ratings on
accounting variables.
16

Our approach differs from that in Ball et al. (2008), who measure the "contracting value" of
accounting information using the ability of changes in accounting information to predict credit rating
downgrades, but is similar to Horrigan (1966), West (1970), and Kaplan and Urwitz (1979). Note that our
objective is different from Ball et al. (2008). First, we use levels rather than changes in accounting data,
as we are interested in the explanatory power of variables actually used in contracts. Covenants are
written in terms of performance or capital indicator levels and thus to understand the use of different
covenant types it is important to focus on these variables. Moreover, performance indicators already
effectively inform us about changes in shareholder's capital and thus differencing capital indicators brings
us to performance measures. Specifically, differencing net worth yields current-period comprehensive
income (or earnings) net of dividends and capital contributions. If the purpose of the analysis is to
compare net worth vs. earnings as two contracting alternatives, differencing net worth is misleading.
Second, predicting credit rating downgrades with (changes in) accounting data is conceptually appealing
but less suitable for measuring contractibility.
17
This is because the lack of a credit rating downgrade,
which is typical for many firms, need not imply that accounting information is uninformative about credit
quality; rather, it may simply suggest relatively stable performance (or sluggishness of credit rating

16
There many potential ways to measure the goodness of fit in non-linear models (e.g., Long 1997, pp. 104-108)
and little consensus in the literature as to which measure is most appropriate (e.g., Hosmer and Lemeshow 2000).
Mittlbock and Schemper (1996) examine 12 measures of fit for logistic regression and advocate the simplest R
2

measure based on correlation between predicted probabilities and binary outcomes. However, this measure is not
straightforward to implement for ordered logit because there are more than two outcomes. We employ pseudo R
2

proposed by Kent (1983) and Maddala (1983, p. 39) and, subsequently, advocated by Cox and Snell (1989, pp. 208-
209) and Magee (1990). This measure (often referred to as Cox-Snell pseudo R
2
) has appealing interpretation in our
context. Specifically, it has a simple link to the R
2
from the standard linear model and can be interpreted as the
proportion of explained variation (Magee 1990). Additionally, Cox-Snell pseudo R
2
reduces to classical R
2
when
applied to a linear model, is consistent with maximum likelihood estimation (used here), and asymptotically
independent of sample size (Nagelkerke 1991) (which varies across industries). Meinel (2009) also finds that Cox-
Snell pseudo R
2
, and its variations, is preferred to McFaddens pseudo R
2
.
17
While a specification in changes allows one to get closer to a causal relation between accounting variables and
credit rating, from contracting viewpoint, the strength of association rather than the causal relation is what matters.

35

agencies).
18
In addition, because levels of earnings/capital are likely to be important in determining credit
risk, calculating changes would difference out this essential piece of information. As a result, it is difficult
to evaluate whether accounting information is a sufficient statistic for credit risk by focusing on credit
rating downgrades.
19

Given the ordinal nature of credit ratings, we use an ordered choice probability model advocated in
Kaplan and Urwitz (1979) and more recently applied by Ashbaugh-Skaife et al. (2006). Our first proxy
for contractibility, C1, is the Cox-Snell (1989) pseudo R
2
from the following industry-level ordered logit
regression:

(C1)
where Rating
it
is constructed by assigning 1 to companies with the highest credit rating following
quarter t, 2 to companies with the second-highest credit rating, and so on.
it s
E


is earnings before
extraordinary items in quarter divided by average total assets over the quarter.
20

Our second contractibility proxy, C2, is the pseudo R
2
from the industry-level ordered logit
regression:

(C2)
where Rating is defined as above and

is quarter interest coverage (EBITDA divided
by total interest expense).
Notice that both C1 and C2 are formulated in terms of performance indicators that are commonly
used in debt contracts. One may also measure the extent to which accounting information maps into credit
quality based only on balance sheet variables, i.e., capital indicators. Doing so allows us to contrast
capital ratios with performance indicators. Our third proxy, C3, is based only on one key capital indicator
leverage and is given by the pseudo R
2
from the following industry-level ordered logit regression:
0 1 2 1 3 2 4 3
4 5
it it it it it
it it
Rating Leverage Leverage Leverage Leverage
Leverage
o o o o o
o c

= + + + +
+ +

(C3)
where Rating is as defined above and is long-term debt divided by total assets in period t.
Finally, we base our all-in contractibility proxy, C4, on the pseudo R
2
from the following
industry-level ordered logit regression:
4 4 4
0
0 0 0
it k it k k it k k it k it
k k k
Rating E Coverage Leverage o | o c

= = =
= + + + +


(C4)
where all variables are as defined previously.
To construct our contractibility proxies we link the S&P Credit Ratings Database to the
Compustat quarterly database and use S&P's entity-level long-term credit ratings. Each end-of-quarter
credit rating is linked to accounting information from the current and preceding quarters. If S&P did not

18
Econometrics of panel data suggests that taking differences exacerbates measurement error when there is a lack of
within-subject (company) variation in the variables of interest (i.e., subjects are correlated over time) (Hsiao 2003,
Section 10.5).

19
As a technical complication, our data do not allow us to construct a measure of credit rating downgrades.

20
We use quarterly data, as compliance with accounting-based covenants is often determined on a quarterly basis in
private debt contracts.

0 1 2 1 3 2 4 3 5 4 it it it it it it it
Rating E E E E E o o o o o o c

= + + + + + +
t s
0 1 2 1 3 2
4 3 5 4
it it it it
it it it
Rating Coverage Coverage Coverage
Coverage Coverage
o o o o
o o c


= + + +
+ + +
it s
Coverage

t s
it
Leverage
36

update a firm's credit rating during a particular quarter, we use the most recent long-term credit rating.
S&P Credit Ratings data date back to the 1920s, but coverage is sparse before 1986. As we further require
cash flow statement data, we limit the sample to the period 1988-2008. Over this period S&P rated over
5,500 companies and on average released credit rating (or economic outlook) information 1,900 times per
year (this number ranges from about 500 in 1988 to 3,300 in 2008). In general, it takes more than a year
for S&P to update information about a given company's long-term credit rating.
Contractibility is measured based on SIC industry classification: 3-digit SIC codes are used in
cases where more than 25 companies and 250 quarterly observations are available; 3-digit SIC codes that
do not meet this requirement are combined and considered at their 2-digit level (all industries are
mutually exclusive). This procedure achieves a more balanced distribution of companies across resulting
industry groups. We further exclude industry groups with less than 25 companies or 250 quarterly
observations to improve the reliability of estimates and avoid overfitting that occurs in small samples.
This procedure results in 51 industry groups.
A question that warrants some discussion here is why private loan covenants are not written in
terms of credit ratings directly, as this has implications for whether credit ratings are suitable benchmarks
for measuring accounting information's contractibility. While it is beyond the scope of this paper to
establish why covenants are not written in terms of credit ratings, several explanations are possible. First,
the presence of conflicts of interest between rating agencies (compensated by the borrower) and
debtholders can discourage contracting on ratings. Second, circularity can arise because ratings are
determined in part by firms' access to bank financing (Standard&Poor's 2010) and therefore lenders'
decisions. For example, S&P could downgrade a company's debt in response to lenders' intention to recall
a loan, in which case contracting on ratings would make default a self-fulfilling prophesy, similar to
covenants written on credit spreads. It is worth pointing out that whereas circularity reduces the
usefulness of ratings in contracts, to our knowledge, it should not bias the contractibility proxies used in
this study. Nonetheless, as a robustness check, in Section 5.6.2. we repeat our analyses using credit
default spreads instead of credit ratings.
Timely Loss Recognition (TLR)
While there is no consensus in the accounting literature on how to measure accounting quality
(Dechow et al. 2009), we use timely loss recognition (TLR) as an alternative proxy for contractibility.
TLR, or conditional conservatism, plays an important role in debt markets (Watts 2003). In particular,
TLR improves the effectiveness of accounting-based covenants by facilitating transfers of control to
debtholders when a company approaches financial distress (Ball and Shivakumar 2005). TLR is therefore
important for tripwire-type covenants, which apart from being interesting on its own helps us validate our
main contractibility proxies.
We measure TLR as coefficient from the following industry-level regression based on Basu
(1997):
(5)
where E
t
/P
t-1
is the ratio of annual earnings before extraordinary items scaled by beginning-of-period
market value of common stock, R
t
is the stock return from CRSP compounded over the 12-month period
starting three months after the beginning of the fiscal year (to exclude prior earnings announcement
effects), and D(.) is an indicator function. We employ the same industry classification procedure when
measuring TLR, which is estimated using the intersection of CRSP and annual Compustat data.
21
We omit
1% of the observations for CRSP and Compustat variables at each tail and restrict the sample to non-
negative EBITDA (which is necessary to compute interest coverage).
22

21
The resulting set of industries is larger as we do not require S&P data to be present.

22
The results are not sensitive to this choice.
3
|
1 0 1 2 3
/ ( 0) ( 0)
t t t t t t t
E P D R R D R R | | | | c

= + < + + < +
37

Appendix C: Variable Definitions
Firm characteristics
Adv = Advertizing expense divided by total revenue (Compustat: XADV/REVT).
Age = Natural logarithm of the number of years the firms has been covered by CRSP.
B/M = book-to-market ratio (Compustat: SEQ/(PRCC_FCSHO)).
Capex = Capital expenditures divided by total assets net of capital expenditures (Compustat:
CAPX/(AT CAPX)).
Dividends = Dividend yield computed as the ratio of common dividends to the market value of equity
(Compustat: DVC/(PRCC_FCSHO)).
F-Constraints-WW= Index of financial constraints based on Whited and Wu (2006). Observations are
ranked into three categories such that the index takes values 1 to 3. See Appendix B for
details.
F-Constraints-KZ= Index of financial constraints based on Kaplan and Zingales (1997) as implemented
by Lamont et al. (2001). Observations are ranked into three categories such that the index
takes values 1 to 3. See Appendix B for details.
F-Constraints-CL= Index of financial constraints based on Cleary (1999). Observations are ranked into
three categories such that the index takes values 1 to 3. See Appendix B for details.
Leverage = ratio of long-term debt (Compustat item TLDT) to market value of total assets
(Compustat: AT SEQ + PRCC_FCSHO).
Loss = An indicator variable that takes the value of one if the firm has negative net income, and
zero otherwise.
MVAssets = the market value of total assets (Compustat: log(AT SEQ + PRCC_FCSHO)).
ROA = Return on assets defined as the ratio of income before extraordinary items to total assets.
R&D = R&D expense divided by total revenue (Compustat: XRD/REVT). Missing R&D expense
is replaced with zeros.
Size = natural logarithm of the market value of total assets (Compustat: log(AT SEQ +
PRCC_FCSHO)).
StdRet = Natural logarithm of the standard deviation of daily returns over the fiscal year.
Tangible = Asset tangibility defined as the ratio of net value of property, plant and equipment to total
assets (Compustat: PPENT/AT).
Z-Score = Altman's credit risk score computed as 1.2*(Current Assets - Current Liabilities)/Total
Assets + 1.4*Retained Earnings/Total Assets + 3.3*Pretax Income/Total Assets +
0.6*Market Capitalization/Total Liabilities + 0.999*Revenue/Total Assets.
Loan-related variables
P-covenants = Number of performance-covenants (See Appendix A for classification).
C-covenants = Number of capital-covenants (See Appendix A for classification).

38

P/P+C ratio = Covenant mix: P-covenants/(P-covenants + C-covenants).

Amendment = Indicator variable that takes the value of one if a contractual agreement was amended
prior to its maturity, and zero otherwise. Because we are interested in amendments related
to covenants, we only consider amendments where the description field contains
"covenant", "definition", or "provision".
#Amendments = Count of amendments; see Amendment..
Maturity = Months to maturity.
DealSize = Natural logarithm of total deal (all facilities included).
Secured = An indicator variable that takes the value of one if debt is secured, and zero otherwise.
LendFreq = Lending frequency computed as the number of loan deals a company has had over the
prior five years.
Revolver = An indicator variable that takes the value of one if a revolving facility exists in the deal
package, and zero otherwise.
Secured = An indicator variable that takes the value of one if debt is secured, and zero otherwise.
Dividend Covenant = An indicator variable that takes the value of one when a restriction on dividend
payments is a part of the credit agreement, and zero otherwise.
Capex Covenant = An indicator variable that takes the value of one when a restriction on capital
expenditures is a part of the credit agreement, and zero otherwise.
Cash Sweep = An indicator variable that takes the value of one when a cash sweep is part of the credit
agreement, and zero otherwise. Cash sweeps require cash proceeds from certain activities
(e.g., asset sales) are (partially) used to repay debt.
N-covenants = Sum of dividend covenant, capex covenant, and cash sweep, defined above.
Rating-grid = An indicator variable that takes the value of one if rating-based loan pricing grids is
present, and zero otherwise. Types of rating-based grids include grids formulated in terms
of: commercial paper rating, subordinated debt rating, and senior debt rating.
P-grid = An indicator variable that takes the value of one if a loan pricing grids is based on
performance (profitability) indicators. The performance indicators include: debt service
coverage ratio, fixed charge coverage ratio, interest coverage ratio, senior debt to cash flow
(EBITDA) ratio, and total debt to cash flow (EBITDA) ratio.
C-grid = An indicator variable that takes the value of one if loan pricing indicators formulated in
terms of capital ratio-based indicators. The list of capital indicators includes: leverage, debt
to tangible net worth, and senior debt leverage ratio.
Industry-level variables
C1 -- C4 = Proxies for the contractibility of accounting information, which measure the extent to
which accounting information explains S&P's entity-level long-term credit ratings. See
Appendix B for details on their construction.
StdCFOind = SIC industry-level standard deviation of cash flow from operations (see Appendix B for
industry definitions).
StdROAind = SIC industry-level standard deviation of cash flow from operations (see Appendix B for
industry definitions).
39

TLR = Proxy for timely loss recognition based on Basu (1997). See Appendix B for details on
its construction.

40

Figure 1: Frequency of P- and C-covenants from 1993 to 2010

Figure 1 presents the frequency of C-covenants (P-covenants) in Panel A (Panel B) from 1993 to 2010. We use the
most recent version of Dealscan to obtain information on financial covenants. The sample consists of 22,800 loans
for which covenant data is available on Dealscan (for these figures we do not require an available link to Compustat
or impose other data requirements). Panel A depicts the frequency by year of contracts that include at least one C-
covenant. Panel B depicts the frequency by year of contracts that include at least one P-covenant.

Panel A: Fraction of Contracts with C-covenants from 1993 to 2010


Panel B: Fraction of Contracts with P-covenants from 1993 to 2010

0.2
0.25
0.3
0.35
0.4
0.45
0.5
0.55
0.6
0.65
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
0.7
0.72
0.74
0.76
0.78
0.8
0.82
0.84
0.86
0.88
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
41

Table 1: Descriptive Statistics

Table 1, Panel A presents summary statistics for control variables used in the analysis. We obtain loan
characteristics from Dealscan, accounting and firm characteristics from Compustat, and return data from CRSP. We
restrict the sample to Dealscan observations that link to Compustat and CRSP. Contracts without covenant
information are excluded. Deals with multiple credit facilities are aggregated and considered at the deal level.
Individual variable sample size varies depending on data availability. Table 1, Panel B presents Pearson correlation
statistics. All variables are defined in Appendix C.
Panel A: Summary Statistics
VARIABLE #Obs. Mean Std.Dev. Min Median Max
MVAssets 12107 4719.0 14635.2 1.1 1073.1 556685.3
Size 12107 6.958 1.820 0.122 6.978 13.230
Age 12117 2.278 1.047 0 2.303 4.419
Leverage 11966 0.204 0.164 0 0.178 0.682
B/M 12054 0.630 0.556 -3.695 0.520 5.035
Adv 12038 0.007 0.019 0 0 0.156
R&D 12114 0.021 0.094 0 0 3.067
ROA 12107 0.018 0.113 -2.337 0.033 0.276
Loss 12107 0.222 0.416 0 0 1
Dividends 11967 0.011 0.020 0 0 0.121
Tangible 11258 0.313 0.252 0 0.239 0.990
Z-Score 11987 3.495 3.451 -1.099 2.621 21.009
StdRet 12071 0.118 0.064 0.020 0.104 0.461
StdCFOind 12117 0.123 0.048 0.020 0.118 0.293
StdROAind 12117 0.155 0.067 0.009 0.147 0.353
DealSize 12117 18.631
1.616 13.440 18.830 23.590
Maturity 11955 43.657 22.984 1 39.818 361.00
LendFreq 12117 2.368 2.237 0 2 19
Revolver 12117 0.818 0.386 0 1 1
Secured 12117 0.570 0.495 0 1 1
*Note: Additional descriptive statistics provided for individual types of analysis.

Panel B: Pearson Correlations

[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16] [17]
[1] Size 1
[2] Age 0.3 1
[3] Leverage 0.15 -0.04 1
[4] B/M -0.25 -0.03 -0.04 1
[5] Adv 0.03 0.02 -0.03 -0.05 1
[6] R&D -0.09 -0.06 -0.13 -0.08 0.00 1
[7] ROA 0.23 0.1 -0.06 -0.12 -0.01 -0.32 1
[8] Loss -0.21 -0.1 0.09 0.17 0.02 0.18 -0.6 1
[9] Dividends 0.24 0.16 0.20 0.06 -0.05 -0.09 0.07 -0.13 1
[10] Tangible 0.10 0.06 0.28 0.03 -0.07 -0.13 0.02 -0.01 0.14 1
[11] Z-Score -0.27 0.03 -0.30 -0.01 0.06 -0.07 0.05 -0.02 -0.23 -0.22 1
[12] StdRet -0.40 -0.21 -0.08 0.18 -0.01 0.14 -0.34 0.36 -0.31 -0.08 0.16 1
[13] DealSize 0.81 0.23 0.29 -0.12 0.03 -0.17 0.18 -0.16 0.19 0.13 -0.19 -0.33 1
[14] Maturity 0.07 0.00 0.20 -0.08 0.01 -0.06 0.08 -0.04 -0.10 0.08 -0.02 -0.11 0.24 1
[15] LendFreq 0.41 0.14 0.22 -0.01 -0.02 -0.10 0.07 -0.07 0.14 0.1 -0.12 -0.16 0.39 0.01 1
[16] Revolver -0.15 -0.04 -0.03 0.00 0.01 -0.05 0.01 0.00 -0.07 -0.06 0.11 0.04 0.04 0.10 -0.08 1
[17] Secured -0.43 -0.24 0.11 0.11 -0.01 0.05 -0.20 0.23 -0.26 -0.03 0.07 0.32 -0.29 0.09 -0.13 0.12 1

Table 2: Summary Statistics and Correlations among Financial Covenant Types

Table 2 presents summary statistics in Panel A and Pearson correlations among individual covenants types in Panel
B. We obtain covenant data from Dealscan. We restrict the sample to Dealscan observations that link to Compustat
and CRSP. Contracts without covenant information are excluded. Performance covenants (P-covenants) are defined
as the sum of (1) Cash interest coverage ratio; (2) Debt service coverage ratio; (3) Level of EBITDA; (4) Fixed-
charge coverage ratio; (5) Interest coverage ratio; (6) Ratio of debt to EBITDA; and (7) Ratio of senior debt to
EBITDA. Capital covenants (C-covenants) are defined as the sum of (1) Quick ratio; (2) Current ratio; (3) Debt-to-
equity ratio; (4) Loan-to-value ratio; (5) Ratio of debt to tangible net worth ratio; (6) Leverage ratio; (7) Senior
leverage ratio; (8) Net Worth; and (9) Tangible Net Worth. P/P+C ratio is defined as P-covenants divided by the
sum of P- and C-covenants.

Panel A: Summary Statistics
VARIABLE #Obs. Mean Std.Dev. Min Median Max
P-covenants 12117 1.53 0.98 0.00 2.00 6.00
C-covenants 12117 1.02 0.90 0.00 1.00 4.00
P/P+C ratio 11985 0.60 0.34 0.00 0.67 1.00

Panel B: Pairwise Correlations
VARIABLES Debt/
profitability
covenant
Interest
coverage
Liquidity
covenant
Leverage
covenant
Net worth
covenant
P-
Covenants
C-
covenants
Debt/profitability cov. 1
Interest coverage cov. 0.24 1
Liquidity covenant -0.12 -0.15 1
Leverage covenant -0.54 -0.21 0.08 1
Net worth covenant -0.14 -0.01 0.13 0.16 1
P-covenants 0.70 0.64 -0.18 -0.46 -0.09 1
C-covenants -0.43 -0.17 0.52 0.68 0.70 -0.37 1

Table 3: Covenant Mix and Financial Constraints

Table 3 presents regressions of covenant mix, P/P+C ratio, on financial constraints proxies (F-Constraint), firm-specific
characteristics, and contract specific characteristics. P/P+C ratio is defined as P-covenants/(P-covenants + C-
covenants). P-covenants is the number of performance covenants, and C-covenants is the number of capital covenants.
Classification into P- vs. C-covenants is provided in Appendix A. Financial constraints proxies are described in
Appendix B. We obtain loan characteristics from Dealscan, accounting and firm characteristics from Compustat, and
return data from CRSP. We restrict the sample to Dealscan observations that link to Compustat and CRSP. Contracts
without covenant information are excluded, and if a deal has multiple credit facilities, we aggregate information at the
deal level. All other variables are defined in Appendix C. Compustat variables are truncated at both tails using 1% cutoff
values. Robust t-statistics clustered by company and year are in brackets; *** p<0.01, ** p<0.05, * p<0.10.

(1) (2) (3) (4)
VARIABLES P/P+C ratio P/P+C ratio P/P+C ratio P/P+C ratio

Age -0.0270***
[-5.47]
Dividends -1.5074***
[-3.33]
Leverage 0.3272***
[11.76]
F-Constraint-WW 0.0473***
[7.32]
F-Constraint-KZ 0.0430***
[6.40]
F-Constraint-CL 0.0174***
[3.27]
Size -0.0365*** -0.0314*** -0.0411*** -0.0404***
[-4.68] [-3.95] [-5.27] [-4.91]
B/M -0.0790*** -0.0588*** -0.0596*** -0.0638***
[-6.73] [-4.81] [-5.04] [-5.08]
ROA 0.2016*** 0.1870*** 0.2052*** 0.2180***
[4.73] [4.42] [4.47] [5.49]
Loss 0.0598*** 0.0718*** 0.0665*** 0.0710***
[3.85] [4.63] [4.47] [4.87]
Adv 1.0149*** 1.0425*** 0.8800*** 1.0765***
[3.84] [3.81] [3.25] [4.01]
R&D -0.2398*** -0.2811*** -0.2645*** -0.2727***
[-4.59] [-4.70] [-5.08] [-4.73]
Tangible -0.1433*** -0.1081*** -0.1868*** -0.1320***
[-5.06] [-3.52] [-5.51] [-3.94]
Z-Score 0.0029*** 0.0008 0.0022* 0.0011
[2.85] [0.64] [1.80] [0.72]
StdRet -0.1292 -0.0364 -0.0615 0.0700
[-1.44] [-0.47] [-0.81] [0.79]
DealSize 0.0662*** 0.0780*** 0.0746*** 0.0728***
[10.58] [12.30] [12.06] [10.22]
Maturity 0.0025*** 0.0028*** 0.0028*** 0.0028***
[12.20] [13.17] [13.42] [11.13]
LendFreq -0.0052* -0.0031 -0.0046* -0.0038
[-1.95] [-1.23] [-1.83] [-1.42]
Revolver 0.0127 0.0005 0.0062 0.0035
[0.78] [0.03] [0.35] [0.18]
Secured 0.0575*** 0.0818*** 0.0765*** 0.0932***
[5.45] [7.78] [7.08] [8.05]
Constant -0.6044*** -0.9652*** -0.8061*** -0.7794***
[-6.89] [-10.25] [-8.39] [-7.23]
45

# Observations 10,475 10,471 10,372 9,572
R
2
0.256 0.236 0.241 0.228

Table 4: Contractibility Proxies

Table 4, Panels A and B present summary and correlation statistics for our contractibility proxies (C1-C4) and
timely loss recognition (TLR) proxy. The contractibility of accounting information is defined by its ability to capture
and explain credit risk. C1-C4 proxies are measured at the industry level by taking a pseudo R-squared from ordered
logistic regression, which explains credit ratings as a function of accounting information. TLR is also measured at
the industry level based on the methodology in Basu (1997). Appendix B provides details on construction of these
variables. Panel C presents correlations of the contractibility proxies (C1-C4) with P-covenants, C-covenants, and
P/P+C ratio. P-covenants is the number of performance covenants, and C-covenants is the number of capital
covenants. P/P+C ratio=P-covenants/(P-covenants + C-covenants). Classification into P- vs. C-covenants is
provided in Appendix A. We obtain loan characteristics from Dealscan, credit ratings from S&P Credit Ratings
Database, accounting and firm characteristics from Compustat, and return data from CRSP. We restrict the sample
to Dealscan observations that link to Compustat and CRSP. Contracts without covenant information are excluded.
Panel A: Summary Statistics
VARIABLES N Mean Std.Dev. Min p50 Max
C1 10140 0.20 0.13 0.02 0.18 0.53
C2 10140 0.29 0.17 0.01 0.22 0.76
C3 10140 0.19 0.12 0.01 0.18 0.58
C4 10140 0.35 0.17 0.05 0.34 0.79
TLR 12117 0.22 0.10 0.01 0.21 0.53

Panel B: Correlation Matrix for Contractibility Proxies
VARIABLES C1 C2 C3 C4 TLR
C1
1
C2
0.791 1
C3
0.459 0.758 1
C4
0.751 0.955 0.816 1
TLR
0.235 0.169 -0.09 0.033 1

Panel C: Correlation of Contractibility Proxies with Covenant Types
VARIABLES C1 C2 C3 C4 TLR
P-covenants 0.178 0.198 0.085 0.156 0.120
C-covenants -0.207 -0.186 -0.123 -0.176 -0.070
P/P+C ratio 0.229 0.243 0.140 0.210 0.133

Table 5: Covenant Mix and Contractibility Proxies: Controlling for Firm and Contract
Characteristics
Table 5 presents regressions of covenant mix, P/P+C ratio, on firm-specific characteristics and contract specific
characteristics. P/P+C ratio is defined as P-covenants/(P-covenants + C-covenants). P-covenants is the number of
performance covenants, and C-covenants is the number of capital covenants. Classification into P- vs. C-covenants
is provided in Appendix A. The construction of the financial constraints proxies (F-Constraint), contractibility
proxies (C1-C4), and timely loss recognition (TLR) proxy is explained in Appendix B. We obtain loan
characteristics from Dealscan, credit ratings from S&P Credit Ratings Database, accounting and firm characteristics
from Compustat, and return data from CRSP. Contracts without covenant information are excluded. The sample is
further restricted to Dealscan observations that link to Compustat and CRSP. Deals with multiple credit facilities are
aggregated into one observation and considered at the deal level. Compustat variables are truncated at both tails
using 1% cutoff values. All variables are defined in Appendix C. Robust t-statistics clustered by industry and year
are in brackets; *** p<0.01, ** p<0.05, * p<0.10.
(1) (2) (3) (4) (5)
VARIABLES P/P+C ratio P/P+C ratio P/P+C ratio P/P+C ratio P/P+C ratio

C1 0.5361***
[6.36]
C2 0.3659***
[5.25]
C3 0.3305***
[3.44]
C4 0.3444***
[5.27]
TLR 0.4155***
[3.21]
F-Constraint-WW 0.0437*** 0.0434*** 0.0413*** 0.0421*** 0.0461***
[5.24] [5.62] [5.16] [5.43] [6.93]
Size -0.0234*** -0.0158* -0.0210** -0.0182** -0.0244***
[-2.66] [-1.77] [-2.20] [-2.01] [-2.70]
B/M -0.0339** -0.0352*** -0.0381*** -0.0388*** -0.0416***
[-2.55] [-2.74] [-2.92] [-2.98] [-3.32]
ROA 0.1949*** 0.1668*** 0.1609*** 0.1641*** 0.1736***
[3.24] [3.01] [2.79] [2.90] [3.51]
Loss 0.0591*** 0.0605*** 0.0638*** 0.0622*** 0.0605***
[3.33] [3.56] [3.59] [3.57] [3.68]
Adv 0.5921* 0.8305** 1.1580*** 0.8483** 0.9349***
[1.87] [2.44] [3.12] [2.55] [2.88]
R&D -0.3489** -0.3379** -0.3475** -0.3473** -0.3582**
[-2.55] [-2.47] [-2.25] [-2.53] [-2.45]
Tangible -0.1497*** -0.1234** -0.1343* -0.1348** -0.1072
[-3.11] [-2.14] [-1.94] [-2.27] [-1.44]
Z-Score -0.0006 -0.0001 -0.0002 -0.0003 -0.0005
[-0.41] [-0.10] [-0.12] [-0.18] [-0.42]
StdRet -0.0738 -0.1193 -0.1841** -0.1351 -0.0552
[-0.87] [-1.46] [-2.14] [-1.64] [-0.63]
StdCFOind -1.4849* -1.2696 -1.3579 -1.5556* -1.6682**
[-1.82] [-1.58] [-1.54] [-1.89] [-1.98]
StdROAind 1.4382** 1.3565** 1.5625** 1.6592*** 1.1791*
[2.55] [2.29] [2.35] [2.75] [1.79]
DealSize 0.0739*** 0.0671*** 0.0710*** 0.0685*** 0.0754***
[8.35] [6.99] [6.95] [7.09] [7.74]
Maturity 0.0025*** 0.0024*** 0.0027*** 0.0025*** 0.0027***
[8.48] [8.21] [8.56] [8.41] [10.05]
LendFreq -0.0032 -0.0032 -0.0030 -0.0032 -0.0035
[-1.19] [-1.24] [-1.15] [-1.21] [-1.39]
Revolver -0.0048 -0.0041 -0.0059 -0.0056 0.0008
48

[-0.26] [-0.24] [-0.32] [-0.32] [0.05]

Secured 0.0846*** 0.0855*** 0.0852*** 0.0848*** 0.0837***
[6.81] [6.84] [6.78] [6.82] [6.85]
Constant -1.0770*** -1.0171*** -1.0249*** -1.0430*** -1.0319***
[-7.82] [-7.10] [-6.81] [-7.23] [-6.66]

Year Dummies Yes Yes Yes Yes Yes

# Observations 8,649 8,649 8,649 8,649 10,471
R
2
0.285 0.280 0.263 0.276 0.254

Table 6: Contract Amendments and Performance vs. Capital Covenants

Panel A: Univariate Analysis
Table 6, Panel A presents correlations between covenant types and contract amendments. Amendment takes the value one
if there is at least one contract amendment on Dealscan and zero otherwise. #Amendments count the number of
amendments in specific lending agreements on Dealscan. To maximize the likelihood that amendments are related to
covenant renegotiation, we search for the terms "covenant", "definition", or "provision" in the amendment description
field and exclude amendments that do not contain any of these terms. P/P+C ratio is defined as P-covenants/(P-
covenants + C-covenants). Performance covenants (P-covenants) and capital covenants (C-covenants) are defined in
Appendix A. *** indicates statistical significance at the 1% level.
VARIABLES
P-
Covenants
C-
Covenants
P/P+C ratio
Amendment 0.151*** -0.141*** 0.153***
# Amendments 0.152*** -0.107*** 0.126***
Panel B: Multivariate Analysis
Table 6, Panel B, Columns (1)-(3) present estimates from logistic regressions of Amendment, a dummy variable
indicating the presence of an amendment, on performance and capital covenants and control variables. Columns (4)-(6)
present estimates from Poisson regressions of covenant amendments count, #Amendments, on performance and capital
covenants and control variables. To construct a proxy for covenant amendments, we count the number of amendments in
specific lending agreements on Dealscan. We search for the terms "covenant", "definition", or "provision" in the
amendment description field and exclude amendments that do not contain any of these terms. Performance covenants (P-
covenants) and capital covenants (C-covenants) are defined in Appendix A; all other variables are defined in Appendix
C. We obtain loan characteristics from Dealscan, accounting and firm characteristics from Compustat, and return data
from CRSP. Contracts without covenant information are excluded, and if a deal package has multiple facilities, we
aggregate information at the deal level. Compustat variables are truncated at both tails using 1% cutoff values. Robust t-
statistics clustered by company and year are in brackets; *** p<0.01, ** p<0.05, * p<0.10.
(1) (2) (3) (4) (5) (6)
VARIABLES Amendment (Logit) # Amendments (Poisson)

P-covenants 0.155*** 0.161*** 0.116*** 0.115***
[3.84] [3.93] [3.613] [3.497]
C-covenants -0.036 0.022 -0.0420 -0.00422
[-1.01] [0.59] [-1.303] [-0.127]
Size -0.189*** -0.210*** -0.188*** -0.175*** -0.188*** -0.175***
[-5.90] [-6.89] [-5.95] [-6.18] [-6.77] [-6.17]
Age 0.002 -0.011 0.001 0.018 0.010 0.018
[0.08] [-0.57] [0.06] [1.14] [0.61] [1.15]
Leverage 0.102 0.224 0.110 0.059 0.140 0.058
[0.55] [1.27] [0.60] [0.41] [1.04] [0.42]
B/M 0.055* 0.045 0.053 0.038 0.033 0.038
[1.66] [1.37] [1.60] [1.14] [1.00] [1.12]
Adv -2.124 -2.147 -2.079 -1.326 -1.383 -1.334
[-1.53] [-1.51] [-1.50] [-1.13] [-1.12] [-1.13]
R&D -0.457* -0.611** -0.457* -0.367* -0.483** -0.366*
[-1.81] [-2.29] [-1.82] [-1.70] [-2.08] [-1.70]
ROA 0.307 0.411* 0.304 -0.072 -0.003 -0.071
[1.40] [1.79] [1.39] [-0.41] [-0.02] [-0.41]
Loss 0.109 0.110 0.113 0.114* 0.111* 0.114*
[1.50] [1.46] [1.50] [1.78] [1.66] [1.72]
Dividends -1.615 -2.441 -1.633 -1.827* -2.426** -1.823*
[-1.11] [-1.64] [-1.13] [-1.68] [-2.21] [-1.70]
Tangible 0.006 -0.074 0.004 -0.090* -0.147** -0.090*
[0.07] [-0.78] [0.04] [-1.68] [-2.54] [-1.70]
50

Z-Score 0.686 0.530 0.711 0.794* 0.599 0.789*

[1.19] [0.91] [1.24] [1.73] [1.29] [1.74]
StdRet 1.838*** 1.754*** 1.835*** 1.609*** 1.548*** 1.609***
[3.10] [3.07] [3.08] [5.60] [5.77] [5.60]
DealSize 0.261*** 0.282*** 0.262*** 0.205*** 0.219*** 0.205***
[7.52] [8.00] [7.48] [5.11] [5.39] [5.10]
Maturity 0.005*** 0.007*** 0.006*** 0.005*** 0.006*** 0.005***
[3.95] [4.76] [4.12] [4.59] [4.94] [4.55]
LendFreq 0.026 0.024 0.026 0.023** 0.022** 0.023**
[1.49] [1.43] [1.47] [2.32] [2.25] [2.32]
Revolver 0.683*** 0.699*** 0.682*** 0.576*** 0.596*** 0.576***
[11.65] [11.30] [11.51] [7.08] [7.10] [7.08]
Secured 0.326*** 0.362*** 0.326*** 0.300*** 0.330*** 0.300***
[5.31] [5.91] [5.35] [6.89] [7.87] [6.88]
Constant -7.552*** -7.603*** -7.629*** -6.117*** -6.136*** -6.102***
[-10.63] [-10.39] [-10.70] [-8.48] [-8.26] [-8.40]

Year Dummies Yes Yes Yes Yes Yes Yes

# Observations 10,827 10,827 10,827 10,675 10,675 10,675
Pseudo R
2
0.123 0.120 0.123 0.116 0.113 0.116

Table 7: The Use of Negative Covenants and Financial Covenants

Panel A: Univariate Analysis
Table 7, Panel A presents pairwise correlations of performance (P-) and capital (C-) covenants with negative covenant
types. P-covenants and C-covenants are defined in Appendix A. Dividend Covenant, Capex Covenant, and Cash Sweeps
are defined in Appendix C. All correlations are statistically significant.

VARIABLES P-covenants C-covenants
Dividend
Covenant
Capex
Covenant
Cash
Sweeps
P-covenants 1
C-covenants -0.369 1
Dividend Covenant 0.227 -0.088 1
Capex Covenant 0.185 -0.190 0.208 1
Cash Sweep 0.287 -0.097 0.219 0.120 1
Panel B: Multivariate Analysis
Table 7, Panel B, Columns (1)-(3) present estimates from Poisson regressions of the number of negative covenants on
performance and capital covenants and control variables. N-covenants is a count of the indicator variables for dividend
covenant, capital expenditures (capex) covenant, and the presence of at least one cash sweep. Performance covenants (P-
covenants) and capital covenants (C-covenants) are defined in Appendix A; all other variables are defined in Appendix
C. We obtain loan characteristics from Dealscan, accounting and firm characteristics from Compustat, and return data
from CRSP. Contracts without covenant information are excluded, and if a deal package has multiple facilities, we
aggregate information at the deal level. Compustat variables are truncated at both tails using 1% cutoff values. Robust t-
statistics clustered by company and year are in brackets; *** p<0.01, ** p<0.05, * p<0.10.
(1) (2) (3)
VARIABLES N-covenants (Poisson)

P-covenants 0.134*** 0.125***
[13.32] [14.97]
C-covenants -0.078*** -0.037*
[-3.54] [-1.78]
DealSize 0.134*** 0.148*** 0.132***
[12.47] [11.80] [11.66]
Maturity 0.002*** 0.003*** 0.002***
[3.19] [4.70] [2.84]
LendFreq -0.001 -0.001 -0.000
[-0.18] [-0.25] [-0.07]
Revolver -0.025 -0.006 -0.025
[-0.62] [-0.14] [-0.63]
Secured 0.347*** 0.379*** 0.347***
[5.66] [6.18] [5.68]
Size -0.091*** -0.108*** -0.093***
[-7.12] [-7.80] [-6.92]
Age -0.006 -0.015* -0.006
[-0.71] [-1.80] [-0.65]
Leverage 0.185*** 0.263*** 0.170***
[4.06] [6.44] [3.90]
B/M 0.010 0.006 0.012
[0.65] [0.38] [0.78]
Adv -0.266 -0.343 -0.338
[-0.77] [-0.94] [-0.98]
R&D -0.279*** -0.368*** -0.276***
[-4.03] [-4.91] [-3.97]
52

ROA 0.088 0.156* 0.091

[0.94] [1.82] [0.99]
Loss 0.086*** 0.078*** 0.080***
[4.60] [4.44] [4.41]
Dividends -2.629*** -3.384*** -2.619***
[-4.44] [-5.19] [-4.43]
Tangible -0.123*** -0.180*** -0.119***
[-2.61] [-3.99] [-2.64]
Z-Score 0.451*** 0.267** 0.426***
[3.59] [2.12] [3.36]
StdRet 0.812*** 0.745*** 0.817***
[4.93] [4.25] [5.01]
Constant -2.660*** -2.573*** -2.533***

[-10.82] [-8.07] [-8.74]

Year Dummies Yes Yes Yes

# Observations 10,726 10,726 10,726
56

Table 8: Robustness Check Based on Factor Analysis of Covenant Package

Table 8, Panel A presents the summary of factor analysis on binary variables that include eight indicator variables --
one for the presence of (at least one) leverage covenant, liquidity covenant, net worth covenant, debt-to-profitability
covenant, dividend covenant, capex covenant, and cash flow sweep covenant. The factor analysis is based on
tetrachoric correlation matrix, as these variables are binary. Panel B shows Pearson correlations of the retained first
factor score with each individual covenant type. Panel C replicates the analysis in Table 5 using the retained first
factor score as the dependent variable to examine how financial constraints and accounting contractibility proxies
affect the covenant package. The construction of financial constraint proxies, contractibility proxies (C1-C4), and
timely loss recognition (TLR) proxy is explained in Appendix B. Panel D replicates the analysis in Table 6 using the
retained first factor score to explain the frequency of contract amendments. Column (1) presents estimates from
logistic regressions of Amendment, a dummy variable indicating the presence of an amendment, on performance and
capital covenants and other control variables. Column (2) presents estimates from Poisson regressions of covenant
amendments count, #Amendments, on performance and capital covenants and other control variables. To construct a
proxy for covenant amendments, we count the number of amendments in specific lending agreements on Dealscan.
We search for the terms "covenant", "definition", or "provision" in the amendment description field and exclude
amendments that do not contain any of these terms. Performance covenants (P-covenants) and capital covenants (C-
covenants) are defined in Appendix A. We obtain loan characteristics from Dealscan, credit ratings from S&P Credit
Ratings Database, accounting and firm characteristics from Compustat, and return data from CRSP. Contracts
without covenant information are excluded. The sample is further restricted to Dealscan observations that link to
Compustat and CRSP. Deals with multiple credit facilities are aggregated into one observation and considered at the
deal level. Compustat variables are truncated at both tails using 1% cutoff values. All variables are defined in
Appendix C. Robust t-statistics clustered by industry and year are in brackets; *** p<0.01, ** p<0.05, * p<0.10.
Panel A: Eigenvalues and Explained Variance
Factor Eigenvalue Proportion of variance explained
Factor1 2.431 0.779
Factor2 0.592 0.190
Factor3 0.371 0.119
Factor4 0.338 0.108
Factor5 -0.027 -0.009
Factor6 -0.117 -0.038
Factor7 -0.169 -0.054
Factor8 -0.299 -0.096

Panel B: Correlations of Package Factor Score with Covenants
C-covenants P-covenants N-covenants
Leverage
covenant
Liquidity
covenant
Networth
covenant
Debt to
profitability
covenant
Interest
coverage
covenant
Dividend
restriction
Capex
restriction
Sweep
covenant
-0.847 -0.259 -0.27 0.858 0.409 0.234 0.205 0.228

Panel C: Contractibility and Covenant Package Factor Score
(1) (2) (3) (4) (5)
VARIABLES factor score factor score factor score factor score factor score

C1 0.3994***
[5.04]
C2 0.2998***
[4.64]
C3 0.3005***
[3.38]
57

C4 0.2756***
[4.67]
TLR 0.3660***
[2.83]
F-Constraint-WW 0.0711*** 0.0713*** 0.0696*** 0.0702*** 0.0745***
[8.07] [8.41] [8.03] [8.16] [9.55]
Control variables Yes Yes Yes Yes Yes
Year Dummies Yes Yes Yes Yes Yes

# Observations 8,746 8,746 8,746 8,746 10,591
R
2
0.335 0.336 0.328 0.333 0.314

Panel D: Contractibility and Covenant Package Factor Score
(1) (2)
VARIABLES Amendment (Logit) # Amendments (Poisson)

Factor score 0.526*** 0.436***
[8.00] [5.28]

Control variables Yes Yes
Year Dummies Yes Yes

# Observations 10,595 10,595
Pseudo R
2
0.14 0.11


58

Table 9: Correlation Matrix for Performance Pricing Types, Covenant Types, and
Contractibility Proxies
Panel A: Univariate Analysis
Table 9, Panel A presents Pearson correlations among performance pricing grid types, covenant types, and
contractibility proxies. Rating-grid, P-grid, and C-grid are rating-, profitability-, and capital-based performance
pricing grids, respectively, and are defined in Appendix C. P-covenants and C-covenants are performance and
capital covenants, respectively, and are defined in Appendix A. The construction of contractibility proxies (C1-C4)
is explained in Appendix B.

P-covenants C-covenants Rating-grid P-grid C-grid
P-covenants 1
C-covenants -0.369 1
Rating-grid -0.391 0.049 1
P-grid 0.535 -0.220 -0.646 1
C-grid -0.150 0.330 -0.176 -0.276 1

C1 0.178 -0.207 -0.112 0.268 -0.101
C2 0.198 -0.186 -0.186 0.295 -0.079
C3 0.085 -0.123 -0.111 0.187 -0.069
C4 0.156 -0.176 -0.149 0.266 -0.072

Panel B: Multivariate Analysis
Table 9, Panel B presents estimates from multinomial logit regressions of pricing grid types on the contractibility
proxy C1 and control variables. Rating-grid (baseline outcome), P-grid, and C-grid are indicators for rating-,
profitability-, and capital-based performance pricing grids, respectively, and are defined in Appendix C. The C1 is a
contractibility proxy described in Appendix B, and all control variables are defined in Appendix C. We obtain loan
characteristics from Dealscan, credit ratings from S&P Credit Ratings Database, accounting and firm characteristics
from Compustat, and return data from CRSP. Contracts without performance based pricing grids are excluded, and
if a deal package has multiple facilities, we aggregate information at the deal level. Compustat variables are
truncated at both tails using 1% cutoff values. Robust t-statistics clustered by industry are in brackets; *** p<0.01,
** p<0.05, * p<0.10.

(1) (2)
VARIABLES P-grid C-grid

C1 2.1518** 0.3377
[2.29] [0.31]

Control variables Yes
Year Dummies Yes

Observations 5,375
Pseudo R
2
0.479