THE ECONOMICS OF THE PRIVATE MARKET
Loans to information-problematic borrowers, which are typically medium-sized or smaller borrowers, generally have tighter covenants than loans to less-information-problematic borrowers. Covenants are one mechanism that lenders can use to reduce the likelihood of borrowers' taking actions that might lead to an expropriation of wealth from lenders. In the absence of covenant restrictions, smaller borrowers are, on average, more likely to attempt such expropriations. They often have less to lose in terms of reputation and are typically more information-problematic so that detection and control of expropriation attempts are more difficult for lenders. Thus, the more information problematic the borrower, the larger the number and the tighter the nature of covenants by lenders. Stated differently, lenders offer smaller, more problematic borrowers lower interest rates in return for tighter covenants, and thus such borrowers are more willing to negotiate debt contracts that include tight covenants. Moreover, without such covenants, lenders might refuse to make loans to such borrowers regardless of the interest rate.
Covenants in any debt contract are either affirmative covenants, negative covenants, or financial covenants (which are a subset of negative covenants). Affirmative covenants require a borrower to meet certain standards of behavior. They include requirements that the firm stay in the same business and meet its legal and contractual obligations. They are common in public bonds, private placements, and bank loans. Negative covenants restrain the borrowing firm from taking actions that would be detrimental to the bondholders. They include restrictions on capital expenditures, on the sale of assets, on dividends and other payments, on the types of investments that the firm can make, on the amount of additional debt that the firm can incur, on liens that the firm can give to other lenders, and on merger and acquisition activity. 28
Financial covenants restrict measurable financial variables and can stipulate, for example, minimums to be maintained on capital, the ratio of assets to liabilities, working capital, current ratio (current assets/current liabilities), or the ratio of earnings to fixed charges. 29 A financial covenant can be either a maintenance covenant or an incurrence covenant. With a maintenance covenant, the criterion set forth in the covenant must be met on a regular basis, say at the end of each quarter. With an incurrence covenant, the criterion must be met at the time of a prespecified event, such as the firm's making an acquisition or incurring additional debt.
The number and the tightness of negative and especially financial covenants in private placements are associated with the quality of the issuer, that is, with the degree of both its information problems and its observable risk. Tightness refers to the likelihood that a particular covenant will be binding in the future. Private placements for lower-quality issuers often include many financial covenants. 30 Contracts for moderately risky issuers often include only one or two financial covenants with minimum values farther from current values and thus less likely to be violated. Highly rated issues (A or better) usually have no financial covenants, unless their average life exceeds seven years, in which case an incurrence covenant on a debt ratio is often included. Most financial covenants in private placements are incurrence covenants, although occasionally one or two maintenance covenants may be included, especially when these are designed to match maintenance covenants in other debt of the issuer, such as bank loans.
Bank loan agreements typically contain only maintenance covenants. Financial covenants in bank loan agreements are reportedly generally tighter than in private placements, even for borrowers with the same characteristics. As with private placements, the number and the tightness of bank loan financial covenants depend on the quality of the issuer. Loans to small and mediumsized borrowers typically include many financial covenants. Very large companies, however, generally obtain bank loan facilities, frequently in the form of unfunded loan commitments, without meaningful financial covenants.
Indentures in publicly traded bonds, even for below-investment-grade bonds, generally contain no financial covenants. Beginning in 1992, however, some public junk bonds included financial covenants, especially debt ratio and interest coverage covenants. Market participants disagree on whether this development is permanent or transitory. Some participants assert that such issues were bought by investors that did not fully understand the nature of the monitoring and renegotiation activities associated with their purchases and that these investors will stop buying such issues at some future time. Others assert that such issues are, in effect, illiquid and were bought by mutual funds with staffs of credit analysts, making the instruments functionally equivalent to below-investment-grade private placements. This difference of opinion may not be resolved until some of the securities deteriorate in quality and must be renegotiated.