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Contracting Costs, Covenant-Lite Lending, and Reputational Capital

Published online by Cambridge University Press:  07 August 2023

Dominique C. Badoer ,
Mustafa Emin Open the ORCID record for Mustafa Emin [Opens in a new window]  and
Christopher M. James Open the ORCID record for Christopher M. James [Opens in a new window]
Dominique C. Badoer
Affiliation:
University of Illinois Chicago College of Business Administration [email protected]
Mustafa Emin
Affiliation:
Tulane University A. B. Freeman School of Business [email protected]
Christopher M. James*
Affiliation:
University of Florida Warrington College of Business
*
[email protected] (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

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Using a large sample of leveraged loans, we provide evidence that, despite having fewer creditor control rights, covenant-lite (Cov-Lite) loans have similar recovery rates and significantly lower spreads than loans with maintenance covenants. We find that the propensity to borrow Cov-Lite is related to various proxies for the reputational capital of a borrowing firm’s private equity sponsor. We construct a simple model to illustrate the relationship between reputational capital, covenants, and loan spreads in the leveraged loan market. Our model illustrates how reputational capital can substitute for covenants in mitigating agency costs of debt, leading to lower loan spreads for Cov-Lite loans.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 7 , November 2024 , pp. 3376 - 3415
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Thierry Foucault (the editor), Boris Vallée (the referee), seminar participants at the Australian National University, Copenhagen Business School, University of Colorado Boulder, and conference participants at the 2020 FMA Annual Meeting for their helpful comments and suggestions. A prior version of this article was titled “Contracting Costs and Reputational Contracts.”

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