THE ECONOMICS OF THE PRIVATE MARKET
The Covenant-Monitoring-Renegotiation Paradigm
The literature on covenants and that on financial intermediation offer considerable insight into the ways in which markets address issues of bondholder-stockholder conflict. Separately, however, they fall short of describing the realworld financial landscape. The literature on covenants has not adequately addressed the association of covenant constraints with information production-due diligence at the origination stage and monitoring after loan funding. In addition, although covenant constraints can be value-enhancing to the extent that they minimize costs associated with borrower-stockholder conflict, they may also be value-reducing in that they may prevent the borrowing firm from investing in positive-value projects. A complete theory must account for the fact that borrowers choosing contracts with restrictive covenants also tend to be served by lenders that provide flexible renegotiation of the contracts. Borrowers agreeing to contracts with covenants want the option to pay off their loan or the ability to renegotiate the contract if they are constrained from investing in value-enhancing projects. Like loan origination, loan renegotiation requires that lenders produce information.
The existing information-based theories of financial intermediation fall short because they generally do not capture nor analyze the dynamic nature of intermediated loans: Intermediaries produce information both at the origination stage (lender due diligence) and on a more-or-less continuous basis after funding (monitoring). 85 Dynamic production of information in conjunction with covenant restrictions enables a lender to declare a loan in default and demand immediate repayment if necessary while still offering flexibility through renegotiation. The information-based models also generally do not explain why some borrowers are served in intermediated markets and others in the public debt markets and why the contracts offered in those markets differ so dramatically. 86 What has been missing in the theoretical literature until quite recently is a link between the theory of covenants, the mechanism of renegotiation, and the information-based theory of financial intermediation.
An initial attempt at a link was offered by Berlin and Mester (1992), who developed a theoretical model in which financial intermediaries extend loans that include restrictive covenants to borrowers. In their model, covenants are beneficial because they limit the problems discussed earlier. Berlin and Mester's financial intermediaries use observable, but not necessarily verifiable, information to form the basis for renegotiation; renegotiation is beneficial because it enables borrowing firms to invest in positive-value projects that they otherwise would have forgone because of covenant restrictions. 87
In a more general setting than Berlin and Mester's, covenants can be viewed as a mechanism for triggering reevaluation of borrower riskiness by a financial intermediary. A covenant violation does not necessarily (and, indeed, usually does not) indicate that risk has increased. 88 It can occur, for example, because a borrower wishes to invest in a new value-enhancing project that would trigger a violation of a covenant restricting new investments. Lenders can determine the appropriate response to a violation only if they analyze the borrower's situation, that is, if they produce information at the time of the violation. Simple monitoring during the life of the loan is often of little use except insofar as it improves the lender's ability to respond to covenant violations because, in the absence of a violation, lenders typically cannot change the terms of the loan no matter what their monitoring reveals.
Because financial intermediaries have a comparative advantage over small individual investors in producing information about borrower risk and in facilitating renegotiation, loans with covenants, especially financial covenants, are in general naturally made by intermediaries. Also, intermediaries may have more incentive to consider granting a covenant waiver than individual investors, as individual investors that do not expect to make many loans regularly in the future may perceive that they have little to gain from granting a waiver, whereas intermediaries that regularly invest in the market may profit from a reputation for being constructively flexible. Such a reputation may give intermediaries another competitive advantage over individual investors in conducting information-intensive lending.
This view of financial intermediation is our covenant-monitoring-renegotiation (CMR) paradigm. In the paradigm, information-intensive financial intermediaries serve informationproblematic borrowers, not so much because they can more efficiently produce information at the origination stage but because they can efficiently employ covenants to control bondholder-stockholder conflicts. 89 In equilibrium, lenders entering into debt contracts that include covenants must be able to monitor efficiently, that is, must efficiently produce information throughout the life of the contract. Lenders monitor a borrower's performance for two reasons: to determine whether the borrower is in compliance with covenants and to determine the proper action in the event of a violation. 90 A covenant violation may indicate that the firm is in distress or signal that a borrower is taking actions not in the lender's interest. Covenant violations are a noisy signal about a borrower's prospects, however, because they can be based only on observable, verifiable information. To decide whether to liquidate a loan that is in technical default, to renegotiate its terms, or to waive the covenant, a lender must produce new information (including information that may not be verifiable) about the borrower, quite apart from simply determining whether the firm is in compliance with its covenants. This type of information production is often similar to that which occurs during loan origination. 91
Berlin and Mester (1992) demonstrate theoretically that the combination of tight covenants and the option to renegotiate becomes more valuable as a borrower's observable quality declines. The intuition behind this result is straightforward. For low-quality firms, information-related problems are more acute. Therefore, low-quality firms benefit the most from the inclusion of restrictive covenants in debt contracts because these covenants provide a mechanism for credibly committing to abstain from behavior that exploits the firm's lenders. However, restrictive covenants have a high probability of being binding in the future. Hence, the option to renegotiate is very valuable, and the reputation of lenders very important.
Covenants may be pareto-improving in any debt contract because they can constrain borrower behavior. Covenants used in conjunction with a debt contract offered by a financial intermediary may be especially potent, for three reasons. First, fixed costs of information production are kept down. Second, renegotiations are most feasible and least costly when the number of lenders is small. Third, because a borrower is often at a bargaining disadvantage in the event of a violation, it will contract initially only with lenders with a reputation for fair dealing in renegotiations. With their long-term presence in the credit markets, intermediaries are most able to build and maintain such reputations. Tight covenants are not present in widely distributed debt because diffuse owners cannot efficiently produce information, renegotiate, or maintain reputations.