THE ECONOMICS OF THE PRIVATE MARKET
Covenants and Renegotiation
Covenants can limit a borrowing firm's flexibility in financial and strategic policymaking. The constraint on flexibility can, however, be relaxed through implicit or explicit provisions for contract renegotiation, thus increasing borrowers' willingness to accept tight covenants. For example, if the pursuit of a new strategy, such as the acquisition of another firm, would violate an existing covenant, the borrower may request that the debt contract be renegotiated. It might, for example, request a waiver of the covenant. The lender analyzes the effect of the new strategy, and if the lender can establish that it will improve the prospects of the firm without increasing the risk to the lender, the lender may agree to waive or adjust the covenant. Even if the new strategy increases the risk of the loan as it is presently structured, the lender may grant a waiver if the borrowing firm agrees to adjust other terms of the debt contract. In effect, banks, insurance companies, and other lenders to information-problematic borrowers offer contracts that limit borrower incentives to take risks and still permit flexibility through contract renegotiation. They can offer flexible contracts because of their ability to monitor and analyze borrowers.
One reason information-problematic firms seldom borrow in the public market is that the benefits of covenants are hard to capture there because diffuse ownership makes them difficult to renegotiate. Knowing that renegotiation with many lenders is very costly, public bond issuers are willing to include at most a few loose covenants. Because many covenants are not feasible in public debt, much of the monitoring technology of information-intensive lenders is not useful for public debt, as public bond buyers may have no legal mechanism for controlling excessively risky borrower behavior even if they detect it. Thus many information-problematic firms are unable to borrow in the public market.
This discussion implies that bank loans, private placements, and public bonds will differ not only in the number and the tightness of covenants, but also in the frequency with which the covenants are renegotiated. As noted, the covenants in bank loans are often relatively tight, implying a high frequency of renegotiation because bank borrowers start closer to the limits in their covenants. 31 Those covenants that do appear in publicly issued bonds are relatively loose, implying a low frequency of covenant renegotiation. Private placement covenants and renegotiation rates fall between the two extremes but are generally closer to those of bank loans. The covenants in a private placement are typically violated several times during the life of the security, requiring several waivers or other renegotiations of terms (see Zinbarg, 1975, and Kwan and Carleton, 1993). 32
Including extensive, customized covenants is possible in private placements and commercial loans partly because both are negotiated debt instruments. Issuers and lenders can tailor contract terms in a way that satisfies the objectives of both as much as possible. 33 Publicly issued bonds, which are underwritten without any direct negotiation between the issuer and the investors, are seldom customized.