Peter R. Demerjian

Measuring the Probability of Financial Covenant Violation in Private Debt Contracts

We examine the measurement of financial covenant strictness in private debt contracts. Based on descriptive analysis of detailed underlying covenant definitions, for each Dealscan covenant type we specify a “standard” covenant definition that can be computed using readily available data in Compustat. For most covenants, the average error induced by using our standard definition rather than using the precise covenant definitions is insignificant. Applying these findings, we compute a single Dealscan-based comprehensive measure of financial covenant strictness that utilizes information about slack, volatility of underlying covenant parameters, and their covariance across the entire set of financial covenants included in a contract. We provide evidence that this measure is superior to alternative measures of covenant strictness used in prior literature. Although measurement error undoubtedly exists, our evidence endorses a comprehensive approach to measuring covenant strictness using the full breadth of covenant slack data available in Dealscan.

Uncertainty and Debt Covenants

I examine the use of financial covenants when contracting for debt under uncertainty. Uncertainty, in the context of this study, is a lack of information about future economic events and their consequences for the borrower’s creditworthiness. I examine the implications of ex ante uncertainty that is resolved by information received following loan initiation but prior to maturity. I argue that financial covenants, by transferring control rights ex post, provide a trigger for creditor-initiated renegotiation when the borrower is revealed to be of low credit quality. Using a large sample of private loans, I predict and find that financial covenant intensity is associated with greater uncertainty. I also revisit the agency-based explanation for covenant use and find that this uncertainty explanation is robust to various controls for agency conflicts.

Income Smoothing and Debt Covenants: Evidence from Technical Default

We investigate whether income smoothing affects the usefulness of earnings for contracting through the monitoring role of earnings-based debt covenants. First, we examine initial contract design and predict that income smoothing will increase (decrease) the use of earnings-based covenants if income smoothing improves (reduces) the usefulness of earnings to monitor borrowers. We find that private debt contracts for borrowers with greater income smoothing are more likely to include earnings-based covenants. A structural model exploring the cause of this relation provides evidence that smoothing improves the ability of earnings to reflect credit risk. Second, we examine technical default following contract inception. We find that income smoothing is associated with a lower likelihood of spurious technical default (when the borrower’s economic performance has not declined but the loan nevertheless enters technical default). In contrast, we find no association between income smoothing and performance technical default (when the borrower’s economic performance has declined). Collectively, this evidence is consistent with income smoothing improving the effectiveness of earnings-based information in monitoring borrowers.

Calculating Efficiency with Financial Accounting Data: Data Envelopment Analysis for Accounting Researchers

Recent years have seen a preponderance of accounting research using data envelopment analysis (DEA) to measure efficiency. In this study, I examine the calculation of DEA efficiency, with a focus on large panel datasets of financial accounting information. Using simulation and archival data, I examine four methodological considerations that arise when calculating efficiency with panel data: calculation group size, measuring efficiency over multiple time periods, the choice of calculation group classification, and using subsets of efficiency values calculated from larger datasets. I find that each of these potentially influences the efficiency generated by DEA. Based on these methodological issues, I provide evidence and prescriptions to aid researchers using DEA in designing studies.

Assessing the Accuracy of Forward-Looking Information in Debt Contract Negotiations

We examine the how perceived accuracy of forward-looking information obtained during debt contract negotiations affects the cost of debt. The lender uses forward-looking information to screen the borrower and assess creditworthiness. However, forward-looking information is not verifiable, and therefore the lender must estimate the accuracy of forward-looking information obtained from the borrower. We find evidence consistent with the lender using the borrower’s historical forecast accuracy to estimate the expected accuracy of forward-looking information. Specifically, we find that borrowers with more accurate forecasts receive lower interest rates. We also find this effect is less pronounced when other information sources are available to assess forward-looking information.