Essays on Financial Contracting
Docgne Penlap, Sandrine
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This dissertation consists of two essays on financial contracting. In the first essay, I provide evidence that covenants in bond indentures affect firms' investment policy outside of covenant violations. Using a large dataset of public bonds, and controlling for the self-selectivity of covenant inclusion, I find that bonds with investment (financing) restrictions are associated with a decrease (increase) in investment in the two years following the issue. The effect of investment restrictions is entirely driven by firms that are more financially constrained. Both financially constrained and unconstrained firms have significantly higher investment spending after issuing a bond with financing restrictions, although the magnitude of the effect is higher in the latter group. These findings suggest that while bond covenants can help mitigate agency problems and reduce the cost of debt, they may also have externalities that lead to more investment distortions in firms that are closer to financial distress. This paper is the first to document a positive relationship between a covenant restriction and ex-post investment. In the second essay, I use a forward-looking and exogenous measure of price uncertainty to examine the causative effect of uncertainty on the choice and use of financial covenants in private and public debt contracts, as well as the role that risk management and financial frictions play in that relationship. In private loans, high uncertainty leads to more and tighter financial covenants linked to performance. Risk management attenuates the effect of uncertainty on the inclusion of financial covenants while firms characteristics especially related to default risk intensify the effect. In bond contracts, uncertainty decreases the use of financial covenants for firms that have financial covenants in an existing private loan at the time the bond is issued. These results are consistent with the theory that financial covenants help lenders economize on monitoring costs and suggest that bondholders economize on monitoring costs by free-riding on the monitoring efforts of private lenders.