Measuring Financial Covenant Strictness in Private Debt Contracts

• In Event: Debt contracting
  In Paper Session: Debt Contracting

Abstract

We examine the measurement of financial covenant strictness in private debt contracts using
Dealscan data. Based on analysis of detailed covenant definitions from the Tearsheets dataset,
for each Dealscan covenant type we specify a "standard" covenant definition that can be
computed using Compustat. For most covenants, the average error induced by using our standard
definition rather 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.

Authors

• Peter Demerjian, University of Washington

• Edward Lamar Owens, University of Rochester