Managerial Optimism and Debt Covenants

The allocation of control rights between entrepreneurs and capital providers plays a central role in financial contracting and corporate governance. Debt contracts typically include accounting-based covenants that transfer control rights to lenders when accounting numbers (such as earnings) fall below certain thresholds. A tighter covenant (i.e., a higher threshold) increases the likelihood that the lender gains control, permitting the lender to take actions against the entrepreneur’s will, such as liquidating projects.

One key characteristic of entrepreneurs is that they tend to be overly optimistic about the chances of success of their own projects.[1] After all, individuals who forego other opportunities to start a new venture are typically those who overestimate the chances that their venture will be successful.[2] We develop a model to study the effects of managerial optimism on the optimal tightness of debt covenants and, hence, the optimal allocation of control rights.

Suppose first that the entrepreneur and the lender share the same beliefs about the probability of the project’s success; that is, the entrepreneur has no optimism bias. Upon observing the accounting signal, both parties update their beliefs: The higher the accounting signal, the higher the (updated) probability that the project will succeed. The entrepreneur’s ex ante optimal covenant threshold then implements the socially efficient project liquidation decision. That is, the lender receives control and liquidates the project if and only if the accounting signal is sufficiently unfavorable to make liquidation socially optimal. Choosing a looser covenant to retain more control is suboptimal for the entrepreneur ex ante since the lender protects itself by demanding a higher face value of debt.

Suppose now that the entrepreneur is more optimistic than the lender about the project’s probability of success.[3] If the entrepreneur’s sole goal was to ensure efficient continuation of the project, more optimistic entrepreneurs would choose looser covenants to retain more control and to prevent the lender from liquidating projects the optimist deems promising. We find, however, that the opposite is true: More optimistic entrepreneurs choose tighter covenants. The optimist relinquishes more control to the lender not despite, but precisely because of, the lender’s use of the gained control to liquidate some projects that are socially efficient to continue (from the entrepreneur’s and even the lender’s perspective).

The intuition for these results is as follows. To persuade the lender to participate in the project, the entrepreneur promises to repay the lender in case of project success. Such a contract is costly for the entrepreneur because she is more optimistic about the project’s success probability than the lender. The optimist would prefer to promise the lender a large repayment when the project fails, but this is not feasible due to wealth constraints. The only way the entrepreneur can reduce her perceived excess financing costs is by offering the lender a contract with a tighter covenant. A tighter covenant increases the probability of a covenant violation, which allows the lender to liquidate the project. In exchange, the lender accepts a lower face value of debt, which reduces the repayment in case of success. This shift in repayments reduces the entrepreneur’s perceived excess financing costs more quickly when she is more optimistic relative to the lender and is the reason that optimists choose tighter covenants. One implication is that firms with more optimistic entrepreneurs are more likely to be liquidated at an early stage than are firms of less optimistic entrepreneurs. This prediction does not follow because optimists are less successful than unbiased managers, but because optimists allow lenders to intervene more often to reduce their perceived excess financing costs.

In an extension of the model, we assume that the state of the world (which is indicative of future success) is sometimes observable, but not verifiable, prior to the liquidation decision. The potential observability of the state has no effect on the optimal covenant threshold when the two players have common prior beliefs. When the entrepreneur is optimistic, however, the prospect of observing the state induces her to set an even tighter covenant. The reason is again the shift in the repayments. To reduce the perceived excess financing costs, the entrepreneur wishes to protect the lender in case the parties observe the bad state, and the lender is more likely protected when the covenant is tighter.

We find that the optimal covenant can be so tight that the lender may wish to waive the covenant after a covenant violation, even when the state is ultimately not observed. This finding seems surprising since one might have expected that the same result could have been achieved simply by setting a looser covenant. However, the tight covenant is not meant to protect the lender when the accounting signal is the only relevant information but to protect the lender when non-verifiable information renders liquidation optimal despite a positive accounting signal.

The results in our model are consistent with several facts: Debt covenants are set very tightly, are frequently violated, and are often renegotiated and even waived (e.g., Chava and Roberts, 2008; Dichev and Skinner, 2002; Nini et al., 2012). We offer a novel rationale for these empirical observations based on managerial optimism.

One of the key predictions of our model is that more optimistic entrepreneurs set tighter debt covenants. To the best of our knowledge, the relation between managerial optimism and covenant tightness has not been tested yet. However, Lerner and Merges (1998) examine 200 biotech alliances between financing firms (large pharmaceutical companies) and research firms (small biotechnology companies) and find that financing firms receive significantly more control rights when the research firm’s project is in its early stage at the time the alliance is formed. This finding is consistent with our results since optimistic biases about projects’ prospects are more likely to occur for projects that are in their early stages than for projects in their later stages, when there is less uncertainty.

Further, our model suggests that firms choose tighter debt covenants when additional (noncontractible) information about the project’s prospects is more likely to become available prior to the liquidation/continuation decision. Several empirical studies show that analyst following and media coverage increase information dissemination.[4] Our model therefore predicts that firms with more analyst following and greater media attention choose debt contracts with tighter covenants. This effect is stronger when the manager is more optimistic and vanishes when the manager and the lender share common prior beliefs.

ENDNOTES

[1] See, e.g., Larwood and Whittaker (1977), Cooper et al. (1988), Arabsheibani et al. (2000), Malmendier and Tate (2005), Landier and Thesmar (2009), and Ben-David et al. (2013).

[2] See Van den Steen (2004) for a formal presentation of this argument.

[3] For a discussion of the assumption of heterogeneous prior beliefs see Morris (1995).

[4] See, e.g., Roulstone (2003), Miller (2006), and Fang and Peress (2009).

REFERENCES

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Ben-David, I., J. Graham, C. Harvey, 2013, Managerial Miscalibration, Quarterly Journal of Economics 128 (4), 1547-1584.

Chava, S. and M. Roberts, 2008, How Does Financing Impact Investment? The Role of Debt Covenants, Journal of Finance 63 (5), 2085-2121.

Cooper, A., C. Woo, and W. Dunkelberg, 1988, Entrepreneur’s Perceived Chances for Success, Journal of Business Venturing 3 (2), 97-108.

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Lerner, J., and R. Merges, 1998, The Control of Technology Alliances: An Empirical Analysis of the Biotechnology Industry, Journal of Industrial Economics 46, 125-156.

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Miller, G., 2006, The Press as a Watchdog for Accounting Fraud, Journal of Accounting Research 44 (5), 1001-1033.

Morris, S., 1995, The Common Prior Assumption in Economic Theory, Economics and Philosophy 11 (2), 227-253.

Nini, N., D. Smith, and A. Sufi, 2012, Creditor Control Rights, Corporate Governance, and Firm Value, Review of Financial Studies 25 (6), 1713-1761.

Roulstone, D., 2003, Analyst Following and Market Liquidity, Contemporary Accounting Research 20 (3), 552-578.

Van den Steen, E., 2004, Rational Overoptimism (and Other Biases), American Economic Review 94 (4), 1141-1151.

This post comes to us from professors Jakob Infuehr at the University of Southern Denmark and Volker Laux at the University of Texas at Austin’s McCombs School of Business. It is based on their recent article, “Managerial Optimism and Debt Covenants,” available here.