Finance and Economics Discussion Series (FEDS)
Private Equity and Debt Contract Enforcement: Evidence from Covenant Violations
We document the importance of a financial sponsor when a borrower violates a covenant, providing creditors the opportunity to enforce debt contracts. We identify PE-sponsored borrowers in the Shared National Credit Program (SNC) data and find that they violate covenants more often than comparable non-PE borrowers. Yet, compared to non-PE, PE-backed borrowers experience smaller reductions in credit commitment upon violation, suggesting lenders are more lenient with PE sponsors. This leniency effect is also stronger among financially healthier lenders. We show that our results are consistent with a repeated-deals mechanism, as lenders frequently interact with financial sponsors and choose to preserve relationship rent. Consistent with this mechanism, we find little evidence that PE-sponsored loans eventually underperform relative to non-PE-sponsored loans following covenant violations. Our findings have important implications for understanding heterogeneity in debt contract enforcement and credit constraints faced by distressed borrowers with financial sponsors.
Keywords: Private Equity Funds, Covenants, Debt Contract Enforcement, Bank Lending
PDF: Full Paper
Disclaimer: The economic research that is linked from this page represents the views of the authors and does not indicate concurrence either by other members of the Board's staff or by the Board of Governors. The economic research and their conclusions are often preliminary and are circulated to stimulate discussion and critical comment. The Board values having a staff that conducts research on a wide range of economic topics and that explores a diverse array of perspectives on those topics. The resulting conversations in academia, the economic policy community, and the broader public are important to sharpening our collective thinking.