Conflicting Priorities: A Theory of Covenants and Collateral
Abstract: Debt secured by collateral is repaid ahead of unsecured debt, even if taken in violation of covenants. We develop a model in which this priority leads to conflicts among debt contracts, but can be optimal nonetheless. Whereas creditors' option to accelerate following covenant violations can deter dilution by new secured debt, preventing overinvestment, their option to waive covenants allows some dilution, preventing underinvestment. The optimal debt structure trades off over- and under-investment, blocking "bad" but not "good" dilution. It is multi-layered, including secured and unsecured debt with and without covenants. Our results are consistent with several debt structure regularities.
Written with Jason Roderick Donaldson and Denis Gromb.
Finance Seminars at Caltech are funded through the generous support of The Ronald and Maxine Linde Institute of Economic and Management Sciences (lindeinstitute.caltech.edu).
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