How does financing impact investment? The role of debt covenants

Abstract

We identify a specific channel (debt covenants) and the corresponding mechanism (transfer of control rights) through which financing frictions impact corporate invest-ment. Using a regression discontinuity design, we show that capital investment de-clines sharply following a financial covenant violation, when creditors use the threat of accelerating the loan to intervene in management. Further, the reduction in in-vestment is concentrated in situations in which agency and information problems are relatively more severe, highlighting how the state-contingent allocation of control rights can help mitigate investment distortions arising from financing frictions. WHILE PREVIOUS RESEARCH HAS CLEARLY ANSWERED THE QUESTION of whether financ-ing and investment are related, it has been much less clear on how financing and investment are related (Stein (2003)). In other words, the precise mech-anisms behind this relationship are largely unknown. Further, the extent to which these mechanisms mitigate or exacerbate investment distortions arising from underlying financing frictions is largely unknown as well. The goal of thi