What are debt covenants and why are the debt covenant are heavily used in private debt?

Essay by ilhanikizCollege, UndergraduateA-, October 2014

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What are debt covenants? :

Debt covenants are instruments available to lenders to limit the borrowers' action during the loan term. These agreements between companies and its creditors require companies to operate within the specific conditions of the loan agreements. They are negotiated during the debt structuring process and are different for every transaction. An example of the debt covenants is that if a company misses its interest payments (coupons), the bondholders may acquire the right put the company into liquidation. Further examples of "financial" covenants include maintenance of minimum working capital and debt service coverage ratios, maintenance of minimum net worth, restrictions on other borrowings, shareholder salaries, distributions, or dividends, and limits on borrowing bases. Lenders also can require covenants, labeled as "non-financial" because of their nature, such as to provide annual audits or reviews by a certified public accountant, to provide interim unaudited financial statements and other financial information and to maintain minimum levels of business insurance.

[1: William M. Courson and Tanya K. Hahn, "Tripping Debt Covenants," Healthcare Financial Management 63, no. 7 (July 2009): 54-58.][2: Stephen Valdez and Philip Molyneux, An Introduction to Global Financial Markets, 6 edition (Houndmills, Basingstoke, Hampshire ; New York: Palgrave Macmillan, 2010), p105.][3: Mariah Talavera, "What Lies Beneath: Understanding Debt Covenants and their Impact on your Company", accessed August 7, 2014, http://www.babm.com/accounting/What-Lies-Beneath-Understanding-Debt-Covenants-and-their-Impact-on-your-Company.html]

Why are the debt covenant are heavily used in private debt? :

The uses of these different types of covenants have underlying similar reasons. First, the covenant agreements ameliorate the common agency problems that a debt holder experiences. The common agency problems occur when managers or shareholders who usually have more information about firms acts riskier to increase their earnings at expense of debt holders money. They may involve in benefit seeking activities that are detrimental for creditors. Consequently,