Debt may have led to the 2007–10 financial crisis, but debt instruments came roaring back in its wake, and with them covenants, the elaborate terms to which borrowers and lenders mutually agree. But although these covenants help lenders feel more comfortable, they can make borrowers less likely to invest, according to Chicago Booth’s Hans B. Christensen and Valeri Nikolaev, along with University of Utah’s Daniele Macciocchi.

The researchers describe two kinds of covenants. Capital covenants seek to align the interests of the lender and borrower by, among other things, requiring the borrower to maintain capital in the company—to have skin in the game. Performance covenants, by contrast, require the borrower to meet defined performance thresholds and to cede control to the lender if those thresholds aren’t met. For example, a manufacturer that’s short on a performance target in a covenant might have to turn over certain management decisions to a lender.

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Economists have long argued that the optimal mix of covenants in contracts ought to be determined by maximizing the benefits for both borrowers and lenders. However, the researchers find that the covenant mix is actually driven at least in part by unfavorable economic events that affect lenders’ bottom lines. When lenders experience financial shocks, they’re more likely to use performance-based covenants on new loans, even when borrowers’ fundamentals don’t justify them.

Using data on syndicated loans made between 1996 and 2013, the researchers find that lenders who faced adverse events to their loan portfolios tended to initiate loans using performance covenants more frequently, as compared with lenders who didn’t face such events.

“Overall, the analysis suggests that lenders subject to adverse economic shocks place more value on using tripwires that enable them to have more influence over borrowers as more information is revealed over the loan term,” write Christensen, Macciocchi, and Nikolaev.

And this can have an economic effect, as the addition of more performance covenants in debt contracts impedes borrowers’ incentives to take up new investments, the research suggests. Adding a performance covenant to a loan contract reduced a borrower’s future research-and-development investment by 3 percent and capital expenditures by 6 percent, according to the study. For R&D investment, this decline started after a loan had been originated, and persisted for two years. The same was true for capital expenditures, with the decline persisting for three years after a loan was made.

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