The Bright Side of Covenants in Private Equity Investments

The features of a contract in private equity investments are crucial to assess the value of the target company. Covenant-rich contracts imply better quality firms, while a high number of insiders appointed on the board warns exactly the opposite. This is likely the most striking result of Contracts and Returns in Private Equity Investments, an article by Stefano Caselli (Department of Finance), Filippo Ippolito (Universitat Pompeu Fabra), and Emilia Garcia-Appendini (University of St. Gallen), published in the Journal of Financial Intermediation (Volume 22, Issue 2, April 2013, doi: 10.1016/j.jfi.2012.08.002).

Despite the increasing importance of private equity investments in the economy, there is relatively little empirical evidence on the relation between the design of optimal contracts and the investment returns on the financed company. Such a disconnect looks puzzling as the characteristics of contracts in private equity may affect the investment profitability itself. There are many different dimensions along which private equity investors structure the terms of an investment. These include the choice of securities, voting and cash flow rights, liquidation options, and the appointment of directors in the board of the target firm. In most cases, the definition of these terms is expressed in specific covenants included in the contract at the time of entry.

In their article, the authors show that covenants may act as signals to identify good deals. In particular, covenant-heavy contracts are generally associated with higher returns, regardless the measure of returns employed. The relation seems to be driven by certain types of covenant terms like lockups, permitted-transfer rights, exit ratchets, and, to a lesser extent, rights of first refusal and redemption rights. This evidence is consistent with the idea that firms with better prospects are willing to take up more covenants because they are less likely to be constrained by them. Simply put, the presence of covenants acts as a signal of high quality. The same is true for the number of insider appointed directors as a form of control of the behavior of the target firms. The idea is that insiders are appointed when the need for oversight is greater, generating a negative relationship between investment performance and the strength of the ties between appointed director and fund. The authors support this hypothesis by showing that there is a negative association between the appointment of insiders and target firm profitability.

The information content of covenants has several important implications for private equity investors. The choice of covenants reveals unobservable private information that is not otherwise observable by looking at public information, contained, for example, in accounting variables. The authors interpret this evidence to indicate that firms signal their better prospects to potential investors by accepting more covenants than average, such as a high number of covenants may be associated with better future growth prospects. Likewise, the relationship between the appointment of board directors and returns may carry relevant information which is not typically contained in public sources. Indeed, the authors show that internal directors are appointed in firms that are less profitable, consistent with the idea that insiders are appointed when there is more need for close monitoring.