Soft Information and Loan Contract Design: The Role of Managerial Ability

Abstract

We examine the relation between managerial ability, an important form of soft information for lenders, and loan contract design, focusing on financial covenants. Measuring managerial ability with the score developed by Demerjian et al. (2012), we find managerial ability at the borrowing firm is negatively associated with the number of financial covenants imposed at loan origination. Among financial covenants, this result is strongly observed for performance covenants. Additionally, we use TRACE implementation to identify a causal relation between managerial ability and covenant design. Finally, we show that managerial ability not only affects the covenant decision at origination but also influences the efficiency of the debt contract which is measured by the change in covenants throughout the life of new loans. These results collectively show that managerial ability is useful for lenders in screening borrowers.