Bank Lending Relationships and the Use of Performance-Sensitive Debt

Abstract

We show that performance-sensitive debt (PSD) is used to reduce hold-up problems in repeated lending relationships. Using a large sample of bank loans, we find a more frequent use of PSD if hold-up is more likely, e.g. if a longterm lending relationship exists and the borrower has fewer outside financing alternatives. The use of PSD is less likely in syndicated relationship loans, as hold-up is less important in this market. Finally, we find a substitution effect between the use of PSD and the tightness of financial covenants, which is consistent with PSD reducing hold-up problems caused by the use of covenants.