“Why Inside Debt?” by Dr. Peter R. Demerjian
SHOOL OF BUSINESS
Dr. Peter R. Demerjian
Foster School of Business
University of Washington
We investigate the role of inside debt as a contracting mechanism and how it limits the agency cost of debt when covenants are costly or difficult to contract with. We examine three cases where we expect inside debt to be efficient relative to covenants: when there is a high likelihood of spurious technical default; when information asymmetry between the borrower and lender is high; and when the borrower’s value is comprised largely of intangible assets. We find the expected positive associations in the first two cases. We further investigate the association between inside debt and financial covenant slack. We find that covenants are set more loosely in the presence of inside debt, consistent with inside debt serving as a substitute contracting mechanism.