Covenant violation and operational efficiency

We examine the impact of covenant violation on corporate operational efficiency. Using an aggregate measure of operational efficiency developed by Demerjian et al. (Management Science, 58, 2012, 1229–1248), we provide strong empirical evidence that covenant violations hinder firms from achieving operational efficiency. Our finding is robust to alternative definitions of operational efficiency and various model specifications to address potential endogeneity issues. Further analyses show that lower operational efficiency is attributable to covenant-violating firms' under-investments in capital and labour. In addition, the negative effect of covenant violation on operational efficiency is not universally the same, and is less evident in violating firms with greater agency problems.