Financing constraints and the use of performance-sensitive debt

Performance-sensitive debt (PSD) is a popular financial instrument in the corporate private debt market. In a real-options setting, this paper aims to clarify how PSD impacts on investment policy, capital structure, and agency cost of financing constraints when the firm faces the upper limit of debt issuance. We show that the constrained leverage hardly depends on the performance sensitivity. In particular, our conclusions predict that PSD can decrease the severity of financing constraints relative to the fixed-coupon debt case and the loss of firm value arising from investment and financing distortions due to the presence of financing constraints. The higher the performance sensitivity, the less likely that the firm is financially constrained. These findings provide a novel investment-based explanation for issuance of PSD.