Product Market Threats and Financial Contracting: Evidence from Performance-Sensitive Debt

This paper examines how product market threats shape debt contracting. Bolton and Scharfstein (1990) suggest that while contract terms linked to borrower performance mitigate incentive misalignment between creditors and borrowers, they make a borrower more vulnerable to product market threats, which would decline its performance and make these performance-sensitive terms more likely to become binding. In line with this trade-off between product markets and financial markets, we provide evidence that high product market threats significantly moderate the use of performance sensitive terms in loan contracts, particularly when the benefit of doing so outweighs its cost in exacerbating borrower-creditor incentive conflicts.