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Private Debt Contract Complexity: What the Numbers Don't Tell You

Debt financing is an important source of funding for middle market firms. Private debt pricing is driven by the risk of default and by lenders' imperfect information about borrowers. This information asymmetry is particularly relevant in the middle market, where less information is available from equity analyst, debt analyst, and media coverage.

Borrowers agree to contractual mechanisms such as debt covenants to alleviate lenders' concerns. Borrowers also share private, non-public information with lenders. This private information is likely factored into the negotiated design of covenants and in loan pricing. While that private information itself is not available in the contract, it is reflected in increased contact complexity.

The authors explain how firms can use computational linguistic techniques to extract meaning from the complexity built into financial documents. They measure that complexity in several ways: by contract length, readability, and the prevalence of numbers and key words (for example, "default").

Among other things, their research demonstrates that several measures of contract complexity are associated with initial loan pricing and with a higher probability of borrower credit ratings downgrades. In addition, middle-market bond market participants appear to react positively to increased contract complexity.

There are several implications:

  • Lenders can use the results in their rate negotiations with borrowers to decrease their risk exposure .
  • Secondary market participants - lacking access to the private information available to the original lender - can assess the riskiness of the loan by examining the negotiated covenants and measuring the general complexity of the contract.
  • Borrowers can negotiate for lower rates by offering contractual protections to the lender. These protections may, in turn, improve the secondary market pricing of the debt, leading to reduced future borrowing costs.


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