Conflicting Priorities: Donaldson, Gromb & Piacentino (2025)

What this is. The paper’s five main propositions, the three-date model with its key equations, and the mechanism linking collateral, covenants, and investment efficiency: enough to understand what it proved and how, without reading all 30 pages. To replicate or extend it, read the full source at the original.

TL;DR

The paper develops a theory of debt structure in which collateral and negative pledge covenants are complementary tools for managing the over/underinvestment trade-off. A borrower faces two frictions: limited pledgeability (private benefits cannot be pledged) and nonexclusive contracting (covenants can be violated by taking on new secured debt that retains priority). Because collateral trumps covenants, negative pledge covenants have no teeth on their own: a new secured debt issue retains its priority even when it violates a covenant. Yet covenants are useful: the threat of acceleration, though generally not credible when all debt is covenant-protected, becomes credible when only some debt is. The optimal debt structure is multilayered, combining secured and unsecured debt with and without covenants, and it is always first-best efficient in equilibrium. Covenants are violated and waived on the equilibrium path, consistent with observed practice.

Core results

Propositions are the primary units; locators point into the source PDF.

#	Result	Locator	Key condition
R1	Unsecured debt implements first-best	Prop. 1, p. 1747, eq. (5)-(6)	Private benefit of low-quality project $Y_1^L \le Y_1^*$, or total expected cash flows exceed funding needs; else overinvestment temptation prevents efficiency
R2	Secured debt implements first-best	Prop. 2, p. 1748, eq. (7)-(8)	$X_1^H \ge X_1^L$: high-quality project has higher pledgeable cash flow; “mild” underinvestment problem
R3	Covenants are irrelevant when all debt is covenant-protected	Prop. 3, p. 1749, eq. (9)	Acceleration threat is self-defeating: forcing liquidation subsidizes secured debt without deterring overinvestment; covenants have no bite unless $\phi \le \phi^*$
R4	Mix of covenant-protected and unprotected debt implements first-best	Prop. 4, p. 1750, eq. (10)	$X_1^L \ge X_1^H$: “severe” underinvestment problem; covenant fraction $\phi$ must be small enough that acceleration is credible only when Q=L
R5	Equilibrium debt structure is first-best efficient	Prop. 5, p. 1751	Always achievable; instrument choice (secured vs. covenant-protected unsecured) depends on severity of underinvestment problem

Overall (paper’s conclusion). Collateral and covenants implement efficiency only in concert: covenants commit the borrower not to use collateral when dilution is inefficient (bad dilution); collateral is needed to break that commitment and engage in good dilution when covenants would otherwise block efficient investment. Covenant violations and waivers are on-path, not failures of contracting. The results speak to the policy debate on debt priority: strong priority rules are useful because they let borrowers dilute when, but only when, it is efficient to do so.

Theory / model

The model has three dates $t \in \{0, 1, 2\}$ and a borrower B with two sequential projects (Section I, pp. 1743-1746). Closest in spirit to this paper is Ayotte and Bolton (2011), who also study negative pledge covenants and property versus priority rights. The paper extends that analysis by rationalizing covenant violations and waivers, and by showing covenants and collateral are complementary rather than substitutes. The framework follows Hart and Moore (1995) in using hard claims (debt) to constrain investment. The collateral-overhang problem analyzed in Donaldson, Gromb, and Piacentino (2020a) is the baseline: this paper adds covenants as an additional instrument alongside collateral. Policy implications connect to the debate in Bebchuk and Fried (1996) about the efficiency of strong priority for secured creditors. Collateral and capital structure evidence from Rampini and Viswanathan (2013) is cited in the empirical discussion (p. 1756).

Projects. Project 0 costs $I_0$ at Date 0 and succeeds with probability $p$, yielding cash flow $X_0 > 0$ and private benefit $Y_0 > 0$; its value is positive (eq. 1, p. 1743):

$$p(X_0 + Y_0) > I_0. \tag{1}$$

Project 1 costs $I_1$ at Date 1, succeeds with probability $p$, and yields cash flow $X_1^Q > 0$ and private benefit $Y_1^Q > 0$ depending on quality $Q \in \{H, L\}$ revealed at Date 1. Project 1 has positive value only if $Q = H$ (eq. 2, p. 1744):

$$p(X_1^H + Y_1^H) > I_1 > p(X_1^L + Y_1^L). \tag{2}$$

Frictions. Two frictions generate a role for both collateral and covenants (Section I.B, p. 1744):

1. Limited pledgeability: private benefits $Y_t$ cannot be pledged to creditors; only cash flows $X_t$ are pledgeable.
2. Nonexclusive contracting: existing creditors cannot prevent B from contracting with new creditors at Date 1.

Instruments. Three financing instruments exist (pp. 1744-1745):

1. Secured debt: face value $F^s$, collateral gives absolute priority over unsecured claims.
2. Unsecured debt: face value $F^u$, no collateral.
3. Covenant-protected (unsecured) debt: unsecured but grants the right to accelerate if B takes on new secured debt.

Priority rules. Secured debt has priority over unsecured; earlier secured debt has priority over later secured debt; earlier unsecured (or accelerated) debt has priority over later unsecured debt (p. 1745).

Assumptions. Under the efficient investment policy, expected cash flows exceed funding needs (Assumption 1, eq. 3, p. 1746):

$$pX_0 - I_0 + q(pX_1^H - I_1) \ge 0. \tag{3}$$

Liquidation value suffices to repay secured debt needed to finance Project 1 (Assumption 2, eq. 4, p. 1746):

$$p\!\left(X_0 + X_1^Q\right) > \frac{I_1}{p}. \tag{4}$$

The first-best policy is to undertake both projects and invest in Project 1 if and only if $Q = H$ (Lemma 1, p. 1746). The paper derives conditions on the debt structure at Date 0 under which this first-best is achieved as a subgame perfect equilibrium.

Key tension. Unsecured debt allows dilution at Date 1 by new secured creditors, which relaxes financial constraints (good dilution when $Q = H$) but also enables overinvestment (bad dilution when $Q = L$). Secured debt at Date 0 limits dilution capacity, preventing bad dilution but potentially causing underinvestment. The central result is that a multilayered structure combining instruments can implement the first-best whenever either instrument alone cannot.

Method

The paper uses a three-date contracting model solved by backward induction to subgame perfect equilibrium, with competitive creditors who earn zero profit in equilibrium (Section I.C, p. 1745). All contracts, including covenant violations, are observable. B has full bargaining power in renegotiations (p. 1746). The solution method is to:

1. Characterize the Date 1 subgame equilibrium given any Date 0 debt structure (which instruments, what face values, what covenant fraction $\phi$).
2. Derive necessary and sufficient conditions on the Date 0 debt structure for the first-best to obtain in every subgame.
3. Show that a date-0 structure satisfying those conditions always exists (Proposition 5).

The model builds on principal-agent contracting with nonexclusivity (no exclusivity is enforceable via covenants because new secured debt retains priority regardless of covenant violations). It uses real-options logic in the sense that the right to dilute existing debt is like an option held by the borrower; the debt structure determines when that option is valuable and when it should be exercised.

Covenant irrelevance result (Proposition 3). If all unsecured debt at Date 0 is covenant-protected (fraction $\phi = 1$), the acceleration threat is generically not credible. The covenant-protected creditor’s benefit from acceleration (leapfrogging unprotected unsecured debt) is zero when $\phi = 1$ because there is no unprotected unsecured debt to leapfrog. The threshold fraction at which acceleration becomes credible is (eq. 9, p. 1749):

$$\phi^* := 1 - \frac{(1-p)I_1/p}{p(X_0 + X_1^L - I_1/p)} \in (0,1). \tag{9}$$

Acceleration is credible only if $\phi \le \phi^*$. Above $\phi^*$, covenants have no bite.

Proposition 4 condition. For covenants (at fraction $\phi \le \phi^*$) to implement the first-best when secured debt cannot, a sufficient (and under additional conditions necessary) condition is (eq. 10, p. 1750):

$$X_1^L \ge X_1^H. \tag{10}$$

This says negative-value projects ($Q = L$) have larger pledgeable cash flows than positive-value projects ($Q = H$). Intuitively, the covenant-protected creditor has more to gain from accelerating against a bad project (larger cash flows to grab) than a good one, making the threat selective.

Empirical specifications

This is a pure theory paper with no empirical estimation. Section IV (pp. 1754-1756) describes empirical relevance and new predictions.

Consistency with stylized facts. The model is consistent with four documented patterns (p. 1754-1755):

• Well-capitalized/highly rated firms rely heavily on unsecured debt (consistent with Proposition 1 and Rauh and Sufi (2010) and Benmelech, Kumar, and Rajan (2024)).
• Negative pledge covenants are common in roughly 44% of debt contracts (consistent with Proposition 4 and Billett, King, and Mauer (2007) and Ivashina and Vallee (2018)).
• Covenants are frequently violated and renegotiated or waived (consistent with Proposition 5; citations include Beneish and Press (1993, 1995) and Dichev and Skinner (2002)).
• Covenants in some debt decrease the yield on other debt by reducing default risk (consistent with Proposition 4; Bradley and Roberts (2015)).

Untested predictions. Propositions 1-5 imply four new predictions not yet directly tested (Predictions 1-4, pp. 1755-1756):

• Firms more exposed to underinvestment (growth opportunities, high fixed costs, nonredeployable assets) use covenants more.
• Firms more exposed to overinvestment (distressed firms, declining industries) use collateral more.
• Collateral use increases and covenant use decreases with asset tangibility.
• Covenant use decreases with the costs associated with asset sales (less redeployable, harder to value, more firm-specific assets).

Datasets used

This is a pure theory paper. No datasets are used in the analysis. The empirical discussion in Section IV cites existing empirical studies (Billett, King, and Mauer (2007); Rauh and Sufi (2010); Benmelech, Kumar, and Rajan (2024); Beneish and Press (1993, 1995)) but does not reanalyze any data.

Dataset	Role in paper	Wiki page
None (theory paper)	N/A	N/A

When to read the full paper

Read the original if you are: building models of debt structure with multiple creditors and priority rules; analyzing why negative pledge covenants exist despite being defeated by collateral priority; studying the design of optimal debt contracts when pledgeability is limited and contracting is nonexclusive; or working on the policy debate about the efficiency of strong priority for secured creditors. The proofs in Appendix A (Lemmas A.1-A.18, pp. 1757-1763) are the formal foundation for all five propositions.

Attribution and rights

Source: peer-reviewed, The Journal of Finance 80(3), June 2025, pp. 1739-1768. DOI: 10.1111/jofi.13445. Published under Wiley VOR terms; no CC licence. This distillation was extracted by an LLM on 2026-06-06 and is not human-verified or independently reproduced. Extract-only: the verbatim PDF is not hosted here.

Donaldson, Jason Roderick, Denis Gromb, and Giorgia Piacentino. “Conflicting Priorities: A Theory of Covenants and Collateral.” The Journal of Finance 80, no. 3 (June 2025): 1739-1768. DOI: 10.1111/jofi.13445. © 2025 the American Finance Association.