Debt Contracting When Borrowers Face Transitory Uncertainty: Evidence from U.S. Gubernatorial Elections

We examine the impact of policy uncertainty surrounding U.S. gubernatorial elections on loan contracting outcomes. Loans made to firms headquartered in election states are more likely to include contingency-pricing provisions and financial covenants. The effect is pronounced for cash flow-based pricing grids and covenants---vis-à-vis balance sheet-based ones---and is stronger when elections are closely contested. Consistent with efficiency of loan contracting under transitory uncertainty, we find no direct effect on loan spreads. However, an important pricing effect is manifested through interest-rate contingencies in pricing grids. The use of rate-increasing grids increases significantly in election years for the firms with geographically concentrated operations and government contract-dependent ones. Our findings suggest that while the contingency-pricing feature curbs an explicit rise in the cost of loans for borrowers facing elections, loan contracts are designed to ensure compensation to lenders for uncertainty---via interest-rate contingencies---and to factor in increased monitoring demand.