Labor Leverage and Debt Contract Provisions
Authors:
David Weinbaum, Whitman School of Management, Syracuse University
Sanjeev Bhojraj, Johnson School of Management, Cornell University
Youngki Jang, Lerner College of Business, University of Delaware
Nir Yehuda, Lerner College of Business, University of Delaware
Journal:
Management Science (2027)
Summary:
Operating leverage refers to the proportion of a firm’s costs that are fixed as opposed to being variable costs. Such leverage tends to make businesses riskier, e.g., the airline industry is a prime example of an industry where operating leverage is high. Operating leverage has traditionally been thought of as being driven by fixed capital and operating assets. From a lender’s perspective, firms with significant operating assets are riskier because of the higher leverage, but also safer because these assets can be pledged as collateral. A firm's labor costs can also be inflexible and thus give rise to a type of operating leverage known as labor leverage. In contrast to capital-based operating leverage, labor cannot serve as collateral. We discovered that banks treat companies with high labor costs very differently than companies with expensive equipment. They specifically price in labor costs as a risk factor, but not equipment costs.
Research Questions:
1. Do banks take labor leverage into account when making loans to corporations?
2. Do they differentiate between labor-based and capital-based operating leverage when designing debt contracts?
What we know:
Prior work treats operating leverage as monolithic, but it has two distinct sources:
1. Capital-based: fixed assets, PP&E — tangible, collateralizable
2. Labor-based: inflexible labor costs — not collateralizable, creates cash flow problems when business slows
Labor leverage amplifies downside risk: you can't sell off employees like you can equipment
Key question: Do creditors distinguish between these two sources?
Novel Findings:
Labor leverage affects both (1) price (loan spreads) and (2) non-price (contract design) features of corporate loans:
1. Price terms:
a. Higher spreads; 5 basis points in interest rates (about 0.05% more per year)
b. Capital-based operating leverage not priced
c. Stronger when it's harder to change labor costs (like in countries with strict union contracts)
d. Confirmed by offshoring diff-in-diff (to show causation rather than correlation)
2. Non-price terms:
a. More restrictive covenants (provisions that limit certain actions by the borrower, e.g., restrictions on paying dividends or issuing additional debt)
b. Fewer financial covenants (provisions that require the borrower to maintain certain financial ratios such as the interest coverage ratio)
c. More collateral required
d. Smaller loans, shorter maturity
e. Less performance pricing
Novel Methodology:
We analyzed 37,154 corporate loans made between 1989 and 2017, studying how loan terms changed based on labor leverage. A key challenge is that firms are not required to disclose labor costs in their financial statements and therefore only about 20% of firms provide this information. We used newly developed research methods to estimate imputed labor costs for the remaining 80% of firms.
Implications for Practice:
We find that banks already recognize labor leverage as a distinct source of operating risk when designing corporate loans. Therefore CFOs may want to consider disclosing detailed information on their labor expenses even when not legally required to do so.
Implications for Policy:
This research bridges managerial accounting (cost behavior) and corporate finance (debt contracting). It has implications for policies on accounting disclosure of labor costs and cost structure, as many firms currently do not disclose labor costs. Policymakers should require firms to disclose labor expenses. This transparency would help banks price loans more accurately and help investors understand risk.
Implications for Research:
Future research on corporate loans needs to account for labor leverage separately from capital leverage. Prior studies that treated them the same missed an important risk factor.
Full Citation:
Bhojraj, Sanjeev, Youngki Jang, David Weinbaum, and Nir Yehuda, Labor Leverage and Debt Contract Provisions, Management Science (forthcoming)
Abstract:
We study price and non-price provisions of debt contracts to gauge how creditors evaluate the labor-induced operating leverage (“labor leverage”) of their borrowers. Labor leverage arises from inflexible labor costs that amplify downside risk but, unlike capital-driven leverage, cannot be mitigated through collateral. We find that lenders explicitly price labor leverage: firms with higher labor leverage face significantly higher loan spreads, while capital-driven leverage is not priced. Creditors also adjust non-price terms, imposing more restrictive covenants, greater collateral requirements, smaller loan sizes, and shorter maturities. To strengthen identification, we exploit plausibly exogenous changes in foreign labor regulations that affect firms’ offshoring opportunities. When these labor regulations become stricter, lenders price labor leverage more significantly, consistent with heightened adjustment frictions. Collectively, our results demonstrate that creditors recognize labor leverage as a distinct source of operating risk and incorporate it into both the pricing and structure of debt contracts.
Web URL for the Article
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4726980