Operating risk is a major concern for firm management and stakeholders. Stark examples of losses due to corporate operations include BP’s $17.2 billion loss in June 2010 following the Deepwater Horizon incident (Wong and Yousuf, 2010) and Freeport-McMoRan’s $13.9 billion loss in 2008 due to plunging metal prices and difficulty with the acquisition of a rival company (James, 2009). The consequences of these and other operating losses are significant, and spill over to connected firms (Wu, 2016). Managers may be willing to make risky operating decisions if they are unaware of the risk or measure it poorly, or if their interests are aligned with equityholders who share in the upside of risky operating decisions. Lenders are excluded from the upside of risky operating decisions and exposed to the downside. Accordingly, operating decisions should be at the heart of the conflict between debtholders and equityholders.
In our paper, we study the effect of lender control on corporate operating decisions in light of their conflicting incentive to reduce exposure beforehand to operations that have unpredictable outcomes. We focus on three key issues in our analysis.
First, we shed light on the influence of lenders on corporate operating decisions, suggesting that the scope of lender influence extends beyond financing and investment decisions. Using a regression discontinuity design, we find that borrowers reduce operational risk-taking following covenant violations, corresponding to a marginal decrease in the probability of experiencing problems within one year by as much as 10 percent. This finding is robust to a variety of theoretically-motivated controls and alternative estimation methodologies.
Second, we examine the determinants of lender influence. Theoretically, covenants are used as tripwires to alert lenders to risky behavior by borrowers and to protect lenders when such risks are realized. The focus of our study is to understand how lender influence differs among borrowers in which debtholder interests are less well aligned and for which information about performance is less transparent. We find that the magnitude of this covenant violation effect is larger when debtholder interests are less aligned and when information about borrower performance is opaque.
We also investigate differences in lender influence across lenders. In particular, we investigate the costs of coordinating among lenders within a syndicate, the predisposition of lenders toward active intervention, and expected losses from a default. Individual lenders have the incentive to defer to other lenders when coordination costs are high (Bolton and Scharfstein, 1996), and this undermines the syndicate’s control over the borrower. Similarly, lenders with active management experience are more likely to have the requisite expertise to more efficiently influence corporate decisions. Lastly, lenders have stronger incentives to exert control when the expected loss from default is high. Our evidence suggests that coordination, active management, and liquidation incentives all contribute to the effectiveness of lender influence.
Third, we introduce a new measure of operational risk using industry-specific data on corporate operations from the Compustat Monthly Updates – Industry Specific Quarterly dataset. We construct industry-specific measures of operational risk for 11 industries: airline, gaming, healthcare, HMO, home-building, lodging, mining, oil and gas, retail, semiconductor, and utilities. We also validate our estimates using the home-building industry as a case study. Other papers establish a link between covenants and firm value: Kahan and Tuckman, 1993; Beneish and Press, 1995; Harvey, Lins, and Roper, 2004.
We face two main empirical challenges in studying these effects. First, isolating lender influence from borrower behavior and performance is difficult. Lenders may influence corporate operations implicitly by withdrawing funding offers, refusing to roll over debt, or imposing harsh terms in renegotiation. Separating the lender’s decision to selectively use this implicit influence from the borrower’s condition that required refinancing, renegotiation, or additional funds is a challenge. Second, ex-ante exposure to operating risk is difficult because this exposure is unobserved and subject to measurement error. Moreover, the assessment of any given project’s operating risk varies with the information and experience of the decision-maker, which varies across companies and time and is likely different from the information available to the econometrician.
We address the first challenge by implementing a regression discontinuity design that compares borrowers just-breaching and just-avoiding financial covenant thresholds, which creates quasi-random variation in borrowers. We also note that our research design is likely to produce a lower bound estimate for the effect of lender control on operational risk-taking. Technical defaults increase lenders’ ability to extract concessions from borrowers in the form of spread increases and loan amount reductions (Beneish and Press 1993; Chen and Wei 1993), which is, in effect, an increase in the cost of loan financing. Managers may have incentives to increase risk following a covenant violation, particularly if the manager holds equity or is otherwise aligned with equityholders (Esmer, 2016). This risk-shifting mechanism suggests that managers should increase exposure to operating risk in response to covenant violations, whereas the direct lender control mechanism suggests that lenders implicitly reduce operating risk. For this reason, our estimates should be viewed as a lower bound for the effects of lender influence.
Our research sheds more light on the classic conflict between equityholders and debtholders and provides a new methodology for estimating the exposure of firms to operational risk. Importantly, these results suggest that the scope of lender influence following covenant violations is not limited to financial risk. Though this study demonstrates one way that financing affects corporate operating decisions, it raises new questions. In particular, it calls for more work to understand the effect of operational risk-taking on future renegotiation and the extent to which lenders condition on borrowers’ operating decisions at loan initiation.
This post comes to us from Professor Stephen Karolyi at Carnegie Mellon University’s Tepper School of Business and Professor John Sedunov at Villanova University. It is based on their recent article, “Operating Risk and the Scope of Lender Control Rights,” available here.