Though the majority of studies in corporate governance focus on the ability of shareholders to advise and monitor firms, debt financing is much more common than equity financing. According to the Thomas Reuters Loan Pricing Corporation, $2 trillion in syndicated loans were issued in 2016, compared with less than $250 billion in net equity. Further, the number of firms issuing debt is a multiple of those issuing public equity. If, as Shleifer and Vishny (1997) argue, “corporate governance deals with the ways in which the suppliers of finance to corporations assure themselves of getting a return on their investment,” then creditors possess both the ability and the incentive to advise and monitor the firms in their portfolios.
A traditional view of creditor governance is that creditors are largely passive until a borrower misses a payment or violates the terms of the loan agreement. However, there is no reason to expect creditors to be passive. Underwriters of syndicated loans are in a unique position to evaluate firm investment policies, since the underwriting process requires a thorough review of firm policies, projects, and opportunities. No stakeholder other than an activist shareholder has as much access to senior management or private information about the firm. Once the loans are issued, underwriters hold concentrated positions in borrower securities—loan shares— and are therefore exposed to borrower risk. Bank asset quality is of obvious importance to bank management, shareholders, and regulators, and creditor monitoring of borrowers is a routine part of portfolio risk mitigation and regulatory compliance. Despite these facts, there is a dearth of empirical evidence that institutional creditors exert a governing influence over borrower firms prior to a covenant violation or payment default. Since the great majority of credit agreements are not violated, it is important to better understand the governance role creditors play in portfolio firms under normal circumstances.
In a recent study, available here, we investigate how much creditors influence the governance of borrowers. We present evidence that, subsequent to loan origination, borrowers are not only significantly less likely to become distressed, e.g. file for bankruptcy protection, but also shift financial and investment decisions away from value-reducing policies and toward value-creating investments. Changes in financing and investment decisions are economically meaningful; borrower cash flows and profitability significantly improve at least three years after loan origination, especially for those firms most likely to have underinvested in profitable opportunities in previous years. Shareholders react positively to news of syndicated loan issuance. Cumulative abnormal stock returns around loan issuance are positive and significant.
Theory predicts that when borrowers are more opaque, lead arrangers must retain a greater proportion of loan shares. We quantify the seriousness of information asymmetry in a loan issue not by using a general proxy for borrower opacity, e.g. research and development expenses, but by the degree to which the spread at origination deviates from what is expected on a risk-adjusted basis. We find that when spreads are significantly higher or lower than what’s expected, underwriters retain a greater portion of loans.
More concentrated holdings expose creditors to greater risk, and we find that creditors exert more influence when they retain more of the loan. Decreases in cash, acquisition activity, shareholder payouts, and salary expenses are more pronounced when creditors hold more concentrated positions. Greater creditor control over governance is associated with increasing investment in inventories, capital expenditures, and property, plant, and equipment. Further, firm profitability and cash flows from operations are higher when creditor positions are more concentrated.
Because prior literature shows that creditors intervene in firm policies after a technical violation of a loan agreement (Nini, Smith, and Sufi, 2012; Becher, Griffin, and Nini, 2017), and that these interventions improve firm financials and performance, we re-examine whether our findings are driven by loans that have been renegotiated following a technical default. We provide strong support for previous findings that creditor governance after a violation is a strong determinant of changes in firm policy and performance. We also find that our previous results hold, even when creditor governance before a covenant violation has different aims than after a violation. For example, loan origination is a strong determinant of increased investments in property, plant, and equipment (PPE), but creditor governance post violation is associated with decreases in PPE, as firms often sell assets to improve liquidity.
Finally, we want to understand the impact of creditor governance relative to shareholder governance. We compare the governance effects of large institutional creditors with those of large institutional shareholders. We find that the presence of a large institutional stakeholder, whether creditor or shareholder, is a strong determinant of changes in firm policies and performance. In other words, though previously thought to be silent providers of capital – at least until a borrower is in trouble – creditors, like institutional shareholders, serve a valuable and important role in corporate governance.
This post comes to us from Professor Tomas Jandik at the University of Arkansas’ Sam M. Walton College of Business and Professor William R. McCumber at Louisiana Tech University’s College of Business. It is based on their recent article, “Creditor Governance,” available here.