In our paper, ‘Creditor Governance’, we investigate the degree to which large creditors exert influence over borrower investment decisions, and whether creditor-influenced changes in firm policies result in improved borrower profitability and operational efficiency.
There is a large literature concerning firm governance driven by institutional shareholders. However, the universe of firms issuing equity is small compared to the number of firms issuing private debt. According to the Loan Pricing Corporation, firms in the United States issued 2 trillion (USD) in loan shares in 2016 compared to less than 250 billion (USD) in equity issuance. 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,’ it is logical to assume creditors assert some influence over borrower firms.
Though creditor monitoring of borrowers is a routine part of portfolio risk mitigation and regulatory compliance, the traditional view of creditor governance is that creditors are passive investors until a borrower violates a covenant threshold, thereby triggering a technical default, or worse, misses a payment. In such cases, creditors renegotiate borrowing terms and are able to direct some changes in borrower firm investment decisions. There is ample evidence that in the event of a technical or payment default, creditor-driven changes improve borrower financials and profitability.
There is no a priori reason to believe creditors are passive investors until a borrower defaults, however, despite the concern that ‘pernicious control’ of borrower decision-making potentially exposes creditors to additional liability if it is found that the lender exercised an ‘unreasonable’ level of control over the borrower. Since the great majority of loan contracts are not breached, it is important to better understand the governance role creditors play in portfolio firms under normal circumstances.
Like their institutional shareholder counterparts, creditors are often sophisticated investors who hold concentrated positions in portfolio firm securities – loan shares – and are therefore exposed to borrower idiosyncratic risk. The underwriting process prior to loan issuance and routine monitoring of borrowers ex post may sometimes grant creditors access to senior management and private information about borrower firm policies, projects, opportunities, and weaknesses.
We present evidence that, subsequent to loan origination, borrower firms are not only significantly less likely to become distressed, eg file for bankruptcy protection, but also shift 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 borrower firms are more opaque, lead arrangers must retain a greater proportion of loan shares to clear the market. We quantify the seriousness of information asymmetry present in a loan issue not via a general proxy for borrower opacity, eg 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 market-clearing spreads are higher or lower than one would expect given observable borrower characteristics, underwriters retain a greater proportion of loan shares.
Since more concentrated holdings expose creditors to greater idiosyncratic risk, we should find more evidence of creditor influence when they hold larger positions in borrower securities. At the means, lead underwriters’ loan portfolios retain 12 million (USD) in additional borrower exposure when spreads are lower than expected, and 23 million (USD) in additional exposure when spreads are higher than expected. We present evidence that creditor influence is more evident when lenders are exposed to greater risk. Decreases in cash, acquisition activity, shareholder payouts, and salary expenses are more pronounced when creditors hold more concentrated positions. Heightened creditor 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 are likely to be renegotiated following a technical default. We provide strong support of previous findings that creditor governance post 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 is markedly different than after one. For example, prior to a default, creditor influence increases borrower investments in productive assets, while after a violation, borrowers are more likely to 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 to those effected by 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; coefficients share the same sign and are of comparable economic and statistical significance. 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.
Tomas Jandik is a Professor of Finance at the Sam M. Walton College of Business, University of Arkansas
William R. McCumber is the JPJ Investments Endowed and Assistant Professor of Finance at Louisiana Tech University