«Agency and Renegotiation in Corporate Finance: Evidence from Syndicated Loans Amir Sufi* Massachusetts Institute of Technology sufi January ...»
JOB MARKET PAPER
Agency and Renegotiation in Corporate Finance:
Evidence from Syndicated Loans
Massachusetts Institute of Technology
January 26, 2005
Syndicated lending is an increasingly important source of corporate finance, with over $1
trillion in new syndicated loans signed annually. This paper empirically explores the syndicated loan market with an emphasis on how information asymmetry and renegotiation considerations influence syndicate structure and the choice of participant lenders. There are two principal findings. First, when the borrower requires more intense investigation and monitoring effort by a financial institution, the lead arranger retains a larger portion of the loan, forms a more concentrated syndicate, and chooses participants that are closer to the borrower (both geographically and in terms of previous relationships). The evidence is consistent with moral hazard in a setting of information asymmetry. The lead arranger attempts to guarantee due diligence effort by increasing its risk exposure, and the lead arranger chooses lenders that minimize information asymmetry. Second, when the borrower is more likely to need to renegotiate the loan agreement, lead arrangers add participants with very small portions of the loan to the syndicate. Given that unanimity of lenders is needed to renegotiate major terms of the loan, adding participants with small portions of the loan reduces the renegotiation surplus expected by the borrower. The evidence suggests that lenders form syndicates to reduce inefficient behavior and strategic default by borrowers.
* I am especially grateful to James Poterba, Antoinette Schoar, and Philip Strahan for their continuous support and help with this project. I also thank Dan Bergstresser, Mark Carey, Benjamin Esty, Robert Gibbons, Michael Greenstone, Bengt Holmstrom, Dirk Jenter, Asim Khwaja, Randall Kroszner, David Matsa, Donald Mullineaux, Stewart Myers, Joshua Rauh, David Scharfstein, Edward Sellers, Lucy White, Peter Wysocki. This paper benefited greatly from seminar participants at MIT (Sloan), NYU (Stern), Chicago GSB, Columbia GSB, Northwestern (Kellogg), Harvard Business School and Yale SOM.
I. Introduction Non-financial U.S. businesses obtain over $1 trillion in new syndicated loans each year, which represents more than 15 percent of their aggregate debt outstanding. Of the top 500 non-financial firms in the Compustat universe in 2002, over 90 percent obtained a syndicated loan between 1994 and 2002. According to the American Banker, syndicated lending represents 51 percent of U.S. corporate finance originated and represents more underwriting revenue for the financial sector than both equity and debt underwriting (Weidner, 2000). The market has experienced strong growth, going from $137 million in 1987 to over a $1 trillion today. Despite the importance of syndicated loans in corporate finance, research on the role of syndicated loans in U.S. corporate finance is limited.1 A syndicated loan is a loan where at least two lenders jointly offer funds to a borrowing firm. There is (at least) one “lead arranger” that establishes a relationship with the firm, negotiates terms of the contract, and guarantees an amount for a price range. The lead arranger then turns to “participant” lenders that fund part of the loan. In this paper, I analyze 14,021 syndicated loan deals to 5,011 U.S. non-financial firms from 1991 to 2003. I use this sample of syndicated loans to explore two of the theoretical foundations of modern corporate finance: information asymmetry and renegotiation. More specifically, I exploit variation in the credit reputation of borrowing firms to explain how information asymmetry and ex-post renegotiation considerations affect the structure of syndicates and the choice of participant lenders. Syndicated loans are especially promising as an empirical laboratory because, unlike most financial products, firms from all points of the credit spectrum (privately-held, high yield, investment grade, etc.) utilize this form of finance. I find evidence that both information asymmetry and renegotiation concerns affect syndicate structure and participant choice in a manner consistent with previous theoretical research.
The first contribution of this paper is to document that information asymmetry shapes syndicate structure and the choice of participants in a manner consistent with prominent theories of agency and moral hazard (Holmstrom, 1979; Holmstrom and Tirole, 1997). A basic assumption in these models is that firms with limited public information require investigation and monitoring by an “informed” lender before “uninformed” lenders invest in the firm. In this framework, there exists a moral hazard problem for the informed lender because the informed lender’s monitoring and investigation effort is unobservable. In order 1 Exceptions include Simons (1993), Dennis and Mullineaux (2000), and Lee and Mullineaux (2004).
There is also a literature on syndicated loans to non-U.S. companies, the pricing and default risk of syndicated loans, and the effect on firm value of loan announcements. I discuss these papers below.
2 to ensure diligence, a lender with monitoring and investigation responsibilities must retain a large financial stake in the borrowing firm; only a bank with a stake in the firm’s performance exerts the necessary effort in due diligence and monitoring. My findings support this theoretical prediction. When borrowing firms require more intense investigation and monitoring (by a variety of measures), the lead arranger (informed lender) retains a larger share of the loan, there are fewer participants (uninformed lenders), and the syndicate structure is more concentrated. For example, after controlling for the size of the loan and the size of the firm, I find that syndicated loans to firms without publicly-available SEC filings have 25 percent fewer participant lenders and the lead arranger holds 10 percent more of the loan. This result is robust when comparing firms with and without publicly-available SEC filings, and when using within-firm variation (when the same firm goes from private to public or vice versa). I also find evidence that information asymmetry shapes syndicate structure among firms with publicly-available SEC filings. Following previous literature, I use the ratio of positive accruals to total assets and the ratio of R&D investment to sales as measures of the need for monitoring and due diligence among public firms. Using these alternative measures, I find similar results: lead arrangers on loans to public firms that require more intense monitoring and due diligence retain a larger share of the loan and form a more concentrated syndicate.
This finding underscores the importance of “informed” capital in the financial health of firms that require more investigation and monitoring by a financial institution. The evidence presented in this paper supports the foundation of models that predict that small, informational-opaque companies are disproportionately affected by shocks to balance sheets of commercial banks (Holmstrom and Tirole 1997; Kashyap, Stein, and Wilcox 1993). In the syndicated loan market, firms that require investigation and monitoring obtain financing from third parties only after an informed lender takes a large financial stake in the firm.
I further document the importance of information asymmetry in syndicate formation by analyzing which participants are chosen as syndicate members. When the borrowing firm has no publicly available SEC filings or no publicly available credit rating, participant lenders on syndicates are “closer” to the borrowing firm, both geographically and in terms of previous relationships. In other words, when there is limited information about a borrower, lead arrangers attempt to reduce the need for information gathering by choosing participants that already “know” the firm.
3 I also examine whether reputation “build-up” may improve the ability for lead arrangers to successfully originate loans for borrowers with limited information. That is, repeated interactions between a lead arranger and a participant may lead to reputation effects that reduce the moral hazard problem when originating loans for opaque borrowers.
However, the evidence is weak. First, previous lead arranger-participant relationships influence participant choice, but previous lead arranger-participant relationships are much less important (both in magnitude and statistical significance) than previous relationships between the borrowing firm and the participant lender. Second, while it is true that relationships between the borrowing firm and participants are stronger among firms without SEC filings, relationships between lead arrangers and participants do not appear to vary systematically across the credit reputation spectrum. The results suggest that a lead arranger selects participants based on the participant’s familiarity with the borrowing firm, not based on the participant’s familiarity with the lead arranger itself. This finding is in contrast to syndicates in IPO issues and venture capital, and suggests that potential information asymmetry problems cannot be overcome by lead arranger reputation alone.
The second contribution of this paper is to demonstrate that ex-post renegotiation considerations influence the ex-ante structure of the syndicate in a manner consistent with incomplete contract theory and strategic default (Hart and Moore, 1988; Bolton and Scharfstein, 1996). Renegotiation is an important aspect of the syndicated loan market, and the number of creditors is a choice variable. Both of these factors make this market a promising empirical laboratory for analyzing these models. Bolton and Scharfstein (1996) document two opposing effects of renegotiation considerations on the optimal number of creditors. When firms are more likely to strategically default, lending syndicates should be larger and make renegotiation more difficult to discourage inefficient behavior by the firm.
When firms are more likely to default due to exogenous shocks (“liquidity default”), lending syndicates should be smaller to facilitate renegotiation. Both theoretically and empirically, the two propensities are highly correlated; only firms with a realistic probability of liquidity default have the ability to “lie” and strategically default. The model therefore provides an ambiguous and testable prediction in the syndicated loan market: is liquidity or strategic default the more important factor in syndicate formation?
I find evidence that strategic default is the more important consideration in syndicate formation. Lenders appear to add participants to the syndicate to make renegotiation more difficult when firms are more likely to default. I isolate the analysis to rated firms with 4 public filings, and I use variation in default risk across firms (proxied by senior unsecured debt ratings and leverage ratio) and within firms (proxied by credit downgrades). I find that loans to high yield firms, which are more likely to renegotiate loan terms due to default, have 15 to 20 percent more participant lenders. This result does not appear to be driven by diversification alone; while the number of participants increases with firm default risk, the actual concentration of the loan and the percentage (or amount) held by the lead does not.
Finally, the larger number of participants is driven by lenders who hold very small amounts of the loan. The average number of lenders holding less than 2 percent of a loan for firms likely to renegotiate is 65% higher than loans to other firms. Given that unanimity of syndicate members is required for renegotiation of loan terms, the evidence suggests that lenders form larger syndicates to make renegotiation more difficult. In other words, each syndicate member has veto power over renegotiation, and so “participant-loading” reduces the expected payoff to the borrowing firm from renegotiation. By reducing the expected value from renegotiation, lenders can reduce strategic default by borrowers. This result implies that ex-post renegotiation considerations affect ex-ante contract structure in a manner consistent with incomplete contract theory.
The rest of the paper is outlined as follows. The next section describes the syndicated loan market, the syndication process, and existing research related to this paper. The third section describes the data and basic summary statistics. The fourth section explores how information asymmetry affects syndicate structure and the participants chosen as syndicate members. The fifth section focuses on renegotiation in the syndicated loan market and how it affects syndicate structure. The sixth section concludes.
II. The syndicated loan market: background and existing research A. Background2 A syndicated loan is a loan made to a firm jointly by more than one financial institution. As Hitchings (1994) notes, “… it is fundamental to syndicated lending that the terms and conditions of the loan are similar for each of the lenders (32)”. Members of the syndicate fall into one of two groups: lead arrangers and participant lenders. The distinction is important, and the two groups vary on three major dimensions. First, participant lenders rarely directly negotiate with the borrowing firm, and typically have an “arm’s-length” relationship with the borrowing firm through the lead arranger. Lead arrangers establish and 2 The information in this section comes from practitioners working in financial institutions and lawyers who specialize in syndicated loan contracts. In addition, Wienke (1994), Hitchings (1994), and Esty (2001) are excellent descriptions of syndicated loan arrangements.
5 maintain a relationship with the borrower, and take on the primary information collection and monitoring responsibilities. (An often-cited “advantage” of a syndicated loan for a borrowing firm is being able to deal with only one bank while accessing funds of many banks.) Second, the lead arranger typically holds a larger share of the loan than any of the participants. Third, in terms of renegotiation rights, unanimity of all syndicate members is always required to change terms related to principal, interest, maturity, or collateral.3 For example, if a borrowing firm enters into a state of default by missing a payment, all members must agree to change contract terms in order to avoid acceleration of the loan. Renegotiation of contracts is common, and is done through amendments to the original loan agreement.