creditor control rights and firm investment policy

Creditor Control Rights and Firm Investment Policy

Amir Sufi*

University of Chicago

Graduate School of Business

[with Greg Nini and David C. Smith]

October 26th, 2006

*I thank the FDIC Center for Financial Research for financial support.

Motivation

• How does financial policy affect investment policy?

• Important theoretical research: creditors should allocate themselves explicit control rights over firm investment policy in debt contracts

– Jensen and Meckling (1976), Aghion and Bolton (1992), Dewatripont and Tirole (1994)

• Virtually no empirical evidence supporting this claim

– Evidence from public bond covenants contradicts these models– Control-based theories of financial contracting have not

influenced literature on how financing affects investment

I. Introduction

Our contribution

• We provide new evidence on the micro-foundations of how financial policy affects investment policy

• In particular, we examine private bank loan agreements and find strong empirical support for control-based theories of financial contracting:

1. Explicit restrictions on capital expenditures are present on almost 40% of loan contracts

2. Capital expenditure restrictions are more likely to be imposed as a borrower’s performance deteriorates

3. Restrictions appear binding: that is, we document a direct effect of financing on firm investment behavior

I. Introduction

Data

• Examination of covenants in private credit agreements is critical

• Public bond covenants are set loose, and almost never bind

• Only 15-20% of firms have access to public debt, 80% use bank credit facilities

• Even among firms with public debt, 95% have a bank credit facility with covenants that are tighter, more likely to be violated, and more relevant for examining firm behavior

• Billett, et al (2006): less than 5% of public bonds contain restrictions on investment

• Our sample:• 4,978 loans made to 1,780 borrowers from 1996 through 2004

• How did we get these contracts?

II. Data

Data Collection

• Start with a sample of loans from LPC’s Dealscan matched to Compustat financial variables

• No information in Dealscan on capital expenditure restrictions

• Extract actual loan agreements from SEC’s EDGAR website and match back to Dealscan

• Search through all 10-Ks, 10-Qs, and 8-Ks using Perl script• Extract loan contracts and assign firm identifier and date• Merge back onto Dealscan (40% match rate)

• Manually search through contracts for capital expenditure restriction

II. Data

Capital Expenditure Restrictions

• Airborne Express, June 29th, 2001

• Limitation on Capital Expenditures. Capital Expenditures for each Fiscal Year shall not exceed the maximum levels as set forth below opposite such Fiscal Year

Fiscal Year Ended: Maximum Level

December 31, 2001 $205,000,000

December 31, 2002 $255,000,000

December 31, 2003 $305,000,000

• American Precision Industries, August 31st, 1998

• CAPITAL EXPENDITURES. For any one fiscal year, [the borrower shall not] make or incur aggregate Capital Expenditures in excess of seven and one-half percent (7-1/2%) of the Company’s Consolidated net sales as shown on the Company’s audited financial statements for such fiscal year

II. Data

Summary Statistics(from Table 2)

Mean St Dev Mean St Dev

CapEx Restrictions Firm characteristics

Restriction {0,1} 0.382 0.486 Total assets ($M) 1,336 1,625

CapEx/assetst-1 0.066 0.039 EBITDA/Assets 0.034 0.035

Restriction, capex/assetst-1 0.089 0.132 Covenant violation {0,1} 0.080 0.272

Loan characteristics Has credit rating {0,1} 0.483 0.500

Loan amount ($M) 274 637 Credit rating

Interest spread (bp) 191 130 Investment grade 0.450 0.497

Secured {0,1} 0.716 0.451 Junk 0.550 0.497

Dividend restriction {0,1} 0.836 0.371 CCC or lower 0.025 0.155

Revolver {0,1} 0.736 0.441

Theoretical Framework

• Conflicts of interest between creditors and management makes allocation of control rights important in financial contracting (Jensen and Meckling (1976))

• Using an incomplete contracts framework, Dewatripont and Tirole (1994) and Aghion and Bolton (1992) formalize this intuition

• Framework: 2 cases of agency conflicts• Manager with private benefits engages in ex-ante sub-optimal

courses of action (shirking via moral hazard)

• Manager engages in ex-post value destroying behavior (risk-shifting, or excess continuation bias)

III. Theoretical Framework

Hypotheses• Given that management prefers more risky investments, creditor

interference represents “punishment” mechanism

• In response to bad performance, creditors restrict the ability of management to invest

• Intuition: bad firm performance is evidence that management has engaged in sub-optimal courses of action. Creditors therefore punish management after bad performance.

• Hypothesis 1: Creditors allocate themselves control over investment policy in origination loan contracts

• Hypothesis 2: Creditors are more likely to impose capital expenditure restrictions when the firm performs poorly


Dewatripont and Tirole (1994)

• “Proper managerial incentives require outsiders to go against the managers’ will only when it is likely that they have engaged in suboptimal courses of action. Poor performance is thus followed by a high probability of external interference [by creditors], while good performance is rewarded by a low probability of external interference”


The Widespread Use of Capital Expenditure Restrictions(from Table 3)

Mean Mean

Restriction {0,1} 0.382

By industry Has credit rating 0.444

Ag, minerals, construction 0.178 Does not have credit rating 0.314

Manufacturing 0.382

TCU 0.319 Conditional on rating:

Trade—Wholesale 0.423 Investment grade 0.093

Trade—Retail 0.480 Junk 0.494

Services 0.458 AAA, AA 0.000

By size quintile A 0.047

1 0.511 BBB 0.112

2 0.490 BB 0.464

3 0.443 B 0.527

4 0.310 CCC or worse 0.627

5 0.152

Capital Expenditure Restrictions and Borrower Performance

• Control-based theories of financial contracting predict increased creditor interference in response to negative performance

• We use three measures of performance

• Average cash flow in the year prior to the loan agreement

• Whether a firm has violated a financial covenant in the year prior to the loan agreement

• The S&P corporate credit rating prior to the loan agreement

• We expect an increased likelihood of capital expenditure restrictions in response to negative performance

IV. Results: Performance

Mean Differences,

by Whether Loan Has Capital Expenditure Restriction(from Table 4)

(1)

No capital expenditure restriction

(2)

Capital expenditure restriction

EBITDA/Assets 0.037 0.031*

Covenant violation {0,1} 0.052 0.125*

Market to book ratio 1.833 1.640*

Book leverage ratio 0.303 0.363*

Conditional on having credit rating

Rating (1 = AAA or AA, 2 = A, etc) 3.333 4.279*

Junk rated {0,1} 0.405 0.866*

Fixed Effect Regressions

• Theoretical framework suggests that the same firm that experiences negative performance increases likelihood of a capital expenditure restriction

• To exploit within-firm variation in performance, we utilize firm fixed effects linear probability regressions

• Standard errors adjusted for within-firm correlation of error terms

2004

1990( 1) *it t i it it itt

prob rest Performance X


The effect of performance on likelihood of having capital expenditure restriction

(from Table 5)

LHS: Capital Expenditure Restriction {0,1} (1) (2) (3)

BBB ratedt-1 {0,1} 0.084

(0.048)

BB ratedt-1 {0,1} 0.288**

(0.094)

B ratedt-1 {0,1} 0.327**

(0.126)

CCC rated or worset-1 {0,1} 0.628**

(0.204)

[Cash flow/assets]t-1 -1.900**

(0.702)

-1.536**

(0.712)

-1.690

(1.345)

Financial covenant violationt-1 {0,1} 0.195*

(0.078)

0.227

(0.121)

N

R2

4,978

0.10

4,978

0.10

2,402

0.18

Negative Performance and Other Loan Terms

• Firms are more likely to have a restriction on capital expenditures imposed after negative performance

• How does the effect of negative firm performance on capital expenditure restrictions compare to the effect of negative firm performance on other loan terms?

• Examine the effect of negative performance on:

• Interest spreads• Whether the loan is collateralized• Whether the loan contains a dividend restriction


The effect of performance on interest spreads(from Table 5)

LHS: Ln (Interest Spread over Libor) (1) (2) (3)

BBB ratedt-1 {0,1} 0.304**

(0.102)

BB ratedt-1 {0,1} 0.580**

(0.141)

B ratedt-1 {0,1} 0.786**

(0.176)

CCC rated or worset-1 {0,1} 0.819**

(0.192)

[Cash flow/assets]t-1 -5.645**

(0.828)

-5.482**

(0.823)

-5.622**

(1.612)

Financial covenant violationt-1 {0,1} 0.092

(0.075)

0.036

(0.122)

N

R2

4,978

0.49

4,978

0.50

2,402

0.71

Figure 1How does a negative performance shock affect loan terms?

0%

10%

20%

30%

40%

50%

60%

Drop in cash flow from 90th to 10th percentile Financial covenant violation in past year

Ch

ang

e at

mea

n

Capital expenditure restriction Interest rate spread

Secured Dividend restriction

Figure 2Changes in loan contract terms in response to credit downgrades

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

Capital expenditurerestriction

Interest rate spread Secured Dividend restriction

Ch

ang

e at

mea

n

BBB BB B CCC or worse

Do Restrictions Affect Investment Policy?

• A large body of research focuses on the causal effect of financing on investment policy

• General approach: some type of indirect friction leads to underinvestment when firms are forced to rely on external finance

• Debt overhang, renegotiation costs, information asymmetry, etc.• To our knowledge, no research documents direct contractual

investment restrictions in debt contracts

• Our approach: creditors impose contractual restrictions on capital expenditures as a second-best solution in the presence of agency conflicts

IV. Results: Investment

Evidence that Restrictions Affect Investment

• Before examining the data, two immediate facts suggest that the restrictions matter for firm investment

1. A well-established theoretical framework suggests that imposed capital expenditure restrictions restrain borrowers in response to negative performance

• Difficult to see why banks would impose a meaningless restriction in response to negative performance

2. The level of detail in the restrictions suggest they are costly to write and enforce

• For example, loan to The Chalone Wine Group on April 19th, 2002 contains separate restrictions on wine barrel capital expenditures and non-wine barrel capital expenditures


Example: Hollywood Park 1997 Credit AgreementCapital Expenditures. [Borrower shall not] Make, or become legally obligated

to make, any Capital Expenditure except:(a) Maintenance Capital Expenditures not in excess of (i) $15,000,000 for the

Fiscal Year ending December 31, 1997, (ii) $15,000,000 for the Fiscal Year ending December 31, 1998 and (iii) $20,000,000 for any subsequent Fiscal Year;

(b) Capital Expenditures to the extent financed by Indebtedness permitted under Section 6.9(h);

(c) Capital Expenditures for the construction of approximately 200 additional hotel rooms, a restaurant, an entertainment lounge, meeting rooms, retail space and parking facilities at the Reno Property not in excess of $25,000,000;

(d) Capital Expenditures for the construction of buffet and restaurant facilities at the New Orleans Property not in excess of $10,000,000;

(e) Capital Expenditures for the purchase of capital assets which, as of the Closing Date, are leased by Borrower or any Restricted Subsidiary from other Persons pursuant to operating leases not in excess of $8,000,000; and

(f) Capital Expenditures not otherwise permitted above which, when added to all other Basket Expenditures theretofore made, do not exceed $40,000,000.


Restrictions and CAPEX / Assets

Showing that Restrictions Matter

• Identification problem:

• Negative performance leads to capital expenditure restrictions• Negative performance also leads to reductions in capital

expenditures• Given negative performance, capital expenditures would likely fall

even if restriction was not put in place

• Our solution: exploit the actual amount of the restriction and show that borrowers tend to “cluster” just below the restriction


Figure 4Capital expenditure/capital expenditure limit, year before and after loan

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

[0.00, 0.2] (0.2, 0.4] (0.4, 0.6] (0.6, 0.8] (0.8, 1] (1, 1.2] (1.2, 1.4] (1.4 & above)

Ch

ang

e at

mea

n

Year before agreement Year of agreement

Summary

• We provide strong support for control-based theories of financial contracting

• Creditors impose capital expenditure restriction on 40% of loans

• Creditors are more likely to impose a restriction in response to borrower negative performance

– The effect of negative performance on likelihood of capital expenditure restriction is stronger than effect of negative performance on other contract terms

• Capital expenditure restrictions appear to restrain borrower capital expenditures

• Financing affects investment given agency conflicts between creditors and management

V. Conclusion

Our contribution

• Micro-foundations of the effect of financing on investment

• Hennessy (2004), Hennessy and Whited (2006)• Private debt covenants: Chava and Roberts (2006), Sufi(2006)

• Control over investment policy shifts to creditors after negative performance

• Evidence from VC: Kaplan and Stromberg (2006); Lerner, Shane, and Tsai (2004)

• Creditors exert contractual control over public firms, well outside of bankruptcy

• Baird and Rasmussen (2006)

V. Conclusion

Future work

1. Contingency and financial covenant violations

2. Do creditors take control because …

• … managerial misbehavior/moral hazard? (Dewatripont and Tirole)

• … managers, acting on behalf of shareholders, engage in risk shifting? (Jensen and Meckling)

3. How close to the first best investment level can we get, even with agency conflicts?

• Or in other words, how efficient is renegotiation?• Can management credibly convince creditors to waive

restriction if there is a positive NPV project?

V. Conclusion

creditor control rights and firm investment policy

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