It turns out the relationship between publicly traded companies and their creditors is a bit like teenagers and their parents: Break the rules — stay out after curfew, or violate the terms of a loan agreement — and the restrictions get tighter.
Faced with protests and complaints, parents claim, “I’m doing this for your own good!” In the business world, if creditors said the same, recent research shows they’d be right.
Recent research by two LeBow professors — Dean’s Industry Fellow and Professor of Finance David Becher, PhD and Associate Professor of Finance Gregory Nini, PhD — looks at companies that violate the terms of their loan agreements and the control that loan issuers have over company activity as a result.
In a sense, their paper covers two sides of the same coin: The acquisitions often drive growth and profit, and the loans that underwrite them and make them possible. But it also uncovers the hidden impact of a common business-world occurrence: a loan covenant violation.
Along with co-author and LeBow doctoral program alum Thomas Griffin, PhD, assistant professor of finance at Villanova University, Becher and Nini found that nearly 75 percent of loan agreements include restrictions that limit borrower acquisition decisions throughout the life of the contract.
Following a financial covenant violation, which can cover anything from a momentary dip in a company’s stock price to a lower-than-expected quarterly earnings statement, creditors then use their bargaining power to tighten these restrictions and limit acquisition activity, particularly deals expected to earn negative announcement returns.
A covenant violation, Becher says, “gives creditors a reason to pay attention and the cover to enforce it, which leads to a better outcome for everyone.”
How much better? Becher and Nini find that firms that do announce an acquisition after violating a financial covenant earn 1.8 percent higher stock returns, on average, and do not pursue more risky deals. Those outcomes can be traced to the influence lenders have over company activity through the terms of their loan agreements.
“Prior research on this topic had historically ignored the role of lenders,” Nini says. “When big firms like Apple or Google make acquisitions, lenders aren’t involved, but there are a lot of big companies that do take out loans to make these deals. That’s why we have so many in our sample, and that’s where we really made a contribution to research on acquisitions.”
The sample pulls in roughly 2,000 publicly-traded firms, both S&P 500-listed industry leaders and smaller ones, with details of their loan agreements and descriptions of their violations mined from 8-K news announcements, annual reports and other financial statements.
Becher and Nini conclude that creditors use contractual rights and the renegotiation process to limit value-destroying acquisitions — a kind of shadow governance controlling firm behavior independent of the firm’s leadership and board directors.
Other researchers have already expressed interest in looking at the data set supporting the paper, but the research is of broader interest as food for thought for finance industry professionals working on either the acquisitions side or the lending side, or for those in board service steering their companies to better performance.
“You hear about shareholders all the time, or about activists pushing for a merger,” Becher says. “Greg has been looking at what creditors could do, and this was a nice way of bringing the two together. It’s been a departure, but it really makes you think: what else have we missed?”
Becher and Nini’s paper, “Creditor Control of Corporate Acquisitions,” was published in June in The Review of Financial Studies, a top-tier academic journal in finance.