# Presentation: 411757

## 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

**Notes:**
The motivation for this project is the large body of theoretical research that suggests that creditors should allocate themselves control rights over firm investment policy in debt contracts, given managerial agency problems.

The foundation for control-based theories is Jensen and Meckling (1979), who discuss how capital structure decisions are affected by the presence of agency conflicts between stakeholders.
As you will recall, the core intuition coming out of Jensen and Meckling is that management, acting on behalf of equity-holders, have incentives to pursue risky projects at the expense of creditors given their convex payoff.
Creditors will want to restrict firm investment as firms approach default to mitigate these risk shifting tendencies
The intuition of Jensen and Meckling is extended by Dewatripont and Tirole, who use an incomplete contracts framework to show that the allocation of control rights over firm investment policy can improve on simple cash-flow based contracts.
The core hypotheses that come from control-based theories of financial contracting are two-fold:

## 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:
- Explicit restrictions on capital expenditures are present on almost 40% of loan contracts
- Capital expenditure restrictions are more likely to be imposed as a borrower’s performance deteriorates
- Restrictions appear binding: that is, we document a direct effect of financing on firm investment behavior

- I. Introduction

**Notes:**
We motivate our analysis with a group of models known as control-based theories of financial contracting.
The foundation for control-based theories is Jensen and Meckling (1979), who discuss how capital structure decisions are affected by the presence of agency conflicts between stakeholders.
As you will recall, the core intuition coming out of Jensen and Meckling is that management, acting on behalf of equity-holders, have incentives to pursue risky projects at the expense of creditors given their convex payoff.
Creditors will want to restrict firm investment as firms approach default to mitigate these risk shifting tendencies
The intuition of Jensen and Meckling is extended by Dewatripont and Tirole, who use an incomplete contracts framework to show that the allocation of control rights over firm investment policy can improve on simple cash-flow based contracts.  As a borrowers performance deteriorates, these models hypothesize that creditors will take explicit control over elements of firm’s investment policy, well before bankrtupcy.

## 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

**Notes:**
 As I mentioned, we focus on private credit agreements between banks and public borrowers.  Most of these are syndicated loans, and most are revolving credit facilities.

We focus on private credit agreements for the following reasons:

Our sample consists of almost 5,000 loans made to 1,800 borrowers from 1996 through 2004.

## 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

**Notes:**
 I could probably spend most of the time describing how we were able to obtain data on capital expenditure restrictions.  Instead, I will go over this quickly and you can see the paper for a detailed look at what we do.

There is a large section of the paper devoted to explaining why we are only able to match 40% of Dealscan Loans.  To make a long story short, Dealscan gets its data from either these credit agreements, or from the banks directly.  When Dealscan gets the data from the banks directly, we can’t get the loan contract.  Unsurprisingly, when we cannot find a loan contract for a Dealscan loan, the information in Dealscan is of much poorer quality.  Meaning, missing information covenants, whether the loan is secured, etc.

Once we have these contracts, we manually search them for capital expenditure restrictions.

## 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

**Notes:**
Here are two examples of restrictions, directly from contracts.

## Slide 7

| 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 |  |  |  |

**Notes:**
This table presents summary statistics for the sample of 4,978 loans to 1,780 borrowers.

Things to note:
Capex restriction data
Most loans are revolvers
Financial covenant violation
Very few of the observations are in bankrupcty

## 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

**Notes:**
 As mentioned above, we motivate our empirical analysis with control based theories of financial contracting.  Jensen and Meckling first documented the importance of creditor control over firm investment policy by showing that management, acting on behalf of shareholders, has the incentive to pursue risky projects at the expense of creditors.  Creditors therefore want to restrict firm investment policy.

The incomplete contracts literature has extended this intuition.  There are 2 cases this literature examines

## 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

- III. Theoretical Framework

## 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”

- III. Theoretical Framework

## Slide 11

| 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 |  |  |  |  |

**Notes:**
Almost 40% of loans contain an explicit restriction on capital expenditures.  These restrictions are common across the industry distribution.

Consistent with the notion that control is more important among smaller, more opaque firms, smaller firms are more likely to have a capital expenditure restriction.  BUT, it is not only small firms that have these restrictions.

The right hand side of this table hints at the next set of results.  It shows that the existence of a restriction is negatively correlated with firm credit quality.  However, it is NOT just firms that are on the verge of bankruptcy that get these restrictions.

## 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

## Slide 13

| 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* |

**Notes:**
In this table, we examine the unconditional means.  On every performance measure, firms that have a capital expenditure in their loan agreement exhibit worse performance in the year prior to the agreement.

## 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

- IV. Results: Performance

**Notes:**
1. While the above table is informative, if we are going to take the theoretical framework seriously, we want to exploit within-firm variation to examine the effect of performance on the likelihood of getting a capital expenditure restriction.

## Slide 15

| 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 |

**Notes:**
 Here are the coefficient estimates.  We regress the {0,1} whether the loan contains a capital expenditure on firm variables in the year prior to the loan being signed.

Columns 1 & 2 examine the full sample, and show that a decline in cash flow or a financial covenant violation leads to an increased likelihood of having a capital expenditure restriction.  In terms of magnitudes, the coefficient estimates suggest that a drop from 75th to 25th percentile of the cash flow distribution leads to a 5 percentage point increase in the likelihood of getting a capital expenditure restriction, which is 13% of the mean.

Column 3 isolates the sample to rated firms, and shows a very strong effect of downgrades on the likelihood of having a capital expenditure restriction.

## 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

- IV. Results: Performance

## Slide 17

| 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 |

## Slide 18

## Slide 19

**Notes:**
In this graph, we are trying to get a “ranking” of which loan terms change most drastically in response to firm negative performance.  We examine four loan contract terms.

 It takes the estimates from the fixed effects estimation, and examines the marginal effect of a negative performance shock on the contract term in question, where the effect is stated as a percentage of the mean.

For example, a drop in cash flow for a given from from the 90th to the 10th percentile results in a 28% increase in the likelihood of having a capital expenditure restriction, evaluated at the mean.

## Slide 20

## Slide 21

**Notes:**
Here, we do the same thing with credit downgrades.  You can think of the bars as giving the slope of how responsive the contract term is to credit downgrades.  The omitted group if firms rated A or higher.

## 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
- 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
- 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

- IV. Results: Investment

## Example: Hollywood Park 1997 Credit Agreement

- Capital 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.

- IV. Results: Investment

## 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

- IV. Results: Investment

## Slide 27

## Slide 28

## 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

**Notes:**
 We believe we are among the first to show that creditors exert control over firm investment policy among public firms well outside of bankruptcy.  Baird and Rasmussen is published in a legal literature and presents mainly anecdotal evidence

Our paper is related to work in venture capital, which shows that control shifts from the entrepreneur to the VC when performance is negative.

Our paper adds to the literature on the importance of covenant in private debt agreements.  The grand majority of the literature focuses on public bond covenants, which, quite frankly, are just not that relevant.  Two exceptions are my paper forthcoming in the RFS and the working paper by Chava and Roberts.  

Finally, we believe this is the first paper to show that financing affects investment through explicit contract terms.  The existing literature focuses mainly on indirect effects, such as debt overhang or costly renegotiation.

## Future work

- Contingency and financial covenant violations
- 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)
- 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