Equity-Holding Institutional Lenders

The following post comes to us from Michael Weisbach and Bernadette Minton, both of the Department of Finance at The Ohio State University, and Jongha Lim of the Department of Finance at the University of Missouri.

In our paper, Equity-Holding Institutional Lenders: Do They Receive Better Terms?, which was recently made publicly available on SSRN, we evaluate the way in which institutional equity holders are involved in the lending process. Participation by equity-holding institutions has become a major part of the syndicated loan market. In our sample of 11,137 institutional “leveraged” loan tranches between 1997 and 2007 from the DealScan database, 2,008 (18%) have participation by a “dual holder” institution that owns at least 0.1% of the borrowing firm’s equity. Lending to firms in which one has an equity position goes against the principle of diversification, since it exposes the investor to firm-specific shocks through both its equity and debt ownership. To justify dual holding, the investor must receive compensation of some sort, either through the improvements in the value of its equity holdings, or by above market rates of return on the loan.

We estimate the abnormal return a dual holder receives by comparing spreads on dual holder tranches to those on observationally equivalent tranches that do not have a dual holder. Our estimates indicate, holding all else equal, that loan tranches with dual holder participation receive a 13 basis-point higher spread than otherwise similar tranches without an equity holder’s participation in the lending syndicate. The positive spread is statistically and economically significant for revolvers as well as term loans and for loans to borrowers of different ratings and to unrated borrowers as well.

It is possible that the equity holding by an institutional investor is correlated with other, potentially unobservable factors related to the loan tranche spread, which could drive the spread premiums. For example, suppose that the risk of the particular tranches for which equity holders tend to invest tends to be higher than is reflected in their ratings. We address the possibility that these spread differences in spreads could reflect unobservable sources of risk by considering differences in spreads across tranches of the same loan. Since different tranches of the same loan share the same underlying risk and have the same seniority, unobservable differences in risk cannot explain differences in spreads of tranches of the same loan. Because factors such as maturity and implicit options affect the spreads of different types of tranches, we test whether the existence of a dual holder affects the relative difference in spreads, holding other factors constant. Our results suggest that in a loan with both a Term Loan B and a revolver, if a dual holder invests in a Term Loan B tranche, the spread between the two is higher than would be expected absent dual holder participation, while if the dual holder invests in the revolver, the spread is lower than expected. In the subsample of dual holder loans that have multiple tranches of the same type, the tranches with dual holder participation have higher spreads than the tranches without dual holder participation.

These results are not consistent with the view that dual holder premiums reflect unobservable risk. Instead, they suggest that equity holders receive additional compensation in terms of additional returns when they lend to firms for which they hold equity positions. There are several channels that would lead to these additional returns. It is possible that common ownership of equity and debt could reduce conflicts of interest between claimholders, leading to improved firm-level investment, or that participation by an equity holder could certify a firm’s quality to outside investors. However, these arguments predict that returns to all tranches of a loan will be higher, and do not explain differences in returns between tranches of the same loan. The within-loan results are better explained by a story in which equity holders receive compensation for participating in tranches that are relatively difficult to fill at times when it particularly important for the firm.

An implication of this argument is that the equity holders with the largest monetary incentives and the flexibility to make loans quickly will receive higher premium. Our results suggest that there are large differences in premiums going to different types of dual holders. When private equity and hedge funds are dual holders, they have a 54 basis-point premium over other loans when other kinds of money managing funds are dual holders, the premium is 28 basis-points, and when all other types of institutional investors are dual holders, the premium is only 6 basis points. Since incentives to maximize returns from holding multiple securities of the same firm are substantially higher in private equity and hedge funds than in other institutions, these large differences reinforce our interpretation of the premium as reflecting equity holding institutions utilize their position inside the borrowing firms when they lend to their firms. In addition, spreads are higher when the investor has a larger equity position in the firm, and when it purchases a larger portion of the loan.

Institutional investors, especially private equity and hedge funds, have become substantial equity holders in corporations. In addition, they are important lenders to corporations through their role in the syndicated loan market. In principle, institutions could use one type of investment to improve returns in their other investments. The evidence in this paper suggests that their substantial equity stakes can lead these investors to obtain higher interest rates than other investors when they lend to the companies in which they hold equity. By comparing spreads across loan tranches of the same loan, we can rule out explanations for this finding coming from unobserved heterogeneity coming from risk or other loan features being associated with dual holders.

The basic point, however, is that there can be interactions among different investments by one financial institution in a particular firm. These interactions can potentially create efficiencies and rents that can be captured by one party or other. Understanding the way in which institutional investors utilize different types of investments to benefit their overall returns would be an excellent topic for future research.

The full paper is available for download here.

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