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E-MailDavid Becher is David Cohen Research Scholar and Associate Professor of Finance; Thomas Griffin is a Ph.D. Candidate in Finance; and Greg Nini is Assistant Professor of Finance, all at Drexel University LeBow College of Business. This post is based on their recent paper.
Corporate creditors play an important role in firm governance. For example, Lee Enterprises, Inc. reported in their third quarter 2008 financial statement that “the Company’s strategies are to increase its share of local advertising through increased sales activities in its existing markets and, over time, to increase its print and online audiences through internal expansion … [and] acquisitions.” [1] The company financed these plans, in part, with a credit facility containing a minimum net worth covenant. In the fourth quarter, Lee’s net worth fell below the contractual limit, resulting in a violation of the credit agreement. To remedy this, Lee Enterprises and their lenders amended the credit agreement to “modify other covenants, including restricting the Company’s ability to make additional investments and acquisitions without the consent of its Lenders.” [2]
This anecdote is consistent with prior evidence that shows covenant violations impact firm policies through the transfer of control rights from borrowers to creditors. However, the fact that the waiver imposed restrictions on Lee Enterprises’ key operational strategy raises several questions about the objectives and effects of creditor interventions. Do creditors use control rights to influence the risk profile of firm investments? How do actions taken by creditors affect firms’ equity holders? In our paper, Congruence in Governance: Evidence from Creditor Monitoring of Corporate Acquisitions, we investigate these questions using a sample of 7,191 mergers completed between 1997 and 2015.
We find that creditors use their bargaining power and contractual authority to limit acquisition activity. Our key innovation is using detailed acquisition data to identify which types of deals creditors prevent and to analyze the implications for shareholder value. Rather than encouraging borrowers to pursue less risky acquisitions, we find that creditors use control rights to limit deals expected to reduce firm value. The likelihood of announcing a value-destroying acquisition falls by roughly 40% when firms are in violation of a covenant. Conversely, we find no evidence that creditors use control rights to limit acquisitions that create value. Creditors’ ability to censor deals with low expected value shifts the distribution of stock returns for deals announced; acquirers that recently reported a covenant violation earn, on average, approximately 1.7% higher three-day announcement returns compared to similar acquirers that did not report a violation. Further, if the acquirer does experience negative stock returns at announcement, the firm is more likely to withdraw the bid when in violation of a financial covenant.
To better understand why firms in violation of a financial covenant earn higher acquisition returns, we examine observable deal characteristics. Prior research shows that entrenched corporate managers destroy value by avoiding private targets and engaging in diversifying acquisitions. Since creditors share less in the upside of returns, they may use control rights to exacerbate this agency problem and “play it safe.” We find no evidence, however, that creditors encourage borrowers to decrease risk via acquisitions as acquirers in violation of a covenant shy away from deals typically associated with shareholder value destruction, including diversifying acquisitions. Nevertheless, deal characteristics cannot fully explain the improved acquisition outcomes. Even after controlling target listing status, deal nature, and method of payment, acquirers in violation of a covenant earn higher announcement returns. Since covenant violations are not randomly assigned, we provide evidence of a causal interpretation by controlling for a host of observable factors known to influence acquisition outcomes and implementing a quasi-regression discontinuity design to identify the effect of a covenant violation.
We interpret these results in light of economic models that show creditor monitoring can produce positive shareholder spillover effects by preventing value-reducing investments motivated by managerial private benefits. We bolster this interpretation by exploring how the effect of a covenant violation varies with the quality of governance provided by equity holders. To the extent that equity holders already prevent managers from pursuing private benefits, we expect smaller creditor effects in well governed firms. We find that our results are concentrated among firms without a large blockholder and firms operating in concentrated industries. These findings suggest that creditors improve acquisition outcomes by filtering deals with low synergies when existing governance mechanisms are inadequate.
Our paper contributes to the literature on creditor control rights and firm investment decisions. Prior research shows that covenant violations are associated with declines in a broad range of investment and financing activity, including capital expenditures, debt issuance, and employment. Our detailed acquisition data sheds light on the type of investments that creditors curtail. We confirm a decline in acquisition activity, but find no evidence that creditors use control rights to alter the risk profile of borrower investments. Instead, our analysis of announcement returns suggests that creditors curtail investments that they expect would destroy firm value, which provides a spillover benefit for shareholders. We conclude that creditors and equity holders share congruent preferences to limit activity motivated by managerial agency conflicts.
The complete paper is available for download here.
Endnotes
1Citations taken from https://www.sec.gov/Archives/edgar/data/58361/000119312508171998/d10q.htm(go back)
2Citations taken from https://www.sec.gov/Archives/edgar/data/58361/000119312508262419/d10k.htm(go back)
