Private credit agreements represent an ideal—and largely overlooked—setting for examining the influence of finance on investment. A private credit agreement specifies the amount, interest rate, and other terms of a loan provided by a syndicate of banks to a firm. Roughly 80 percent of all public firms maintain private credit agreements. Compared with public bonds, private credit agreements contain covenants that are more detailed, comprehensive, and tightly set, making an analysis of private contracts essential to understanding the impact of external finance on firm behavior.

In the study “Creditor Control Rights and Firm Investment Policy,” University of Chicago Graduate School of Business professor Amir Sufi and coauthors Greg Nini of the Board of Governors of the Federal Reserve System and David C. Smith of the University of Virginia’s McIntire School of Commerce present new evidence that creditors exert direct control over the investment policy of solvent public firms via credit agreements.

The authors examined 3,720 contracts between U.S. banks and 1,931 publicly traded U.S. corporations from 1996 to 2005. They found that 32 percent of these contracts contained an explicit restriction limiting the firm’s capital expenditures. Such restrictions are more likely to be added following a decline in a firm’s cash flow or a deterioration in the firm’s credit quality. In addition, creditors are more likely to impose a capital expenditure restriction if a firm violates financial covenants in the credit agreement. These covenants usually state that the firm must maintain a high level of earnings and a low level of debt in order to comply with the credit agreement.

Capital expenditure restrictions in the credit agreement explicitly state that managers cannot spend more than a nominal dollar amount for a given fiscal year. These restrictions typically limit “cash” capital expenditures, an important component of firm investment. Alternatively, capital expenditure restrictions can be enforced as ercentages of revenue or earnings variables. To invest more than the limit, the firm must obtain the permission of the bank to temporarily remove the restriction.

Control over investment policy is among the most important performance-contingent contractual features found in credit agreements. For example, whether a credit agreement includes an investment restriction is often more sensitive to changes in firm performance than changing interest rates or collateral requirements.

A breach of the financial covenant means that the borrower is in technical default of the loan, giving the lender the right to demand immediate repayment of the entire balance. Such a demand can easily trigger a bankruptcy filing. The bank, however, can opt to renegotiate the contract. Thus, financial covenants serve as “tripwires” that put substantial power in the hands of banks. Banks can impose new contracts with higher interest rates and more restrictions, and add capital expenditure restrictions.

Sufi, Nini, and Smith find that new and tougher restrictions cause a reduction in firm investment spending. While creditors appear to force a reduction in investment, firms obtaining contracts with new restrictions experience subsequent increases in their market value and operating performance, suggesting that restrictions reduce inefficient excess investment by managers.

“Theoretical research in financial contracting assumes that there are important incentive conflicts between borrowers and lenders, and our findings strongly support this assumption” says Sufi. “While managers want to go after big, risky projects, creditors are naturally more conservative.”

Incentive Conflicts
“Optimal contracting models propose a simple, intuitive idea: when you lend someone money, you want some power over what they will do with that money,” says Sufi.

Sufi, Nini, and Smith examine this idea with a set of private credit agreements collected directly from Securities and Exchange Commission filings of public firms. The authors matched credit deals from Reuters DealScan database to firm financial characteristics from the Standard & Poor’s Compustat database. They also collected data on whether firms violated financial covenants in the year prior to the credit agreement.

“Our study focuses on the contracts, given their increasing importance,” says Sufi. “In recent years, there has been significant innovation in debt markets, and people are starting to understand that the contract is crucial.” The authors found widespread use of capital expenditure restrictions. Between 1996 and 2005, 42 percent of firms in the sample had loan agreements with a capital expenditure restriction.

Capital expenditure restrictions are common across industries, outside of agriculture. Restrictions were seen in approximately 40 percent of credit agreements obtained by borrowers operating in retail trade, wholesale trade, and services industries. Approximately one-third of credit agreements to manufacturing firms contained this type of restriction.

Restrictions were more common for small firms, but a substantial fraction of firms with over $1 billion in assets also had agreements with restrictions. There was a considerable difference in the incidence of investment restrictions among investment grade and junk borrowers. Only 6 percent of agreements obtained by investment grade borrowers had a capital expenditure restriction, while 44 percent of junk borrowers had agreements with restrictions.

Previous research has showed that one in four public firms violated a financial covenant at some point during a similar sample period. While 36 percent of credit agreements obtained before financial covenant violations included a capital expenditure restriction, over 60 percent of renegotiated agreements following such violations included these restrictions.

Restricted Investing
Sufi, Nini, and Smith’s empirical analysis yielded several sets of results. First, the authors documented that private creditors restricted the investment policy of a large fraction of public companies. Extrapolating their findings to all U.S. public firms, approximately one in three firms faced a capital expenditure restriction in a private credit agreement at some point in the last 10 years.

Second, the authors show that creditors obtained more control over firm investment policy in response to negative firm performance and increases in firm credit risk. Capital expenditure restrictions were more likely to be imposed when a borrower has lower cash flow, higher credit risk as measured by a firm’s credit rating, or has recently violated a financial covenant in an existing credit agreement.

“In some cases, banks are less interested in increasing the loan’s interest rate than in determining how the firm will use the money,” says Sufi.

In all estimates, there was a sharp increase in the likelihood of a firm receiving capital expenditure restrictions as it moved from an investment grade rating to a “junk” rating. For example, a firm that was downgraded from the lowest investment grade S&P rating (BBB) to the highest speculative-grade rating (BB) experienced a 21 percentage point increase in the likelihood of facing a capital expenditure restriction. These findings suggest that future contracts are explicitly contingent on the borrower’s performance.

Last, the authors show that capital expenditure restrictions indeed limit firm investment. Firms obtaining credit agreements with new restrictions experienced a 15 percent decline in investment compared to firms that obtain a new agreement without a restriction, even after considering observed changes in investment opportunities and performance.

In addition, the authors collected the exact values of restrictions for a portion of the sample contracts and found that actual expenditures appeared to cluster closely below the contractual limit. Before new credit agreements, almost half of the firms’ investments were above the yet-to-be-imposed restriction amount. After the restriction was imposed, less than 10 percent were above the restriction amount, and over 60 percent of firms hovered in the expenditure area two percentage points below the restriction.

Do creditor-imposed restrictions promote or hinder efficient investment? To provide evidence on the consequences of imposing capital expenditure restrictions, the authors examined how market value and operating performance changed after a firm obtained a credit agreement with a new restriction. Firms that faced restrictions on capital expenditures experienced increases in both market value and operating performance compared to firms without a restriction.

Do Creditors Add Value?
The findings suggest that restrictions that minimize incentive conflicts may prevent value-decreasing investment.“When the creditor is restricting investment, you don’t see decreases in firm performance,” notes Sufi. “There is the notion that restrictions will hurt firms and their shareholders, but the striking finding is that market performance and operating performance both go up after restrictions are imposed. While we interpret this evidence with caution, it suggests that managers were undertaking unprofitable projects before the restrictions.”

Sufi adds: “It’s important for firms to understand that when they get into trouble, they will face more than just higher interest rates. However, when creditors interfere, it’s not always a bad thing. Restrictions may benefit shareholders because managers may have been pursuing unprofitable acquisitions or bad investments.”

 

“Creditor Control Rights and Firm Investment Policy.” Greg Nini, David C. Smith, and Amir Sufi.