The researchers outline how demand for pledgeability varies with the economy, which leads to a cycle. When the economy is booming and shows no signs of slowing, banks are less concerned about pledgeability and are willing to do business with even opaque companies. In this case, banks issue more covenant-light loans.
In a boom that may not continue, lenders may be somewhat concerned about pledgeability, and a company’s managers have to weigh the trade-offs involved. It is likely, however, that in such times, a company can still borrow more with high leverage and low pledgeability. And in a bust, lenders demand pledgeability and lower leverage, because the managers’ pledgeability decisions have large ramifications.
If a company has opted to be more pledgeable but goes bankrupt in a bust, its pledgeability could help it finance a sale to an industry insider who will run it— allowing a higher recovery to lenders in bankruptcy. If a company instead opted against pledgeability, industry insiders would have a tough time financing the sale, and the company might get bought up at a low price by outsiders who don’t know much about the industry but are better able to raise financing. Under them, productivity can fall, and this can make a downturn more painful.
However, “while industry outsiders have little ability to operate the asset themselves, this may be a virtue—outsiders have a strong incentive to improve cash flow pledgeability because they do not want to own the asset long term, but instead want to sell the asset back to industry insiders at a high price,” the researchers write. Thus, these outsiders, such as private-equity firms, can replace managers and improve pledgeability until they can flip the company for a profit. But eventually “the incentive to maintain cash flow pledgeability wanes once again,” the researchers write, “and the cycle resumes.”