Wednesday, March 28, 2007

SSRN-Control Rights and Capital Structure: an Empirical Investigation by Michael Roberts, Amir Sufi

SSRN-Control Rights and Capital Structure: an Empirical Investigation by Michael Roberts, Amir Sufi:

Roberts and Sufi show that "financing decisions of solvent firms are dictated by creditors...."

More specifically they show that following a covenant violation, creditors exercise some of their power and limit further debt issuances. (Of course this is not surprising, but still always good to see what we expect to happen actually happens.)

A couple of look ins:
"... 97% of credit agreements contain at least one financial covenant and almost 80% of these agreements explicitly restrict the amount of debt that a firm may have in their capital structure....more than one quarter of all publicly listed firms in the US violate a financial covenant at some point...Among firms with an average leverage ratio of at least 5%, this fraction approaches one third. Thus, financial covenants are not only a prominent feature of debt contracts (Smith and Warner (1979) and Bradley and Roberts (2003)) but they are also frequently violated (Dichev and Skinner (2002)) and, importantly, rarely lead to default
or acceleration of the loan (Gopalakrishnan and Parkash (1995))."
Just because the paper shows that the violation does not lead to accelerationof the loan, it does not mean that violation does not bring with it penalties. From reduced credit, to increased rates, to forced equity issues, the creditors do use their power to protect their position but do fall short of demanding immediate payment.

As the authors state:
"[The paper] documents that the transfer of control accompanying covenant violations has significant consequences for corporate debt policy over and above any changes in manager’s preferences for debt. Specifically, net debt issuances decline, on average, by 70 basis points in the quarter following a covenant violation. This sharp reduction in net debt issuance is persistent for two years following the violation, and leads to a reduction in leverage ratios by 3%."

Cool paper! I^3!!!


Roberts, Michael R. and Sufi, Amir, "Control Rights and Capital Structure: an Empirical Investigation" (January 31, 2007). Available at SSRN:

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