Debt Renegotiation And The Design Of Financial Contracts

Christophe J. Godlewski

University of Strasbourg – LaRGE Research Center (Laboratoire de Recherche en Gestion et Economie); EM Strasbourg Business School; Université de Haute Alsace – FSESJ

January 13, 2016

Abstract:

I study the impact of bank loan renegotiation on the design of financial contracts. Debt renegotiation can be beneficial for borrowers and lenders but its impact on the design of financial contracts is less clear. However, contract design is crucial for borrower’s investment, operating and financing policies. I find that the design of renegotiated credit agreements is not homogenous. Main renegotiation packages contain amendments to loan amount and maturity. I show that secured loans with longer maturities experience broader amendments. Creditors’ friendly environment and the presence of reputable, sound, and profitable lenders have a similar effect.

Debt Renegotiation And The Design Of Financial Contracts – Introduction

By their nature, loans are flexible contracts that can be revised and amended from time to time and this flexibility is considered one of the major advantages of corporate financing through bank loans. However, we still have a very limited knowledge on how credit agreements are redesigned following a renegotiation1. For instance, are amendments marginal, with few loan characteristics being renegotiated? Or on the contrary, are all contract terms amended during a renegotiation? This is a crucial issue because of the role of debt contract design for firm’s investment, operating and financing policies, with important consequences for the company’s stakeholders. Indeed, the design of credit agreements serves to allocate contractual control and decision rights. Under asymmetric information, debt contracts yield control rights to lenders, especially through covenants (Dessein, 2005; Garleanu and Zwiebel, 2009), which are frequently amended to relax constraints on borrower’s investment and financial policies (Denis and Wang, 2014) and to mitigate underinvestment problems (Pawlina, 2010) and involuntary liquidity defaults (Acharya et al., 2005).

This article provides empirical evidence on two important issues: how renegotiation shapes the design of credit agreements and what the determinants of the renegotiation package are. My explained variable capture the content or composition of renegotiation packages; i.e. the number of different loan characteristics that are amended. I use detailed data on amendments to more than 1,500 bank loan facilities between 1999 and 2014. I investigate how the initial loan characteristics, the structure of the lending pool, legal environment, and borrower and lender financial conditions affect the renegotiation package.

I focus on the European credit market for two main important reasons. First, the design of credit agreements is much more important in Europe because the European financial system is bank based (de Haan et al., 2012) and European companies are much more dependent of private credit to finance their growth than in the United States. Second, European legal environment is less protective of creditors when compared to US. According to Favara et al. (2012), creditors’ recovery rate in US is close to 90% while it is below 70% in the European Union. In such a legal environment, the issue of credit contract design is if utmost interest for borrowers, lenders but also policy makers.

Following notably Moraux and Silaghi (2014) and Hege and Mella-Barral (2005), I consider amendments as concessions that the counterparties to the contract are willing to accept, in order to achieve a better mutual outcome in terms of contract’s completeness. The willingness for concessions will depend on the borrower’s investment, operational and financial conditions, the potential agency problems, and the lenders situation. These elements depend ultimately on the bargaining power of the borrower and the lender(s), the contractual allocation of control and decision rights, the informational frictions shaping the initial contract design, and the adverse effects of ex ante incentives. To capture those features, I focus on four categories of variables related to the loan and syndicate structure at origination, the legal environment of the borrower country, and the borrower and lenders financial conditions.

I find that renegotiation packages are far from being homogenous. Loan amount (35%) and maturity (22%) are the most frequent material amendments. These two loan characteristic are also the most frequently amended when a renegotiation package involves the renegotiation of only one loan characteristic (respectively 45% and 24% of the cases). The breakdown of amended loan terms becomes more homogenous for more complex renegotiation packages, i.e. when multiple loan terms are amended. However, renegotiating the entire credit agreement and amending all loan characteristics is very rare (3%), while amending two or three loan terms is more common (34% and 12% respectively).

Among loan and syndicate characteristics at origination, collateral, maturity and lender reputation are the only significant variables with a positive influence on the number of amended terms following renegotiation. Creditors’ friendly legal environments, especially in terms of priority and recovery rate, have a similar impact. Lenders’ financial conditions, in particular their soundness and profitability, also allow to amend larger parts of the credit agreement. These effects are economically significant as each standard deviation increase translates into 0.15 to 0.3 standard deviations changes of the number of amended loan characteristics. Overall, these findings are robust to periods of financial crises, specific conditions at loan origination, borrower country effects, and alternative estimation methods.