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THE ECONOMICS OF THE PRIVATE MARKET

Asymmetric Information, Contracting, and the Theory of Covenants

Two imperfections of capital markets are at the heart of many of the contracting problems that shape debt markets. ⁷⁶  First, the interests of bondholders and stockholders of borrowing firms are not always aligned; second, parties to financial contracts are not likely to be equally informed about the characteristics of the issuing firm. ⁷⁷  The informational advantage borrowers have over lenders leads to two kinds of bondholder-stockholder conflict. First, once a debt contract is signed, borrowers have incentives to expropriate wealth from lenders (moral hazard). Second, before a contract is signed, potential borrowers have incentives to understate the risks they will pose for lenders, including moral hazard risks. A simple example of moral hazard risk is provided by Black (1976), who noted that ''there is no easier way for a company to escape the burden of a debt than to pay out all of its assets in the form of a dividend, and leave the creditors holding an empty shell'' (p. 7). In the absence of sufficiently powerful constraints or capacity for lender monitoring and enforcement capacity, such actions may be either unobservable by the firm's bondholders or beyond their control. Smith and Warner (1979) identify four major kinds of moral hazard that lenders must control:

Dividend payment

 If a firm issues bonds and the bonds are priced assuming the firm will maintain its dividend policy, the value of the bonds is reduced by raising the dividend rate and financing the increase by reducing investment. At the limit, if the firm sells all its assets and pays a liquidating dividend to the stockholders, the bondholders are left with worthless claims.

Claim dilution

 If the firm sells bonds, and the bonds are priced assuming that no additional debt will be issued, the value of the bondholders' claims is reduced by issuing additional debt of the same or higher priority.

Asset substitution

If a firm sells bonds for the stated purpose of engaging in low variance projects and the bonds are valued at prices commensurate with that low risk, the value of the stockholders' equity rises and the value of the bondholders' claim is reduced by substituting projects which increase the firm's variance rate.

Underinvestment

Myers (1977) suggests that a substantial portion of the value of the firm is composed of intangible assets in the form of future investment opportunities. A firm with outstanding bonds can have incentives to reject projects which have a positive net present value if the benefit from accepting the project accrues to the bondholders. ⁷⁸

Covenants may alter the relationship between bondholders and stockholders in two fundamental ways. First, covenants affect the relationship when the borrowing firm is in financial distress by providing lenders with a mechanism for early intervention. This intervention may take one of several forms: forced bankruptcy, a renegotiated restrucEagleTraders.comg, or the imposition of additional constraints on firm behavior. This can be viewed as the role of covenants ex post, which is to permit these interventions after the consequences of the firm's actions have been revealed.

Second, and possibly more important, is the role of covenants ex ante. Debt contracts that include covenants can effectively constrain the ability of stockholders to engage in strategies designed to expropriate wealth from bondholders or otherwise to engage in actions that are detrimental to bondholders. Smith and Warner document that covenants of the kind observed in private placements and bank loan contracts can mitigate bondholder-stockholder conflicts. They also demonstrate that contracting is not a zero-sum game. Terms of contracts affect not only the distribution of wealth between the bondholders and the stockholders but also the total value of the firm. Covenants can increase a firm's value (relative to value under a contract without covenants) by providing disincentives to, or restrictions on, exploitive stockholder behavior. For example, asset substitution incentives may be so powerful that under a contract without constraints stockholders are willing to substitute an asset with a lower expected return so long as it has a sufficiently higher risk than the existing asset. Such a substitution increases stockholder wealth even though it decreases the firm's total value because the bondholders lose more than the stockholders gain. Rational bondholders, however, anticipate that some of their claim will be expropriated through asset substitution and price their bonds accordingly (that is, they demand a higher rate).  Thus, in the absence of constraints on asset substitution, equilibriums involving debt financings have two features: First, firms will take more risks than in the presence of constraints (the incentive to substitute assets does not disappear just because the bondholders' anticipation of asset substitution is reflected in the interest rate). ⁷⁹  Second, a firm's stockholders will absorb the loss in the firm's value that results from the asset substitution.  Consequently, any covenant that restricts asset substitution (for example, a requirement to stay in the same business, a restriction on asset sales, or restrictions on investments, mergers, and acquisitions) can increase firm value. Because ultimately the stockholders gain from such restrictions in equilibrium, they will agree to covenants in debt contracts.

The theory of covenants and renegotiation emphasizes that covenants must be based on mutually observable and verifiable characteristics, actions, or events (see, for example, Berlin and Mester, 1992, and Huberman and Kahn, 1988). Covenants cannot, for example, be written on characteristics, actions, or events that are observable only by the stockholders and not by the bondholders. Covenants also need to be observable and verifiable by third parties, such as a court of law. ⁸⁰  Characteristics, actions, or events that are observable but not verifiable cannot be included in covenants; however, they may still significantly affect an optimal debt contract. For example, a bank can refuse to renew a one-year loan on the basis of a mutually observable but nonverifiable characteristic but would have difficulty legally declaring a two-year loan in default at the end of the first year because of a violation of a covenant written on that same characteristic. This example suggests that, in many cases, a short-term loan without a covenant may dominate a longer-term loan with a covenant (see Berlin, 1991, and Hart and Moore, 1989).

Although covenants can be written only on observable and verifiable characteristics, they may be related to nonverifiable and even unobservable characteristics. This relation greatly increases the power of covenants for mitigating bondholder-stockholder conflicts. A relation between observables and unobservables may exist for two reasons. First, observable, verifiable actions or events may be correlated with nonverifiable or unobservable actions or events. For example, the true risk of a firm, that is, the volatility of its returns, may not be observable. However, its current ratio may be correlated with this volatility and, therefore, serve as a proxy for risk. Second, an observable characteristic, action, or event may be related to an unobservable characteristic, action, or event through either self-selection or incentive effects. For example, a firm's ability to take unobservable risks may be much greater in industry A than in industry B. Consequently, a covenant that restricts a firm to industry B limits the ability of a firm to alter its (unobservable) risk profile. A financial covenant may have the same effect. For example, a minimum current ratio requirement may constrain a borrower from selling on account to slow-paying customers. ⁸¹  Selling to such customers necessarily increases the observed liquidity risk of the firm because its current ratio deteriorates. It may also create an incentive to increase the firm's unobservable risk, to the extent that the firm has more ability to sell to unobservably (to the lender) riskier customers if it is permitted to extend trade credit on longer terms. ⁸²

Collateral can also be used to mitigate bondholder-stockholder conflict. For example, a lien on firm assets (inside collateral) prevents borrowers from selling those assets without lender approval. ⁸³  This limits the firm's ability to expropriate lender wealth through asset substitution (see Smith and Warner, 1979). Owners' pledging personal assets as collateral for a corporate loan (outside collateral) effectively increases their equity exposure. Such increased exposure may have important incentive effects depending on the owner's level of risk aversion. Outside collateral may also be useful in solving adverse selection problems because a borrowing firm's willingness to pledge collateral may reveal its true quality (see Chan and Kanatas, 1985), or it may be useful in solving incentive problems because it may alter the marginal return to risk shifting (that is, asset substitution) (see Boot, Thakor and Udell, 1991).

76. Modigliani and Miller (1958) argued that if capital markets are perfect and there are no taxes, a firm's capital structure is irrelevant-that is, the value of a firm is independent of the way it is financed. They argued that the structure of the right-hand side of the balance sheet will determine the way the firm's cash flow will be allocated, but it will not affect the amount of the cash flow. By extension, the structure of the firm's financial contracts (that is, the right-hand side claims) is also irrelevant. For example, pledging the firm's equipment to one lender as collateral will alter the allocation among creditors in liquidation but will not alter the amount allocated.

77. In keeping with the literature on contracting, we refer to a borrowing firm's bank, its private creditors, and its public creditors collectively as its bondholders.

78. Smith and Warner (1979), pp. 118-19. Black and Scholes (1973) and Merton (1974) have shown that option pricing theory can be used to value debt and equity. In effect, issuing a bond is equivalent to the owners' selling the firm's assets to the bondholders in exchange for a package consisting of the proceeds from the bond issue, a claim on the firm's dividends, and a European call option on the firm's assets with an exercise price equal to the face value of the bonds and an exercise date equal to the bond's maturity. Because stockholders' equity is essentially a call option, the stockholders' interest is to increase the riskiness of the firm's assets-just as the owner of a call option benefits from an increase in the risk of the stock on which the option is written. Ceteris paribus, the gain in stockholders' equity (that is, the European call option) will be offset by the loss in the value of the bonds.

79. Even when bondholders price in anticipation of asset substitution, stockholders are still better off substituting assets (that is, switching to the riskier strategy) than they would be sticking with the safe strategy. If stockholders stuck with the safe strategy, the bondholders, having priced their bonds on the basis of a risky strategy, would enjoy a windfall.

80. It is not difficult to imagine a wide variety of observable, but not verifiable, characteristics, actions, or events. For example, qualitative attributes of owner-managers would generally be mutually observable but not verifiable. Some characteristics of firms may be too complex to include in covenants.

81. If a company sells on account to slow-paying customers, its turnover of accounts receivable will slow down (that is, the days turn, or the average days an invoice is outstanding, will increase) as its accounts receivable increase. Assuming no increase in the firm's capitalization (that is, its stockholders' equity plus long-term debt), this increase in accounts receivable will have to be financed by an increase in current liabilities. Because the current ratio is defined as current assets/current liabilities, the current ratio necessarily decreases.

82. A firm's accounts receivable generate risk because the firm is extending credit to its customers. It is generally assumed that slower-paying customers are riskier on average than faster-paying customers (ignoring for purposes of this discussion the ability of the firm to affect the payment patterns of any individual customer through discounts and collection activity). The firm chooses whether to sell to safe or to risky customers based on the risk-return trade-off. This decision will be reflected in the firm's turnover of accounts receivable and its current ratio, which can be observed by the bank. However, it can also affect the firm's unobservable risk. Let us assume, for example, (1) that all customers who pay their trade debts in less than thirty days (fast payers) are low risk, (2) that half of all potential customers who pay in more than thirty days (slow payers) are low risk and the other half of the slow payers are high risk, and (3) that the risk quality of the slow payers is perfectly observable by the firm extending the trade credit, but only the accounts receivable turnover and the current ratio are observable by the bank. Under these assumptions, a constraint on the firm's trade policies through a minimum current ratio would effectively limit the ability of the firm to change its unobservable risk profile because it would truncate the firm's decision set.

83. See Berger and Udell (1990) for a discussion of the distinction between inside and outside collateral. Essentially, inside collateral involves pledging firm assets to a particular lender, creating a creditor preference. Aside from lender control effects, this type of collateral alters the payoff allocation among creditors in liquidation but does not affect the aggregate amount of the payoff. Outside collateral involves pledging nonfirm assets (typically by the firm's owners) to specific lenders. This type increases the assets available to satisfy creditor claims in liquidation (that is, it increases the amount of the payoff in liquidation).

Information-based Theories of Financial Intermediation

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