F R S INANCE ESEARCH EMINAR S U UPPORTED BY NIGESTION “How Effectively Can Debt Covenants Alleviate Financial Agency Problems?” Prof. Andrea GAMBA Warwick University, Warwick Business School Abstract We examine the effectiveness of debt covenants in alleviating financial agency problems. Distortions in both investment and financing policies with long-term debt are captured in a structural dynamic model where both policies are endogenously determined by shareholders. The combined and compounding effect of these distortions is shown to be large. We impose covenants that restrict the level of debt, or control the use of proceeds from asset sales or debt issuance, and analyze how, and how much, they mitigate financial agency costs. We investigate the direct and indirect impact of covenants on financing and investment policies, including at the point where covenants are violated, providing alternative interpretations of recent empirical evidence. We conclude that the presence and enforcement of debt covenants significantly alters dynamic financing and investment policies, not only at the point of covenant violations, and thus should be an important element of structural models. Friday, November 14, 2014, 10:30-12:00 Room 126, Extranef building at the University of Lausanne How Effectively Can Debt Covenants Alleviate Financial Agency Problems? Andrea Gamba Alexander J. Triantis∗ February 10, 2014 Abstract We examine the effectiveness of debt covenants in alleviating financial agency problems. Distortions in both investment and financing policies with long–term debt are captured in a structural dynamic model where both policies are endoge- nouslydeterminedbyshareholders. Thecombinedandcompoundingeffectofthese distortions is shown to be large. We impose covenants that restrict the level of debt, or control the use of proceeds from asset sales or debt issuance, and analyze how,andhowmuch,theymitigatefinancialagencycosts. Weinvestigatethedirect and indirect impact of covenants on financing and investment policies, including at the point where covenants are violated, providing alternative interpretations of recent empirical evidence. We conclude that the presence and enforcement of debt covenants significantly alters dynamic financing and investment policies, not only at the point of covenant violations, and thus should be an important element of structural models. ∗Gamba is at the Warwick Business School, Finance Group, University of Warwick ([email protected]). Triantis is at the Smith School of Business, Department of Finance, Uni- versityofMaryland([email protected]). Triantisgratefullyacknowledgesfinancialsupport from the Center for Financial Policy at the Robert H. Smith School of Business. We thank without implications for comments and suggestions Yuri Tserlukevich, Thomas Dangl, and the participants of the 2013 SFS Finance Cavalcade, University of Miami, and the 2013 EFA Annual Conference, Univer- sity of Cambridge, and at seminars at Warwick Business School and Arizona State University for their helpful comments. 1 Introduction It has long been argued in the corporate finance literature that the use of debt financing introducesdebt–equityagencyconflictsintheformofdistortionstocorporateinvestment and financing policies. The evolution from static to dynamic corporate finance models has expanded our perspectives on the nature and magnitude of these distortions, and the extent to which different debt contract designs can mitigate these conflicts. These have included a focus on seniority, maturity, and call and reset features.1 However, the role of debt covenants in resolving financial agency problems has not yet been carefully explored in a dynamic setting, despite much recent interest in the empirical literature on the role and impact of covenants. In this paper, we introduce different debt covenants into a dynamic structural model of the firm to analyze how, and how well, they mitigate investment and financing distortions. Given the prevalence of debt covenants, particularly in private debt contracts, they are generally viewed as value enhancing design features. The underlying concept is that they allow a state-contingent transfer of control from shareholders to bondholders which can mitigate financial agency problems. Smith and Warner (1979) provide the first detailed evidence on the types of covenants used, and tied these covenants to agency problems they were designed to mitigate. More recently, Bradley and Roberts (2004) and Billett, King, and Mauer (2007) provide additional empirical evidence on the types of covenants embedded into private and public debt contracts, respectively. Bradley and Roberts (2004) find that covenants have a direct effect on decreasing yields. Billett, King, and Mauer (2007) explore the relationship of different covenants to the leverage ratio, debt maturity structure, and the prevalence of growth opportunities. Another strand of empirical literature on covenants focuses specifically on the states where covenants are violated. Beneish and Press (1993), Beneish and Press (1995), Dichev and Skinner (2002), and Sweeney (1994) document that covenants are written with triggers that are quite tight relative to the firm’s financial condition at the time of debt issuance, and as a result the frequencies of covenant violations are quite high. They also explore firms’ accounting choices as they come close to triggering covenant 1HackbarthandMauer(2012)exploreoptimaldebtpriorityinadynamicsetting. RajanandWinton (1995) discuss the role of short-term debt, but also the impact of long-term loans subject to covenants. Bhanot and Mello (2006) explore shareholder incentives when debt includes rating triggers that affect debt contract structure as a firm’s credit risk increases. 2 violations. More recently, Chava and Roberts (2008), Roberts and Sufi (2009), and Nini, Smith, andSufi(2009)examinefirms’investmentandfinancingbehavioronceafinancial covenant has been violated, finding a decrease in both investment rates and debt levels, and concluding that lenders use the opportunity of a technical default trigger to pressure firms to alter their policies and reduce credit risk. We examine the investment and financing policies that shareholders would follow absent any covenant restrictions, and the resulting magnitude of financial agency costs. While several recent papers have focused on measuring agency costs using dynamic models, their models have imposed either a fixed level of debt (Childs, Mauer, and Ott (2005), Mello and Parsons (1992), Moyen (2007)), a specified maturity schedule for debt (Leland (1998), Parrino and Weisbach (1999)), or restrictions on the issuance of new debt (Titman and Tsyplakov (2007)). While a flexible financing policy could potentially help to mitigate investment distortions, we show how shareholders will instead game the financing policy, taking advantage of legacy debt holders. This financing distortion further exacerbates underinvestment problems, and the resulting compounding effect leads to significant value loss, far greater in magnitude than documented in the existing literature. Using this baseline, we measure how effective debt covenants restrictions can be in moving shareholders’ investment and financing policies closer towards firm value max- imizing policies, and the extent to which agency costs can thus be mitigated. Within the range of covenants used in practice, we focus our attention on three representative restrictions that highlight some key and prevailing characteristics of real life covenants. The first is an asset sweep covenant that requires shareholders to use proceeds from asset sales to pay down debt, and thus discourages asset sales designed merely to fund share- holder payouts.2 The second is a debt sweep covenant that specifies that proceeds from new debt issuance be used to pay down existing debt, and thus targets opportunistic leverage increases that expropriate current bondholders’ wealth.3 The third is a financial accounting covenant which is violated if the firm’s Debt/EBITDA ratio exceeds a spec- 2Sweep provisions are highlighted by Bradley and Roberts (2004). Debt encumbered with an asset sweep covenant is similar to secured debt. Morellec (2001) explores the joint effects of asset liquidity and pledging assets as collateral on the debt capacity of a firm. 3Itisalsocommontofindcovenantsthatrestrictdividendpayments. Wedonotmodelcashretention in our model, so the drivers of excessive dividend payments in our context would be either liquidated capital or new debt issuance, and the two sweep covenants address these potential agency problems directly. 3 ified threshold. Shareholders can remedy this technical default by making investment and/or financing decisions that will limit the firm’s Debt/EBITDA ratio under similar profitability scenarios. We find that these covenants are effective in different ways, and to varying degrees, in reducing investment and financing distortions and mitigating the value loss associ- ated with financial agency problems. Due to the compounding effects of investment and financing distortions, the covenants that reduce the likelihood of new debt issues or increase the incentive to reduce debt are also quite effective in mitigating investment distortions despite not targeting investment directly. Similarly, the covenant that ad- dresses asset liquidations also indirectly mitigates financing distortions. Furthermore, we show that covenants alter investment and financing policies across many states, and not simply at the points where the covenants are binding or violated. These policy modi- fications result in significant value creation, particularly when the propensity to increase leverage is controlled, and in low states of profitability due to either macroeconomic or firm-specific factors. Our state–contingent framework is particularly well–suited to examine the impact of a debt covenant violation on investment and financing policies, and to provide insights on the recent empirical literature on this topic. A key advantage of our model is that we can conduct parallel simulations where debt is, or is not, subject to a financial covenant. We can thus examine in a controlled manner the investment and financing policies at the specific states where the covenant would get violated if it existed, and see whether the existence of the covenant indeed makes a difference. From this controlled experiment, we find that while the investment rate drops fol- lowing a covenant violation, once other factors related to these low states are controlled for in a multivariate regression, the violation itself actually results in higher investment. We put these results in the context of conflicting empirical conclusions in Chava and Roberts (2008), Roberts and Sufi (2009), and Nini, Smith, and Sufi (2009). In contrast, the empirically documented drop in debt levels at the time of a financial covenant vio- lation appears to be an unambiguous consequence of the violation and its remedy. Our simulations also produce a significant drop in net payout once the covenant is violated. 4 Our model is closest in structure to Brennan and Schwartz (1984) and Titman and Tsyplakov (2007).4 In their path-breaking article, Brennan and Schwartz (1984) laid the foundations for models that incorporate both dynamic investment and dynamic financing. Their model also includes a financial accounting covenant. However, the main purpose of their paper is to show how a contingent-claims framework can be applied to value a firm allowing for dynamic corporate policies. Their results regarding the effect of the financial covenant are thus very limited. More recently, Titman and Tsyplakov (2007) present a fully dynamic model of en- dogenous investment and leverage decisions that incorporates the effects of taxes, finan- cial distress costs, and adjustment costs for both financing and investment. While our model shares many similar structural characteristics with theirs, they do not explicitly incorporate debt covenants. They do impose a debt restructuring condition similar to that in Fischer, Heinkel, and Zechner (1989) which requires all debt to be repurchased and new debt to be issued when the firm changes its debt level, even when it reduces debt. Our debt sweep covenant shares some commonality with this condition, but is less restrictive, and its effects are explicitly explored. In a simpler dynamic setting that leads to closed form solutions, Leland (1994) ex- amines the effect of a positive net-worth covenant on the propensity of shareholders to increase the riskiness of assets, and on the firm’s capital structure. Consistent with Leland (1994) and the related dynamic corporate finance literature, we do not seek to derive optimal security designs, but rather to examine the quantitative effect of com- mon debt features on dynamic investment and financing strategies and the resulting firm value. A different strain of the corporate finance literature studies the optimal allocation of control, and derives the design of covenants endogenously (within the class of debt contracts). For example, Garleanu and Zwiebel (2009) examine entrepreneur-lender con- flicts under asymmetric information, while Mao (2011) models managerial-shareholder conflicts and derives debt covenants that address the moral hazard problem.5 4Other papers such as Childs, Mauer, and Ott (2005)) examine dynamic investment in the presence of debt, but allow only for a single growth option that can be exercised once rather than allowing for switching between various capital levels, and they do not incorporate dynamic debt policies. 5Earlier related papers on debt covenants include Berlin and Mester (1992), Rajan and Winton (1995), and Sridhar and Magee (1997). In an interesting departure to the conventional literature on debt covenants, Murfin (2012) examines the issue of covenant strictness from the supply side rather than from the firm’s perspective. He finds evidence that defaults in a bank’s loan portfolio tends to 5 The next section presents a simple example in which we provide the economic intu- ition of some of the results of the quantitative model. Section 2 details the quantitative model. Section 3 provides results regarding the measurement of agency costs, the impact of covenants on investment and financing policies in general and at covenant violation points, and the overall effectiveness of covenants in reducing agency costs. Section 4 concludes the paper. 1 A Simple Example To illustrate our main results, we present a simple example featuring some key assump- tions of the general model. Assume there are three dates, t = 0,1,2, and the state variable is the firm’s productivity, θ, whose dynamics are described in the binomial lat- tice in Figure 1, with a constant conditional probability of 1 for upward jumps. The 2 firm’s cash flow (EBITDA) is θk, where k is the capital stock, with constant return to scale. For simplicity, we assume no taxes, no depreciation, a zero discount rate, and that debt is pari passu. Debt matures at t = 2 and is paid off with the current cash flow only (i.e., the company does not save its cash flows from prior periods and there is no salvage value of capital). At t = 0 the firm has capital k = 1 and debt b = 2.5, as per a prior decision, and the shareholders can decide to either keep the same debt (b(cid:48) = 2.5) or increase it to b(cid:48) = 4 with immediate effect. In the latter case, they receive the market value of the new debt net of a fixed adjustment cost of 0.1. At t = 1, contingent on the outcome for θ, the firm can adjust the capital stock, assuming it can be either doubled (k(cid:48) = 2) or halved (k(cid:48) = 0.5).6 If the equity holders decide to increase the production capacity, they pay 2.6 to buy a unit of new capital, and to sell a previously purchased unit of capital they get only 0.4 for it (and hence 0.2 for a half–unit of capital sold). The new capital, k(cid:48), affects the cash flow at t = 2 only. lead to increased strictness of covenants on subsequent portfolio loans, likely due to learning about the lender’s screening ability. 6We exclude k(cid:48) =0 on the assumption that this extreme asset stripping is prohibited. 6 1.1 Investment distortion: asset stripping We first analyze the investment policy assuming the firm cannot change debt (b = b(cid:48) = 2.5). It is easy to show (and thus excluded for brevity) that the policy that maximizes the total firm value is to double capital (k(cid:48) = 2) if θ = 3 and to keep it at k(cid:48) = 1 if 1 θ = 1. The resulting value of the firm at t = 0 (explained below) is 1 V = 2·1 (cid:18) (cid:19) 1 1 1 + 3·1−2.6+ (4·2)+ (2·2) 2 2 2 (cid:18) (cid:19) 1 1 1 + 1·1+ (2·1)+ (0·1) 2 2 2 (cid:18) (cid:19) (cid:18) (cid:19) 1 1 1 1 1 1 = 4+ −2.6+ (4·2)+ (2·2) + (2·1)+ (0·1) = 6.2, 2 2 2 2 2 2 where the first line is cash flow at t = 0 (θ = 2 and k = 1), the second line is the value 0 in the upper branch at t = 1, when the capital stock is optimally increased to k(cid:48) = 2, and the third line is the value in the lower branch at t = 1, when the capital is optimally kept at k(cid:48) = 1. In the fourth line, we have collected 4, the value of the cash flows at t = 0 and t = 1, which does not depend on firm’s decisions. So, these $4 will be later on included without explanation. Differently from the firm value maximizing policy, the optimal policy from the eq- uity’s perspective is to double capital if θ = 3 and to halve it (asset stripping) if θ = 1, 1 1 with an equity value of E = 4 (cid:18) (cid:19) 1 1 1 + −2.6+ max{4·2−2.5,0}+ max{2·2−2.5,0} 2 2 2 (cid:18) (cid:19) 1 1 1 + 0.2+ max{2·0.5−2.5,0}+ max{0·0.5−2.5,0} 2 2 2 = 4.55, where the third line is the value to equity in the lower branch at t = 1, when the capital is optimally halved to k(cid:48) = 0.5. Notably, the final payoff to equity in t = 3 is positive 7 only if k(cid:48) = 2 in t = 1. All other choices for k(cid:48) are dominated by this one and thus not presented. To conclude, when b = b(cid:48) = 2.5, equity holders deviate from the first best investment policy and take advantage of existing unprotected debt holders by cashing out part of the assets of the firm. 1.2 Financing distortion: claim dilution We now analyze the debt policy, by forcing k = k(cid:48) = 1 (i.e., the firm cannot change the capital level). As per our assumptions, we will only look at whether b(cid:48) should continue to be equal to 2.5, or increase to 4. Since the debt does not mature until t = 2, the cash flows at t = 0 and t = 1 are identical to the ones seen before, with a combined value of $4. As for the firm value maximizing policy, if b(cid:48) = 2.5, the firm value is equal to $4 plus the probability weighted average cash flow at t = 3 given k = 1: 1 1 1 V = 4+ (4)+ (2)+ (0) = 6. 4 2 4 If b(cid:48) = 4, the total firm value is 5.9 = 6−0.1, where 0.1 is the cost of issuing debt at t = 0. So, the first best decision is to keep b = b(cid:48) = 2.5. Considering now the equity value optimization case, for b(cid:48) = 2.5, the value of equity cash flow is 1 1 1 E = 4+ max{4−2.5,0}+ max{2−2.5,0}+ max{0−2.5,0} = 4.375. 4 2 4 If b(cid:48) = 4 is selected instead, the market value of new debt issued with a $1.5 face value is 1 1 1 D = (1.5)+ (0.75)+ (0) = 0.75, 4 2 4 where 1.5 is the payoff to debt when the firm is solvent at t = 2, in the upper state; 0.75 is the part of $2 of cash flow paid to new debt holders in proportion of their fraction (37.5% = (4−2.5)/4) of total debt given the pari passu assumption, in the intermediate 8 state when the firm is in default; and 0 is the payoff in the lower default state, in which there is no cash flow. Therefore, the value of equity in this case is 1 1 1 E = 4−0.1+0.75+ max{4−4,0}+ max{2−4,0}+ max{0−4,0} = 4.65, 4 2 4 in which, at t = 2, there is the operating cash flow minus what shareholders pay both old and new bondholders. The value is higher than what the shareholders get by keeping b constant, since the equity holders are extracting value from the existing debt holders.7 So, theoptimalsolutionisb(cid:48) = 4, andtheequityholdersdistortdebtpolicybyincreasing debt to extract value from existing bondholders. 1.3 Investment distortion exacerbated by dynamic financing: underinvestment Removing the constraint of the previous case, if the debt is increased at t = 0, this will affect the investment policy at t = 1, and the new bondholders anticipate the equity holders’ selection of k(cid:48) when buying the new debt (i.e., the effect is incorporated in the debt price). From the previous analysis, the firm value maximizing solution is to leave b un- changed, since there is no advantage to higher debt (and there is a cost to issuing debt). Under b(cid:48) = 2.5, the first–best policy is to double the capital (k(cid:48) = 2) if θ = 3, while 1 leaving k(cid:48) = 1 if θ = 1. 1 However, shareholders will want to increase the debt to b(cid:48) = 4 to expropriate wealth from the existing bondholders. If they do so, the shareholders will select k(cid:48) = 1 (under- investment) rather than k(cid:48) = 2 if θ = 3. The resulting solution is better for shareholders 1 than keeping b(cid:48) = 2.5, in which case they would double the capital if θ = 3. Sharehold- 1 7To see this, the original debt holders receive 1.625 (= 1(2.5)+1(2)+1(0)) if b(cid:48) =2.5, but only get 4 2 4 1.25 (= 1(2.5)+ 1(2·2.5/4)+ 1(0)) if b(cid:48) = 4. The equity holders get this difference, i.e. .375, minus 4 2 4 the cost of issuing debt, 0.1, or a net value of .275 as additional value. 9