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1. Introduction
Syndicated loan, which is provided by a group of lenders and arranged by one or several commercial or investment banks, is one of the major funding channels for corporations worldwide. It often occurs in situations where a borrower requires a large sum of capital that may be too much for a single lender to provide, or outside the scope of a lender's risk exposure levels. The syndicated loan market has become dominant for issuers to tap banks and other institutional capital providers for loans because syndicated loan is less expensive and more efficient to administer than traditional bilateral loans.
It is common for syndicated loan agreements to include financial covenants and performance pricing covenants. Financial covenants in a syndicated loan contract enforce either maximum or minimum financial performance measures against borrower’s performance. For example, with a minimum current ratio specified in the loan contract, the borrower must maintain its current ratio above this level to avoid technical defaults. If not maintained, the covenant will offer lenders the opportunities to negotiate a loan contract and give them the right to terminate the agreement or force the borrower into default. In most cases, the lender would choose to demand immediate repayment, to increase spread, or to include additional collaterals if borrowers are in violation of certain covenants.
Performance pricing covenant (PPC) was first introduced in the 1970s and has been widespread in many syndicated loan contracts since the early 1990s. Contracts with PPC include a pricing grid that defines performance levels based on certain criteria and their corresponding interest spreads. PPC may be tied either to the firm's credit rating or to an accounting measure of risk, such as the leverage or the
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debt-to-EBITDA ratios.
Performance pricing provisions can be divided into two categories: an interest-increasing covenant when firms experience bad performance and creditors can charge higher interest rates and an interest-decreasing covenant when firms have good performance and creditors can lower interest spreads specified in the loan contract. Loans with performance pricing will punish borrowers with higher spreads if borrowers’ performance deteriorates while will reward borrowers with lower spreads if they outperform their initial state. Loan contract may include both interest-increasing and interest-decreasing performance pricing as well as financial covenants, and the same financial variables can be set on all these provisions.
The theoretical literature showed that PPC can reduce transaction costs, alleviate asset substitution and signal firm’s financial conditions (Asquith, 2005, Bhanot, 2006, Manso et al, 2010). While these theories explain some reasons of PPC inclusion, the inclusion still remains a puzzle in some situations. Adam and Streitz (2014) identified that there is only a few public bond issues include performance pricing covenants. In contrast, the use of performance pricing is common in loan contracts1 (47% of their sample contain performance pricing covenants). By analyzing our sample of USA loan market data, we observe that the use of PPC differs between types of financial institutions. Table 1 shows the percentage of usage of PPC by four types of financial institutions. It is clear that traditional commercial banks tend to use more performance pricing covenants in loan contracts than the other three types of financial institutions (Finance Company, Investment Bank, and Insurance Company).
[Insert Table 1 here]
1 Adam and Streitz (2014) identify only 115 public bond issues with performance pricing provisions from 74 distinct companies between 1989 and 2012.
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Furthermore, we examine the difference of using PPC by separating financial institutions into “Domestic” and/or “Foreign”. Table 2 outlines the total lending amounts from 1990 to 2010 of both “Domestic” and “Foreign” institution in the USA loan market. As showed in Table 2, we know that syndicate loans seem to clustered in local financial institutions. Table 3 shows that the probability of using PPC by domestic financial institution is higher than by foreign financial institutions.
[Insert Table 2 and 3 here]
There should be no concerns about hold-up problem in public bond markets but there is serious hold-up problem in loan contracts, where the four types of financial institutions may have different market strategies toward different types of loan customers. Finally, a fundamental difference between foreign- and domestic banks is that domestic banks emphasis more on long-term relationship. The difference of in loan market share between “Domestic” and “Foreign” financial institutions may also affect their bargaining power. Foreign banks may price products bellow domestic competitors and offer better terms in loan agreements to capture more market share .The situations mentioned above address three questions. Why do firms issue loan with PPC? What is the main reason for creditors to include PPC in loan contracts?
Does the bargaining power or lending relationship affect the decision to include PPC in loan contracts?
Adam and Streitz (2014) argue that PPC is used to reduce hold-up problem in long-term banking relationships. The use of PPC is more common if the borrower is
“locked in” by lenders. For example, banks can exploit borrowers by charging higher interest rates or refusing interest rate reductions when the borrower`s performance
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different types of PPC (mixed, interest-increasing, interest-decreasing)2.
To explore the difference of using PPC, we examine whether a long-term lending relationship or the bargaining power may lead to the discrepancy in using different types of PPC. We posit that there is a relation between the use of different types of PPC and use several proxies for lending relationship and lender-borrower bargaining power. Using a large loan sample from the USA syndicate loan market data between 1993 and 2010, we find that the use of PPC is more common if there is a steady long-term lending relationship.
We further analyze whether the use of PPC varies systematically across different types of borrowers. We find that interest-increasing PPC is more common in relationship lending arrangements with smaller firms, firms with a lower long-term issuer credit rating at the time of the loan origination, and firms with lower analyst coverage. The presence of a lending relationship between borrowers and lead arrangers reduces the probability of using interest-increasing PPC. This is consistent with the argument that lead arrangers cannot capture all rents from holding-up borrowers. Thus for lead arrangers hold-up is a less attractive strategy than preserving the relationship with the client.
Finally, we find that the use of interest-decreasing PPC is more likely to happen when lead arrangers rank lower in loan market league table. The results support our hypothesis that lenders with less loan market share may try to use more interest-decreasing PPC to attract borrowers in relationship loans.
The rest of the paper proceeds as follows. Section 2 reviews the related literature about the use of performance pricing covenant. Section 3 develops hypotheses based on different types of PPC. Section 4 describes methodology. Section 5 discusses our empirical results, and Section 6 concludes.
2 The authors only show the three types of PPC are positively correlated with relationship strength.