Agree to Disagree: Within-Syndicate Conflict and Syndicated Loan Contracting

By | September 28, 2020

Recent studies show that dual holders—that is, institutions that simultaneously hold equity and debt of the same firm—internalize the shareholder-creditor conflict and lead to incentive alignment between the two parties (Jiang et al., 2010; Chava et al., 2017; Chu, 2018; Anton and Lin, 2020). However, mitigation of the shareholder-creditor conflict comes at the cost of introducing a new conflict among creditors. Creditors holding large equity stakes in debtor firms may have very different incentives than creditors holding very small or no equity stakes. This conflict between creditors can thus affect ex-ante debt contracting and ex-post debt renegotiation. In our recent paper, we try to analyze the impact of the conflict of interests among syndicate members induced by dual holding.
As the frequency of dual-holding has increased, so too has within-syndicate conflict, which has been increasing substantially in syndicated loans in the U.S. from 1994 to 2012. To measure within-syndicate conflict, we use the dispersion of the ratios of equity value to loan stakes across all syndicate members in a syndicated loan. We find that the level of within-syndicate conflict remains high even after the 2008 financial crisis. It is therefore important to understand the effect of the within-syndicate conflict on loan contracting and, consequently, corporate policy.
We first examine how within-syndicate conflict affects the use and design of loan covenants. Aghion and Bolton (1992) argue that financial contracts theoretically rely on two mechanisms to mitigate agency conflict. The first mechanism aligns the interests ex-ante to minimize disagreement ex-post; the second mechanism reallocates control rights ex-post. Christensen and Nikolaev (2012) argue empirically that capital covenants, those relying on information about sources and use of capital, are designed to align ex-ante interests; and the performance covenants, those relying current-period profitability and efficiency indicators, are designed to facilitate ex-post transfer of control rights. In the context of within-syndicate conflict, lenders with low equity stakes may be exploited ex-post by lenders with high equity stakes. For example, lenders with high equity stakes may prefer waiving covenant violations and not taking actions to restrict risk-taking activities, which undermines the interests of lenders with low or no equity stakes. Lenders with low equity stakes will thus require more protection ex-ante.
We use the dispersion of the ratios of equity value to loan stakes across all syndicate members in a syndicated loan to capture within-syndicate conflict. We find that loans with high within-syndicate conflict have more capital covenants, but fewer performance covenants. The results are consistent with the hypothesis that within-syndicate conflict makes ex-post resolution more difficult and hence ex-ante alignment of interests more important.
We also find that the strictness of performance covenants decreases with within-syndicate conflict. In contrast, within-syndicate conflict has no effect on the strictness of capital covenants. These results suggest that loans with high within-syndicate conflict rely less on ex-post renegotiation that may be triggered by covenant violation. Indeed, we find that the within-syndicate conflict is negatively associated with the likelihood of ex-post loan renegotiation.
We then proceed to examine whether within-syndicate conflict affects the probability of covenant violation. On the one hand, within-conflict conflict leads to fewer and looser performance covenants, and hence should lead to fewer covenant violations. On the other hand, the difficulty of ex-post lender coordination may encourage borrowers to behave more aggressively, and hence lead to more covenant violations. To this end, we find that the first effect dominates, that is, within-syndicate conflict decreases covenant violations.
Finally, we examine the effects of within-syndicate conflict on other loan contract terms. We find that loans with high within-syndicate conflict have lower loan amounts, shorter maturities, and higher spreads, consistent with the notion that within-syndicate conflict may increase agency costs. This suggests that limiting loan commitments can be another measure for lenders to deal with within-syndicate conflict, along with trading off performance covenants for more intensive use of capital covenants, and incentivizing more lead bank monitoring.
Our paper contributes to the growing literature on dual holders. All existing papers document the positive effect of dual holders in resolving shareholder-credit conflict. Our paper, in contrast, shows that the existence of dual holders may also induce conflict of interests within the lending syndicates and thus impact loan contracting. Our paper also contributes to the literature on within-syndicate conflict of interest by examining the unique conflict arising from syndicate members’ different equity holdings in the borrowers.

Yongqiang Chu is the Director of the Childress Klein Center for Real Estate and Professor of Finance at the UNC Charlotte Belk College of Business.
Luca X. Lin is a PhD Candidate studying finance at IESE Business School, University of Navarra.
Zhanbing Xiao is a PhD Candidate studying finance at Sauder School of Business, University of British Columbia.

This post is adapted from their paper, “Agree to Disagree: Within-Syndicate Conflict and Syndicated Loan Contracting,” available on SSRN.

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