Renegotiation is a crucial element in private debt contracting. Unlike public bonds, whose vast dispersed ownership structure makes renegotiation impossible to coordinate, private loans are typically issued by either one lender or a coterie of lenders (also known as a loan syndicate)—so renegotiating these contracts is a lot easier. Indeed, loan contracts are frequently amended during a lending relationship, with amended items running the gamut from interest rates, to maturity, to debt covenants.
Motivation
In theory, renegotiations should benefit all parties to the contract—why would a party agree to revise contracts if doing so would only harm it? In a sense, observed renegotiations should be close to what economists would call “Pareto-efficiency,” a theoretically ideal scenario where no one party could be made better off without making at least one other party worse off. After a loan contract is initially written, circumstances facing the contracting parties might change, often due to unforeseen events (for example, a sudden increase in the borrower’s financing needs), that make the initial contract terms overly restrictive. Renegotiations allow the contracting parties to return to the negotiation table and revise contract terms to accommodate the impacts of these changes. This process makes information “more complete,” to use a contracting parlance. Another important benefit is lender influence. During renegotiation, lenders can use their bargaining leverage to persuade (or even sometimes pressure) borrowers to improve their debt service capacity, which ultimately translates to improved cash flows for the borrower over the course of the lending relationship.
To be sure, renegotiations are not without costs. Legal and transactions costs can quickly pile up when renegotiations get contentious. Also, contracts are written by people who have various cognitive biases that lead them to make flawed decisions and depart from best practices. For example, overconfident managers might put too much weight on the gains but too little weight on the costs associated with a loan amendment. This tunnel vision hurts both the lender and the borrower down the road. Moral hazards could also be at play. Bank managers hoping to hide loan losses from the banks’ balance sheets might roll over loans to unprofitable borrowers knowing full well that full repayment of such loans was not possible (this ever-greening or zombie lending behavior was rampant in 1990’s Japan). Such cost-benefit tensions motivate our inquiry into the long term value creation of renegotiations. Specifically, we study renegotiation through the eyes of the borrower and ask whether borrowers perform better after renegotiating their debt.
Sample
Unlike prior studies that manually collect credit amendments, we build a large dataset of over 17,000 credit amendments using an algorithm that sifts through millions of public firm securities filings stored on the Electronic Data Gathering, Analysis, and Retrieval system (EDGAR). The Securities and Exchange Commission (SEC) mandates that its registrants disclose publicly, in item 1.01 of Form 8-K, significant corporate events, chief among which are material contractual agreements (think loan contracts) and their amendments (think renegotiated loan contracts). Here is the kicker: item 1.01 not only tells us whether a credit agreement is amended, but it tells us the major contract provisions amended and how they are amended. This lets us delve a lot deeper than other studies into how different amended items affect renegotiation outcomes. We build a dictionary of key words commonly used by companies to describe credit amendments in securities filings and feed these keywords to our algorithm to identify amended items.
Results
Our headline result is that renegotiations enable borrowers to deliver positive long run stock returns. Compared to non-renegotiating firms matched on size, book-to-market, profitability, and investment (which are necessary to control for common risk factors), renegotiating firms have 11 percent higher stock returns over the three years after the renegotiation (it is 19 percent over five years). This long run effect manifests regardless of how the market initially reacts to the 8-K filing announcing the renegotiation, judging by the cumulative abnormal stock returns over the three days surrounding the announcement. In other words, even when renegotiations initially draw skepticism from the market, they end up boosting the borrower’s performance in the long run, just like renegotiations whose announcements are cheered by the market.
We conduct many tests to unpack the mechanisms through which renegotiations benefit borrowers. We examine whether and how renegotiation’s long run effects vary with the contract items amended. We identify seven major amended items: (1) borrowing amounts, (2) maturity, (3) pricing terms, (4) financial covenants, (5) consent and waiver, (6) covenants on specific events like share repurchases, and (7) addition of contractual parties like new lenders. We find that renegotiations which result in waivers and consents—whereby lenders permit borrower actions that are otherwise prohibited under the prevailing terms—produce by far the largest returns among all loan amendments, averaging 45.1 percent over the next three years. This finding also tells us that lenders by and large make informed loan workout decisions that help unlock a borrower’s growth potential, which runs counter to a popular belief that lenders make flawed renegotiation decisions that prolong or exacerbate borrower problems. Amendments on loan maturity and specific corporate events produce much weaker long run returns.
We also link the changes in borrowers’ accounting performance after renegotiations to their stock returns. We find that borrowers’ capital expenditures and working capital (i.e., the amount of capital used for day-to-day operations) increase immediately after renegotiations, whereas cash flow from operations, return on assets, and bankruptcy risk improve a year later. The first two items broadly reflect borrowers’ financial flexibility, and the latter three capture different dimensions of profitability. That improvements in financial flexibility lag behind improvements in profitability is expected. While renegotiation often injects new funding into the borrower for additional investments, these investments take time to bear fruit and eventually yield profits. As further evidence of the intricate link between the changes in borrower accounting performance and their stock returns after renegotiations, we show that borrowers who improve accounting performance generate larger abnormal stock returns.
We further explore how the bargaining dynamics between borrowers and lenders shape the long run outcomes of renegotiation. There are two opposite views. On one hand, borrowers with strong bargaining power relative to the lender might be able to retain more of the gains brought about by the renegotiation, and consequently these borrowers should produce greater long run return. On the other hand, lenders with more control can better discipline moral hazard and more credibly threaten to end the negotiation if the borrowers take on bad projects. Consistent with the latter view, we find larger post-renegotiation outperformance when the borrower has less bargaining power, i.e., when the borrower has weaker stock performance before renegotiation, has fewer banking relationships, and is closer to—or has committed—a covenant violation.
The tests we discuss so far are largely associational, meaning that we can go only so far as saying that renegotiation is associated with—but does not necessarily cause—positive long run returns for borrowers. To tease out a causal effect, we want to use a shock event that, for instance, increases a borrower’s tendency to renegotiate but is beyond the borrower’s control and thus is unrelated to long run performance. We use mergers of banks that lend to the same borrower in the same loan syndicate. The idea is that after a bank merger, the number of lenders in the syndicate drops (by one), reducing the likelihood any particular lender vetoes the loan amendment, and therefore, makes renegotiation more probable. Using a difference-in-differences technique that compares the change in stock returns before and after the merger for borrowers affected by the merger (treatment group) and borrowers unaffected by the merger (control group), we show that borrowers affected by the merger experience larger stock returns, corroborating our main inference.
Conclusion
Our collective evidence suggests that renegotiations benefit borrowers in the long-run, but that the stock market does not instantly and fully incorporate such benefits upon a renegotiation announcement; it does so only gradually. A plausible explanation is that the information exchanged between the negotiating parties, together with the underlying motives for the renegotiation, is not fully disclosed to the market, despite the public announcement of the renegotiation event. The borrower’s stock price gradually goes up as the market picks up such information over time. From a disclosure perspective, we think the market could understand renegotiations better—and price them in more quickly—if the SEC pushes firms to provide more detailed disclosures about credit amendments, such as the rationale for reaching a particular provision adjustment. These disclosures could also narrow the information gap between the public (stocks, bonds) and private (loans) side of the capital markets.
Wei Wang is an Assistant Professor of Accounting at Temple University
Zhongnan Xiang is a PhD Candidate at Temple University
Sudipta Basu is a Professor of Accounting at Temple University
This post is adapted from their paper, “Long run Performance of Debt Renegotiations: Large-Sample Evidence” available on SSRN.
