Control rights in private credit agreements

Abstract

I examine the effect of creditor control rights on borrowers’ financing policy both ex-ante and ex-post. The novelty introduced by this thesis is the use of an investor protection variable reflecting the pledgeability of a firm’s assets, both at industry and country level, alongside the contractual allocation of control rights, in understanding financial contracting and capital structure mechanics. At industry level, the empirical analysis is first motivated with a model that allows debt contracts to allocate control rights over the reorganization or liquidation decision of distressed firms and where cash flow pledgeability can vary. The model delivers two main predictions: (1) Ex-post, creditor control should be associated with an increased likelihood of resolving financial distress out of court relative to filing for bankruptcy, particularly in industries where assets are easier to collateralize; (2) Ex-ante, creditor control should be associated with an increased use of leverage, particularly in industries where assets are easier to collateralize. Empirical results provide evidence consistent with these two predictions. At country level, strong judicial effectiveness is found to alleviate the effect of the contractual enforcement of rights by creditors on financing policy. Net debt issuing activity declines sharply following a covenant violation, when creditors use their contractual acceleration and termination rights to increase interest rates or halt any further supply of credit. The decline is however found to be less pronounced in countries with stronger legal enforcement. This result is also observable for a variety of financial and investment policy measures including capital expenditures, asset growth and cash holdings, therefore highlighting the importance of strong contract enforcement in reducing financial and investment conservatism following a covenant violation and improving firm performance.