Ebook Family Firms, Debtholder-Shareholder Agency Costs and the Use of Covenants in Private Debt
Recent research indicates that family firms (companies in which the founders or their families exert significant influence through either their equity stake in the firm and/or their presence in senior management and/or on the board of directors) are surprisingly common. LaPorta et al. (1999), Claessens et al. (2000), and Faccio and Lang (2002) show that family firms are at least as prevalent as non-family firms in Europe and Asia, and Anderson and Reeb (2003a) report that in the U.S., one-third of Standard and Poor’s (S&P) 500 firms can be classified as family firms. Further, Anderson and Reeb (2003a) provide evidence that family members tend to have a significant equity stake in their firms: On average, family members hold approximately 19% of their company’s shares. To date, accounting researchers have focused on the impact of founding family ownership structure on shareholder-shareholder conflicts by studying how it affects the incentive to manipulate earnings (Ali et al. 2005, Wang 2006), and the way in which executive compensation contracts are tied to accounting numbers (Chen 2005).
Finance researchers have focused on its impact on firm performance (e.g., Anderson and Reeb 2003a, Bennedsen et al. 2006, Villalonga and Amit 2006) and the cost of public debt (Anderson et al. 2003, Ellul et al. 2005). In this paper, we contribute to this literature by focusing on the debtholder shareholder conflict in family firms and its effect on the use of financial covenants in private bank loans. Because we examine covenants that rely on accounting numbers, our paper contributes to the accounting literature in particular by assessing the usefulness of financial statement information in private debt contracting between family firms and their lenders.
We focus on the use of covenants in private loan agreements for two reasons. First, private loans dominate the market for corporate debt. Dichev and Skinner (2002) report that private debt represents 80% of funded debt for their sample of large Compustat firms, a result that is consistent with Houston and James’s (1996) estimate that only 17% of outstanding debt is public. Second, private debt, which includes syndicated loans, is both easier to renegotiate and easier to liquidate than public debt (Edwards 1986, Eichengreen and Mody 2000, Dichev and Skinner 2002, Allen and Gottesman 2005, Altunbas et al. 2006). As a result, private debt is more likely to include covenants designed to address a variety of agency problems (Smith and Warner 1979, Gilson and Warner 1998, DeAngelo et al. 2002).
Family firms have a unique ownership structure that lends itself well to the examination of the agency costs arising from the debtholder-shareholder conflict and whether and how they affect the decision to include covenants in debt contracts. In particular, family firm ownership tends to be highly concentrated and family members tend to be relatively poorly diversified. According to Anderson and Reeb (2003a), family members have over 69% of their wealth, on average, invested in their firms, and 45.7% of family firms have founder or descendent CEOs. In addition, unaffiliated blockholders, who could serve as strong external monitors, tend to hold significantly smaller percentages of shares in family firms (Anderson and Reeb 2003b). Although the unique structure of family firms might mitigate certain agency problems (in particular, the owner-manager agency problem), Jensen and Meckling (1976) and Smith and Warner (1979) argue that when management’s and shareholders’ interests are closely aligned, as they are in family firms, the conflict of interest between shareholders and debtholders gives rise to opportunistic behavior by managers in which debtholder wealth is expropriated.
One method of mitigating this agency cost is through the use of covenants that protect lender(s) from the borrower using cash or assets in ways that increase the lender(s)’ risk. For example, liquidity and net worth covenants specify minimum limits on financial measures such as the current ratio, EBITDA, interest coverage, and the firm’s (tangible) net worth and thus inhibit the transfer of cash and assets to shareholders. They also help to ensure that the current debt can be serviced, and if not, that there are assets available for the lender(s) to claim. Leverage covenants that restrict additional borrowing reduce the possibility of opportunistic borrowing by managers and thus help to maintain the value of existing debt by placing maximum limits on the debt already in place.
We hypothesize that family firms are more likely than non-family firms to include such financial covenants in their private debt contracts. We further hypothesize that their inclusion is even more likely if the family’s control over operations is increased through the use of dual-class shares and/or if a family member is CEO. We also note that because renegotiation of private debt contracts is relatively inexpensive (Dichev and Skinner 2002, Allen and Gottesman 2005), even family members who have no history or intention of expropriating debtholder wealth (consistent with their building or maintaining reputation, Anderson et al. 2003) are more likely, relative to managers in non-family firms, to find it beneficial, in net, to “tie their hands” through the use of covenants and alleviate any concern of the lenders.
We test our hypotheses by studying the financial (liquidity, net worth and leverage) covenants included in 2,687 private loan packages of S&P 500 firms identified as family firms by Business Week in its November 10, 2003, issue. Business Week defines a family firm as: “…any company [in the S&P 500] where founders or descendants continue to hold positions in top management, on the board, or are among the company’s largest stockholders.” To identify these firms, Business Week relies on the methodology developed by Anderson and Reeb (2003a) but fine-tunes the process by examining individual firms in more detail, as required, to ensure that family members do in fact exert significant influence on company operations.
The private loan packages of the other (non-family) S&P 500 firms serve as a control sample. We gather covenant and loan package details, including average interest rate spread over LIBOR and maturity, from the 2005 Dealscan database. We gather dual-class share information from the Investor Responsibility Research Center database, CEO data from proxy statements and other necessary data from Compustat. Because our sample is restricted to S&P 500 firms, we note for the reader that we focus on the slice of the private debt market accessed by some of the largest and most stable firms in the U.S. economy. Further, the private debt in our sample is relatively short-term in nature, consistent with other research: the average (median) maturity is approximately three (two) years.
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