Ebook How Do Creditors Value Corporate Diversification? Evidence from Bank Loan Contracting
Whether corporate diversification increases or destroys firm value has been the subject of extensive investigation in the finance literature. Earlier evidence generally shows that diversified firms sell at a discount relative to focused firms and suggests that diversification destroys share value (e.g., Lang and Stulz, 1994; Berger and Ofek, 1995). Recent studies have argued, however, that diversification per se does not cause a discount (e.g., Graham et al. (1999); Lamont and Polk (1999); Villalonga (2004); Campa and Kedia (2001)). Using a plant-level database that covers the entire U.S. economy, Villalonga (2005) even finds that diversified firms are traded at significant premia compared to focused firms in the same industry.
A corporation embeds the claims of various stakeholders including shareholders, managers, and creditors and each group may attach a different value to diversification. For example, managers may value diversification because it allows them to have greater discretion on the firm’s cash flows by creating an internal capital market, and because it reduces the potential risk in managerial compensation linked to the firm’s overall performance. Or, diversification may be of value for equity-holders if they are able to diversify their own individual investment portfolios only at higher cost. While substantial evidence has accumulated on the effect of corporate diversification on equity holders and on managerial behavior, little is known about creditors’ assessment of the merits of corporate diversification.
This paper provides an analysis of creditors’ evaluation of business diversification. We examine the impact of corporate diversification on bank loan contracting for primarily two reasons. First, bank loans are a primary source of corporate debt financing; Bradley and Roberts (2005) show that since 1994 the amount of private bank debt of corporations is much larger than public debt. Given the increasing proportion of bank debt in corporate financing, as well as the increased level of corporate diversification in recent decades through mergers and acquisitions (see, e.g., Montgomery, 1994; Pryor, 2001), it is important to understand how corporate diversification affects the pricing and structure of bank loans to firms.
Second, creditors’ evaluation of corporate diversification can be inferred from price and non-price features of bank loan contracts such as the loan rate, loan maturity, and loan covenants. Theory suggests that corporate diversification can affect the nature of creditor contracts via the following channels: First, it can reduce the corporation’s overall cash-flow volatility by combining the cash flows of multiple business segments, i.e., via a coinsurance channel. Second, the degree of informational asymmetry may be lower for diversified than for focused firms because idiosyncratic informational errors at business segment levels cancel out, resulting in a lower overall informational asymmetry, i.e., via an information diversification channel.
Third, diversified firms may be harder to evaluate than stand-alone firms because they may be less transparent and it may require more extensive knowledge to evaluate their multiple business segments, i.e., via a transparency channel. Finally, agency costs may be higher for diversified firms because managers have more discretion on resource allocation across business segments of the firm, i.e., via an agency channel. This paper assesses empirically by examining price and non-price terms of firms’ bank loan contracts the potential channels linking corporate diversification to creditor valuation. Note that creditors can employ non-price terms to curb default risk by shortening debt maturity and increasing monitoring frequency, or by tightening debt covenants that constrain the investment choices of managers. Thus, price and non-price terms in bank loan contracting provide a unique means of inferring how creditors evaluate corporate diversification.
We first examine the effect of diversification on the loan spread (the loan rate minus London Inter-bank Offered Rate), a direct cost of a bank loan. Using a standard OLS regression and controlling for various firm and loan characteristics and industry and year effects, we show that diversified firms are charged significantly less on loan rates, than focused firms. There are, however, two potential problems with the standard OLS regression approach. One is the problem of reverse causality in that firms may choose whether or not to diversify based on expected loan costs.
The other is the missing variable bias in that both diversification and the loan rate may be driven by some unmeasurable firm characteristics. These problems create a correlation between the diversification variable and the residuals, resulting in a bias in the OLS regression. To deal with them, we adopt an instrumental variable regression approach. Using the overall propensity of an industry to diversify in a certain year as the instrumental variable, we find that the loan spreads for diversified firms are about 20% lower than for focused firms. Our results suggest that the cost-reducing effects of corporate diversification, i.e., the coinsurance and informational diversification effects, dominate the cost-increasing effects of diversification, i.e., the transparency and agency effects.
Next we examine non-price terms in debt contracts and attempt to identify potential channels via which diversification affects debt contracting. If transparency and agency issues of diversified firms are major concerns for lenders, more restrictive non-price debt contract terms can be adopted to constrain the behaviour of borrowers and to increase monitoring intensity. We test for the effect of diversification on debt maturity, collateral requirements and the intensity of debt covenants (as measured by the number of covenants), and find no evidence that diversified firms are subject to more restrictive non-price contract terms than focused firms.
Thus, the results suggest that transparency and agency effects of diversification may not be of primary concern for banks, which is consistent with our earlier findings that coinsurance and information diversification effects are the dominant effects. These findings are not surprising since banks generally have better access to insider information than the public at large, so that transparency and agency problems may not be of the primary concern in their evaluation of diversified firms.
We also test for the effect of diversification on the likelihood of loan syndication. In a syndicated loan, two or more banks make a joint loan to a borrower. One potential advantage of syndication is the diversification of loan risks, which suggests that banks have fewer incentives to syndicate loans to diversified firms than to focused firms since risk has already been diversified in the former case by combining the cash flows of multiple business segments. A potential disadvantage of syndication is that it reduces the monitoring effort of lenders because of free-rider problems inherent in more diffused loan ownership (see, e.g., Lee and Mullineaux 2004; Sufi, 2005).
If concerns about transparency and agency problems of diversified firms are paramount, lenders will engage in less syndication in order to increase monitoring incentives. Taken together, these effects suggest that lenders have fewer incentives to syndicate loans to diversified firms than to focused firms, other things being equal. We show empirically that this is indeed the case. Utilizing a probit model to estimate the probability that a loan is syndicated, we find that the likelihood of syndication is significantly lower for loans to diversified than to focused firms.
Finally, we take a closer look at the effect of the number of segments on the cost of debt. We find that the relationship between the number of segments on the cost of debt is nonlinear. Specifically, when the number of segments is less than four, an increase in the number of segments reduces the loan spread. In contrast, loan spread increases with number of segments when the latter exceeds four. In our sample, the majority of firms (92%) have four or less business segments.2 Thus, our results are consistent with earlier findings indicating that, on average, diversified firms have lower loan costs than focused firms.
These findings also suggest that, at relatively lower levels of diversification, the cost-reducing coinsurance and information diversification effects are more pronounced than the cost-increasing transparency and agency effects. However, as firms become increasingly more diversified, transparency and agency effects become more pronounced while the marginal benefits of coinsurance and information diversification get smaller. Consequently, when the number of segments is high an increase in the number of segments leads to a higher cost of debt. The results are also consistent with the arguments of Scharfstein (1998), Rajan et al. (1997), and Shin and Stulz (1998) that managers are more likely to misallocate capital when there is a higher degree of heterogeneity across a diversified firm’s business segments.
Our results are closely related to a study by Mansi and Reeb (2002), who find that if market value (but not book value) of public debt is used in calculating the value of the firm, firm value is insignificantly related to diversification. They argue that their findings imply that diversification reduces the risk to public debt holders and increases the market value of public debt, and that equity holders lose while debt holders gain from diversification. But, if this is true, why would equity holders choose to diversify in the first place? Our results provide an answer by showing that any risk-reduction effect of diversification benefits equity holders as well since the risk-reduction effect will be capitalized in the price of new debt. Thus, diversification could benefit existing debt holders as well as equity holders who reap the ex-ante benefits of a lower cost of borrowing.
Our paper complements a recent study by Dimitrov and Tice (2006) that finds that during recessions sales-growth rates drop more for bank-dependent focused firms than for rival segments of bank-dependent diversified firms while there is no difference in growth rates between bank-independent focused and diversified firms. They argue that the lower volatility in real business activity of diversified firms is due to the fact that diversified firms have greater debt capacity and face less credit constraints. Our findings are consistent with their results but provide direct evidence showing that diversification lowers the debt financing costs of firms, other things being equal. To the extent that lower debt financing costs increase firm value, our findings also offer a possible explanation for recent results in the corporate diversification literature that diversified firms are not traded at a discount, but possibly at a premium.
The paper is organized as follows: Section 2 discusses further theoretical predictions on channels through which diversification affects a creditor’s evaluation of a firm. Section 3 describes the data, section 4 presents the empirical results on the effect of diversification on debt contracting features, and section 5 summarizes and concludes the paper.
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