Bank lending to targets of active takeover attempts: The simultaneous choice of loan maturity, pricing, and security

• Author: Justin Lallemand
• DOI: http://doi.org/10.1002/rfe.1075
• Date: 01 April 2020
• Published date: 01 April 2020

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wileyonlinelibrary.com/journal/rfe Rev Financ Econ. 2020;38:332–351.

© 2019 University of New Orleans

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INTRODUCTION

Two important questions emerge from extant literature relating to the observation that loans are often made to targets of active

takeover attempts. Firstly, why do corporations that are subject to active takeover attempts borrow additional debt given that the

majority of such firms will ultimately be acquired? Secondly, why and how do banks lend to targets of active takeover attempts?

Finance theory has addressed the former question as Stulz (1988), Harris and Raviv (1988), and Israel (1992) argue that

by increasing leverage, target managers may be able to extract maximum value from acquirers by utilizing debt proceeds to

repurchase equity and concentrate managerial voting rights. Empirical results from Jandik and Lallemand (2017) provide sup-

port to these predictions. Alternatively, the same aforementioned research concedes that adding too much leverage can thwart

a takeover attempt altogether by exhausting bidder access to debt. Jandik and Lallemand (2014) provide empirical evidence of

this alternative by demonstrating that debt issuance by takeover targets is interpreted by the market as lowering the likelihood of

takeover completion in ultimately withdrawn takeovers, consistent with Novaes (2003). In summary, target managers can issue

debt to either extract additional value from acquirers or to fend off takeover attempts altogether. The second question addresses

banks’ motivations for lending to active takeover targets and is the primary focus of this study.

I deconstruct the motivations driving bank lending to targets of active takeover attempts by applying specific testable compo-

nents. First, how are covenants, collateral, pricing and maturity related in the context of new bank loans to takeover targets com-

pared to other companies? More specifically, how do these relationships compare in relation to new bank debt loans to similar,

non‐target firms that are not subject to active takeover attempts? Furthermore, how do these same characteristics interact? These

questions are important as bank loans comprise a substantial portion of debt holdings by medium and large firms. Bank loan terms,

especially covenants, are also likely to influence other decisions by managers (e.g., capital structure, dividend policies, etc.).

Received: 31 January 2019

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Revised: 20 June 2019

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Accepted: 29 June 2019

DOI: 10.1002/rfe.1075

ORIGINAL ARTICLE

Bank lending to targets of active takeover attempts: The

simultaneous choice of loan maturity, pricing, and security

JustinLallemand

College of Business,University of Northern

Iowa, Cedar Falls, Iowa

Correspondence

Justin Lallemand, College of Business,

University of Northern Iowa, Curris

Business Building 302, Cedar Falls, IA

50614‐0124, USA.

Email: justin.lallemand@uni.edu

Abstract

I investigate bank loans to takeover targets considering the simultaneous decision

of pricing, maturity, collateral, and covenants applying Generalized Method of

Moments (GMM). Results are largely in line with the Agency Theory of Covenants

(ATC) as pricing for new bank debt is lower given greater collateral and covenant

protection, consistent with existing literature on public debt. However, poor perform-

ing targets demonstrate a positive relationship between pricing and covenants while

bank loans to high performers are consistent with ATC predictions. Finally, loan

terms tied to ex post observations of merger outcomes suggest banks possess some

knowledge of merger outcomes in advance.

KEYWORDS

A&M, bank debt, optimal contracting, simultaneous decision making

JEL CLASSIFICATION

G34; G31

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LALLEMAND

Research on the role of debt characteristics in corporate financial policy has largely focused thus far on public debt whereas

bank debt has been studied to a considerably lesser extent. However, bank loans are a critical source of debt financing for larger

firms, representing roughly 31% of corporate debt as of 2006 (Crouzet, 2018). Additionally, while key elements of capital struc-

ture have been addressed for both public and non‐public debt, none have considered new bank debt loans to targets of active

takeover attempts.

This study is the first to empirically investigate simultaneously determined characteristics of bank loans to takeover targets.

Specifically, utilizing generalized method of moments (GMM) specifications, decisions made by bank lenders on covenants,

collateral, maturity and pricing are considered jointly following methodologies utilized by Billett, King, and Mauer (2007) in

which the authors study simultaneous decisions by firms issuing public debt.1

Consistent with the Agency Theory of Covenants,

or ATC, I find that relative to similar, non‐target firms, targets with a given level of collateral and covenant protection pay in-

crementally less for bank debt.2

Importantly, I further find that targets with high‐performing managers experience even lower

incremental bank loan pricing with increasing levels of collateral and covenant protection.

The remainder of the paper is organized as follows: Section 2 covers the literature review and motivation while Section 3

contains a description of the data and preliminary analyses. Section 4 provides primary results, while Section 5 concludes.

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LITERATURE REVIEW AND MOTIVATION

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Bank lending to takeover targets and the Agency Theory of Covenants

Recent studies demonstrate that, in both withdrawn and completed takeover attempts, targets subject to active takeover

attempts substantially prefer bank debt relative to other forms of debt (e.g., Jandik & Lallemand, 2014). Bank loans are ad-

vantageous as they convey a stronger signal of confidence resulting from banks’ superior capabilities in initially assessing

and monitoring credit risk (Berlin & Loeys, 1988; Chemmanur & Fulghieri, 1994; Diamond, 1991; Fama, 1985), thereby

strengthening the position of target managers.3

In addition, bank debt is also frequently more readily available in response

to a takeover attempt due to ongoing banking relationships, particularly where existing credit commitments are already in

place.

There is considerable opportunity to address “relatedness” in the context of mergers and acquisitions, most often through

acquirer–target lending relationships, as is thoroughly documented by Alhenawi and Stilwell (2018).4 ,5 Additionally, Ahren and

Harford (2014) find the presence of merger waves in industries with stronger product markets, while also noting that poor proxies

for relatedness can skew results when attempting to explain merger premiums. Further, Ushijima (2016) finds diversified firms

trade at a discount to focused firms while, in general, findings form Ahren and Harford (2014) are related as it is more likely that a

focused firm has stronger product market development relative to diverse firms.6 Directly or indirectly, these findings all reinforce

points made by Alhenawi and Stilwell (2018).

Shastri (1990), Billett (1996) and Billett, King, and Mauer (2004) suggest that the coinsurance effect resulting from the debt

of a typically riskier target becoming the obligation of a safer and larger acquirer can allow for bank gains, or at least dramati-

cally lower existing risk resulting from exposure to target debt on a standalone basis; alternatively, existing bank loans may be

paid off entirely at the acquirer’s discretion.

Underpinning the Agency Theory of Covenants (ATC), Jensen and Meckling (1976) and Myers (1977) make the case that

restrictive debt covenants can be utilized to better align managerial motivations with those of debtholders, consequently max-

imizing the overall value of the firm. Stockholders generally prefer riskier projects as their losses are limited to the amount

invested while potential gains are theoretically infinite. In contrast, while losses for debt are also limited to the amount invested,

the yield and the potential for substantive price appreciation are small by comparison. Based on this, it should be in the best

interest of debt providers to maximize the value of debt by minimizing risk. One method of maximizing the value of debt is by

adding restrictive covenants in order to lower the risk of debt investments.

Smith and Warner (1979) contribute substantially to the ATC by noting that covenants created to protect debtholders can

result in the restriction of other activities that may result in secondary effects on the firm overall. As an example, from page 701

of Billett et al. (2007), the authors state:

For example, a restriction on dividend payments indirectly influences investment decisions because the restriction

may prevent the firm from distributing cash to shareholders that otherwise would have been used to finance posi-

tive net present value investments.

The authors also argue that interrelations such as these make it necessary to model relevant variables simultaneously.