Relationship Banking and Loan Syndicate Structure: The Role of Private Equity Sponsors

• Date: 01 August 2018
• Author: Donghang Zhang,Rongbing Huang,Yijia (Eddie) Zhao
• DOI: http://doi.org/10.1111/fire.12146
• Published date: 01 August 2018

The Financial Review 53 (2018) 461–498

Relationship Banking and Loan Syndicate

Structure: The Role of Private Equity

Sponsors

Rongbing Huang

Kennesaw State University

Donghang Zhang∗

University of South Carolina

Yijia (Eddie) Zhao

University of Massachusetts Boston

Abstract

Using a sample of syndicated loans to private equity (PE)-backed initial public offering

companies, we examine how a third-party bank relationship influences the syndicate structure

of a loan. We find that a stronger relationship between the lead bank and the borrower’s PE

firm enables the lead bank to retain a smaller share of the loan and form a larger and less

concentrated syndicate, especially when the borrower is less transparent. A stronger PE-bank

relationship also attracts greater foreign bank participation. Our findings suggest that the lead

bank’srelationship with a large equity holder of the borrower facilitates information production

in lending.

∗Corresponding author: Moore School of Business at the University of South Carolina, 1014 Greene

Street, Columbia, SC 29208; Phone: (803) 777-0242; E-mail: zhang@moore.sc.edu.

We thank an anonymous referee, Lucy Ackert, Vikas Agarwal, Mark Chen, Jie (Jack) He, Sahn-Wook

Huh, Chen Liu, Jay Ritter, Josh White, Adam Winegar,and the seminar participants at the 14th Annual All

Georgia Finance Conference at the Atlanta Fed, the 2015 Midwest Finance Association Meeting, the 2015

FMA European Conference, and the 2015 FMA Meeting for comments. Weare especially indebted to Joel

Houston and Srinivasan Krishnamurthy (the Editor) for their very useful comments. Huang acknowledges

the support of the Coles College of Business at Kennesaw State University.All errors are our own.

C2018 The Eastern Finance Association 461

462 R. Huang et al./The Financial Review 53 (2018) 461–498

Keywords: third-party banking relationship, information asymmetry, private equity, syndi-

cated loan, syndicate structure, IPO

JEL Classifications: G21, G23

1. Introduction

Weexamine how the relationship between a bank and a borrower’s equity block-

holder, which we call a third-party bank relationship, affects information production

in lending. Using a sample of syndicated loans made to U.S. initial public offering

(IPO) companies backed by private equity (PE) firms, we study the effect of the

relationship between a bank and a PE firm on information production in the syndi-

cated loans market.1For loans made to PE-backed IPO companies, we find that a

stronger PE-bank relationship is associated with a lower lead bank share, a larger and

less concentrated syndicate, and a higher probability of foreign bank participation,

suggesting that PE-bank relationships facilitate information production in lending.

These results also suggest that PE-bank relationships allow a PE-backed borrower

to have better access to capital and make it possible for the lead bank to free up its

capital and lend more to other borrowers.

Theories predict that PE-bank relationships can influence the informational en-

vironment of a PE-backed IPO company in taking a loan. When the PE firm possesses

private information about the IPO company, a stronger relationship between the PE

firm and the bank could catalyze a more efficient acquisition and sharing of informa-

tion about the borrower, thereby reducing the lead bank’s costs of due diligence and

monitoring. However,the lead bank’s relationship with the PE firm could augment the

bank’sinformational advantage over other potential lenders, imposing undesired costs

on the borrower if it sidelines the other lenders and leads to adverse selection/hold-up

problems (Rajan, 1992). Even if PE-bank relationships lower the lead bank’s due

diligence and monitoring costs, the bank could have an informational monopoly that

prevents it from sharing the benefitswith the borrower. It is also possible that PE-bank

relationships no longer matter once the borrower becomes public. Therefore, it is an

empirical question as of which effect, if any,of the PE-bank relationship on post-IPO

lending dominates.

We study the effect of PE-bank relationship on loan syndicate structure, an

important aspect of lending. The literature suggests that information asymmetries

1PE firms are active players in the syndicated loans market and build relationships with banks (Ivashina

and Kovner, 2011). PE firms often retain influential equity stakes and/or serve on the boards of their

portfolio companies in the first several years after the companies go public (Cao and Lerner,2009; Huang,

Ritter and Zhang, 2016). PE-sponsored IPOs include both reversed leveraged buyouts(RLBOs) and IPOs

of private companies that were bought by PE firms and did not go through a public-to-private transition.

The PE sponsor of an IPO is not necessarily the sponsor of a post-IPO loan. Unless the context suggests

otherwise, a PE sponsor in this paper refers to the fact that the PE firm is the sponsor of the borrower’s

recent IPO, not the loan.

R. Huang et al./The Financial Review 53 (2018) 461–498 463

between a borrower and its lender(s) and within a lending syndicate are a critical

determinant of the syndicate structure (e.g., Holmstrom and Tirole, 1997; Sufi, 2007;

Ivashina, 2009; Gopalan, Nanda and Yerramilli,2011; Lin, Ma, Malatesta and Xuan,

2012). The lead bank of a syndicated loan package conducts due diligence on the

borrower and markets the loan package to a group of potential participant lenders.

The lead bank is also responsible for ex post monitoring of the borrower during the

life of the loan. Because the lead bank owns only a fraction of the loan but bears

virtually all of the due diligence and monitoring costs, it has an incentive to shirk

due diligence/monitoring responsibilities when its efforts are imperfectly observable

to the participant lenders. Furthermore, the lead bank has an incentive to allocate a

larger share of a lower quality loan to the participant banks (Gorton and Pennacchi,

1995). The participant banks are more concerned about these moral hazard and

adverse selection problems when information asymmetries among the borrower, the

lead bank, and the participant banks are greater. In equilibrium, the lead bank holds

a larger fraction of the loan to mitigate the participant banks’ concerns when there is

greater asymmetric information.

Wetest two competing hypotheses. The efficient information production hypoth-

esis posits that a stronger relationship between the PE firm and the lead bank reduces

the costs for the lead bank to investigate and monitor the underlying borrower, and

thus alleviate potential participant banks’ concerns about the lead bank’s incentiveto

shirk due diligence/monitoring responsibilities. This hypothesis predicts a negative

association between the lead bank’s share of the loan and the PE-lead bank relation-

ship. The exclusive informational advantage hypothesis, on the contrary, suggests

that a stronger relationship between the PE firm and the lead bank elevates the lead

bank’s informational advantage over the participant lenders, which become more

concerned about getting more of a lower quality loan. This hypothesis predicts a

positive association between the lead bank’s share of the loan and the PE-lead bank

relationship.

We analyze syndicate structures for a sample of 291 syndicated loans to PE-

backed IPO companies between 1995 and 2011. Our primary measure of a PE-bank

relationship is the ratio of the total dollar amount of loans from this particular bank

and sponsored by this particular PE firm over the total dollar amount of all loans

sponsored by the PE firm during the past fiveyears. Our findings strongly support the

efficient information production hypothesis. Lead banks retain significantly smaller

factions of loans made to PE-backed IPO companies when these banks have stronger

prior lending relationships with the PE firms. A stronger PE-bank relationship also

relates to a less concentrated syndicate (measured by the Herfindahl index of loan

shares of all lenders in the syndicate). Economically,one of our regressions shows that

a one-standard-deviation increase in the PE-bank relationship allows the lead bank to

hold 6.44% less of a loan. For our sample of loans to PE-backed IPO companies, the

average loan amount is $216 million with the average lead bank share of 51%. If we

assume that the lead bank can only provide $110 million for a loan due to regulatory

capital constraints, a 6.44% decrease from 51% to 44.56% in the lead bank share