By William R. McCumber (College of Business, Louisiana Tech University) and Tomas Jandik (Sam M. Walton College of Business, University of Arkansas)
A traditional view of creditors is that they are largely passive investors unless a borrower violates the terms of a loan agreement or misses a payment. However, like institutional shareholders, creditors hold concentrated positions in firm securities (loan shares), are sophisticated investors, and have access to senior management and non-public information. Since debt financing is much more common than equity financing, and because the great majority of credit agreements are honored, it is important to better understand how creditors advise and monitor portfolio (borrower) firms. We find that creditors play a significant role in corporate governance under normal circumstances, i.e. when firms are not in technical violation or default. Borrower firms are less likely than non-borrowers firms to file for bankruptcy in the intermediate future, and borrowers shift financial and investment decisions away from value-reducing policies and toward value-creating investments. Importantly, these changes are profitable for borrower firms since both cash flows and returns on assets improve at least three years after loan origination, which in turn decreases creditor portfolio risk. We also find that when creditors retain a larger proportion of the loan on their books, changes in borrower firm financials are more pronounced, providing evidence that creditors exert a greater governing force when more exposed to borrower risk.