Creditor Control of Free Cash Flow

Abstract:     
With positive free cash flows, firms can choose between accumulating cash, paying out to shareholders, and reducing debts. However, sometimes creditors include an “excess cash flow sweep” covenant in loan contracts, requiring reduction of debt balances ahead of schedule when free cash flows are positive, i.e., when distress risks are actually lower. About 17% of publicly-traded borrowers in our sample (1995-2006) have this covenant attached to at least one of their syndicated loans. We find that the sweep covenant is more frequently seen among more highly leveraged borrowers. The results are robust to including borrower fixed effects (for those taking out multiple loans) or using industry median leverage as a proxy. We also find that the covenant is more common among borrowers that appear more strongly influenced by shareholders, i.e., when more shares are controlled by institutional blockholders, or when firms are incorporated in states with laws more favorable to hostile takeovers. The positive relation between high leverage and the covenant is stronger when blockholders control more shares. These determinants suggest that the sweep covenant may be a contract for mitigating creditor-shareholder conflicts of interests as in Jensen and Meckling (1976). Finally, we show that the covenant has real effects: borrowers affected by the sweep covenant indeed repay more debts when cash flows are higher.

Number of Pages in PDF File: 35

Keywords: free cash flow, creditor rights, agency problems, bank loans, credit agreements, capital structure, cash holdings, covenants, excess cash flow sweep

JEL Classification: G34, G33, G32, K22

working papers series