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Why Does Takeover Vulnerability Matter to Debtholders?

Joan Farre-Mensa

Harvard Business School

March 15, 2010

Recent work documents that firms that are more vulnerable to takeover have higher borrowing costs. This paper investigates the reasons behind this stylized fact. My results show that firms with few antitakeover defenses face a higher cost of debt because lenders are concerned that takeovers may result in leverage increases. Specifically, I find that takeover vulnerability does not increase loan spreads when the loan deal contains covenants restricting leverage. In order to identify the effect of covenants on spreads, I use two instruments to control for the endogeneity of covenants, which arises from the fact that lenders are more likely to include covenants when lending to riskier firms. My first instrument exploits exogenous supply-side variation in the contracting strictness of the lead-arranger lender, induced by lender-specific factors such as the rate of past defaults suffered by the bank in unrelated loans. My second instrument makes use of the relation between syndicate size and the likelihood that a given loan includes covenants. This instrument exploits exogenous variation in the contribution of the deal to the idiosyncratic risk of the lead bank’s loan portfolio. The identifying assumption is that lead banks tend to include covenants in those loans whose risk has a higher correlation with the risk of their existing portfolio, so that they can syndicate a larger share of such loans. Overall, my findings show how debt covenants can successfully resolve agency conflicts between shareholders and debtholders. In the absence of covenants, takeover defenses have opposite effects on the cost of equity and debt capital. Yet this difference disappears when debt deals contain leverage-limiting covenants.

Number of Pages in PDF File: 40

Keywords: Loan pricing, covenants, corporate governance, takeover defenses.

JEL Classification: G32, G34, G21

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Date posted: November 18, 2009 ; Last revised: October 7, 2011

Suggested Citation

Farre-Mensa, Joan, Why Does Takeover Vulnerability Matter to Debtholders? (March 15, 2010). Available at SSRN: https://ssrn.com/abstract=1507300 or http://dx.doi.org/10.2139/ssrn.1507300

Contact Information

Joan Farre-Mensa (Contact Author)
Harvard Business School ( email )
Rock Center 218
Soldiers Field Road
Boston, MA 02163
United States
617-495-6963 (Phone)
HOME PAGE: http://people.hbs.edu/jfarremensa

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