An Empirical Study of Related-Party Lending
55 Pages Posted: 7 Nov 2016
Date Written: September 30, 2014
Related-party transactions, where one of the parties is owned or controlled by the other, are often regarded as a way to tunnel funds out of firms. This paper provides the first empirical evidence on a specific channel through which related-party lending may benefit borrowers, namely its ability to ease financing frictions. Using a hand-collected sample of 294 loans from related parties to U.S. firms, I identify the drivers of related-party lending and investigate its impact on borrowers. I show that related-party lending mitigates adverse selection at times when a firm is more likely to be credit rationed by unrelated parties. The incidence of related-party loans is positively linked to the degree of financing constraints and lack of transparency that aggravates these constraints. I find that interest rates on loans from related parties (management) are 1.9% (2.6%) higher compared to loans from unrelated parties which I attribute to a premium for loss of diversification required by related-party lenders. I also find that informed lending has a strong signalling effect: the likelihood of obtaining additional debt financing increases by 32.8% in the quarter following a related-party loan. Collectively, this evidence suggests that borrowers agree to "invest" in an expensive loan from related parties in order to increase their chances of obtaining debt financing in the future.
Keywords: Adverse Selection, Debt Financing, Information Asymmetry, Interest Rates, Financial Constraints, Related-Party Lending, Related-Party Transactions
JEL Classification: G31, G32, D92
Suggested Citation: Suggested Citation