Does Institutional Ownership Exacerbate Debt-Equity Conflicts? Evidence from the Auditor Certificate of Debt Covenant Compliance

57 Pages Posted: 29 Jan 2018 Last revised: 20 Jan 2019

See all articles by Mahmoud Gad

Mahmoud Gad

Lancaster University - Lancaster University Management School

Kirak Kim

University of Bristol - School of Economics Finance and Management

Date Written: January 2019

Abstract

We study the effect of borrowing firms’ institutional ownership on lenders’ monitoring demand. Using the data on a covenant-monitoring mechanism known as auditor’s certificate of covenant compliance (ACC), we show that the likelihood that a loan contract includes the ACC provision increases with a borrower’s institutional ownership. Consistent with the debt-equity conflict hypothesis, this result is driven by indexed and transient institutions, which are either ineffective or unmotivated in monitoring portfolio firms. The effect is more pronounced among the borrowers with poorer accounting quality, suggesting that firms’ accounting discretion is the key mechanism in play. We further support the causal interpretation by exploiting Russell index reconstitutions. Our evidence suggests that lenders expect borrowers’ earnings-management incentive to grow with indexed and transient ownership and thus take a preemptive action to ensure the effectiveness of covenants as the control-allocation rule.

Keywords: institutional investors, debt contract, covenant compliance, debt equity conflict

JEL Classification: G30, G23, M40

Suggested Citation

Gad, Mahmoud and Kim, Kirak, Does Institutional Ownership Exacerbate Debt-Equity Conflicts? Evidence from the Auditor Certificate of Debt Covenant Compliance (January 2019). Available at SSRN: https://ssrn.com/abstract=3111459 or http://dx.doi.org/10.2139/ssrn.3111459

Mahmoud Gad

Lancaster University - Lancaster University Management School ( email )

Accounting and Finance Department,
LUMS,
Bailrigg Lancaster, LA1 4YX
United Kingdom

Kirak Kim (Contact Author)

University of Bristol - School of Economics Finance and Management ( email )

12 Priory Road
Bristol, BS8 1TU
United Kingdom

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