Monitoring with Small Stakes

Abstract

This paper proposes a mechanism to explain the "monitoring with small stakes" phenomenon in the leveraged loan market. We theoretically identify two key sources that incentivize creditor monitoring: skin in the game and rent extraction through renegotiation. Rent extraction via renegotiation acts as a substitute for banks' loan stakes, incentivizing institutional investors to participate in syndicated lending. To empirically validate this mechanism, we leverage the passage of a tax policy that exogenously reduced renegotiation costs. Our findings suggest that a less frictional renegotiation environment fosters more diligent monitoring, particularly in loans with concentrated control rights where lead banks have greater flexibility to initiate renegotiations. This enhanced monitoring is associated with improved borrower performance, especially in pre-existing deals with concentrated control right and lower bank shares.

Keywords: contract theory, renegotiation, control rights, monitoring, rent extraction, institutional lenders, cov-lite, covenants, fiscal policy, leveraged loans

JEL Classification: G21, G23, G30