Reading: Understanding and Valuing Debt and Equity

The incentive problems that we have discussed on the previous pages are very general (even though we have illustrated them with arguably rather extreme examples). The potential threat of these problems impedes debt financing. Ultimately, the ones who suffer from this situation are the firms themselves, as the lenders will simply withhold financing.

Note, however, that there are various ways to mitigate these and similar problems and thereby make it easier for borrowers and lenders to find a suitable financing deal: 

• Collateral (secured debt): First and foremost, lenders could ask for collateral to secure their claims. The typical example of secured debt is a mortgage, for which the underlying real estate serves as collateral. Other examples include aircrafts, cars, etc. If the firm fails to make the contractual debt payments, the lender can seize and utilize the asset. If the underlying asset is of sufficient value, also on a resale market, the lender factually eliminates the credit risk.

• Personal liability: Another way for shareholders to signal "good behavior" is to accept personal liability. That is, they could offer guarantees or chooes a legal form with unlimited liability, such as a partnership. Historically, many private banks and law firms were organized as partnerships. Presumably, this signaled the clients that the incentives of the partners are fully aligned with those of the other stakeholders.

• Debt covenants: To limit the costs of divergence in interest, stockholders draft contracts to limit their degrees of freedom in managing the firm. These covenants typically take two forms:
  • Covenants that address the potential incentive conflicts (negative covenants). For example:
    • Restriction on distributions to shareholders (dividends, repurchases, etc.)
    • Limits on future borrowing
    • Prohibitions against new lines of business or mergers
    • Earmarking of cash flows for debt servicing
  • Covenants that allocate the control between borrowers and lenders. For example:
    • Board control shifts to lender if performance targets are not met (in terms of leverage, working capital limits, net income, or other financial metrics)
    • Information rights (quarterly or monthly reports, rights to inspect the premises, etc.)
    • Accounting covenants (e.g., financial statements must be audited by an auditor of the lender's trust, etc.)

• In the case of publicly traded bonds, these contracts typically take the form of an indenture or trust deed between the borrowing firm and the trust company, which represents the bondholders. These contracts can run several hundred pages long and specify, among other things:
• General terms of the deal
• Possible collateral
• Seniority over other claims
• Repayment provisions (sinking fund, lump-sum)
• Callability
• Additional protective and control covenants (see above)

Ultimately, however, it is impossible to write a perfect contract or to find the perfect collateral that can secure the firm's debt obligations in all possible future states of the world. In most situations, borrowing decisions will therefore still entail a residual incentive risk. This is especially true for young and privately held firms. These firms often have limited collateral to offer and they operate a business model whose viability is hard to verify for outsiders. Because such young private firms are especially susceptible to incentive problems, they generally have very limited access to debt financing.

Finally, given the considerations above, it is not surprising that one of the most important elements in lending decisions is what is generally referred to as "Relationship Lending." Relationship lending builds on elements such as:

• High level of personal trust between the involved managers and institutions. This trust factually serves as additional "collateral" for the loan.
• Long track record that allows the borrower to signal quality and the lender to better understand the business model of the borrower (historical profitability, proof of concept)
• Revolving business situation: Single transactions are especially prone to opportunistic behavior (the so-called last-period problem). In contrast, if the involved parties plan to do repeated business over a long time horizon, opportunistic behavior today jeopardized the whole future relationship and is therefore comparatively much more costly. Simply put, a firm might refrain from an asset substitution game if it knows that it will have to rely on the same banking relationship in the future to fund new projects.

It is therefore advisable for firms to nurture their banking relationships even though there might not be an accute financing need. If such a need arises, finding a deal will generally be considerably easier if the involved parties know, trust, and respect each other.