Cem Demiroglu -- Assistant Professor of Finance -- Koc University -- University of Florida -- Christopher James -- Loan covenants -- Private equity -- Reputation

Publications:

The information content of bank loan covenants, with Christopher James, forthcoming, Review of Financial Studies.

This paper examines the determinants of financial covenant thresholds in bank loan agreements and information conveyed through the selection of tight financial covenants. We find that riskier firms and firms with fewer investment opportunities select tighter financial covenants. We also find that selection of tight covenants is associated with improvements in the covenant variable and declines in investment spending and net debt issuance. We observe these changes also for borrowers that do not breach their covenants, suggesting that they are not simply the result of creditor influence conditional on a technical default. Furthermore, we find that violations of tightly set covenants are less impactful on the borrower. In particular, violations of tightly set covenants are less likely to lead to bankruptcy or cancelation of loan agreements and have significantly less of an impact on the borrower's investment spending and net debt issuance than violations of loosely set covenants. Finally, we find that the average stock price reaction to loan announcements is significantly greater for loan agreements with tightly set covenants. Overall, our results suggest that the selection of tight covenants conveys information concerning future changes in covenant variables, investment and financial policies, and the outcome of covenant violations.

The role of private equity group reputation in buyout financing, with Christopher James, forthcoming, Journal of Financial Economics.

This paper investigates whether the reputation of acquiring private equity groups (PEGs) is related to the financing structure of leveraged buyouts (LBOs). Using a sample of 180 public-to-private LBOs in the US between January 1, 1997 and August 15, 2007, we find that reputable PEGs are more active in the LBO market when credit risk spreads are low and lending standards in the credit markets are lax. We also find that reputable PEGs pay narrower bank and institutional loan spreads, have longer loan maturities, and rely more on institutional loans. In addition, while we find that PEG reputation is positively related to buyout leverage (i.e., LBO debt divided by pre-LBO earnings before interest, taxes, and amortization (EBITDA) of the target), and leverage is significantly positively related to buyout pricing, we do not find any direct relation between PEG reputation and buyout valuations. The evidence suggests that PEG reputation is related to LBO financing structure not only because reputable PEGs are more likely to take advantage of market timing in credit markets and but also because PEG reputation reduces agency costs of LBO debt.

The first analyst coverage of neglected stocks, with Michael Ryngaert, forthcoming, Financial Management.

We examine the first analyst coverage of 549 "neglected" stocks that publicly traded at least one year without research coverage. The stocks experience a +4.86% abnormal return at initiation announcement. Positive returns are driven by positive coverage and not the mere introduction of coverage. Initiations from investment banks elicit lower announcement returns if the bank had a prior business relationship with the covered firm. Research firms paid by the covered company to provide coverage elicit announcement returns that are not significantly different from other analysts. Announcement returns are also influenced by liquidity increases and factors consistent with downward sloping demand curves.

- Link to Money Morning article on this paper.

- Link to Empirical Finance Blog article on this paper.

Working Papers:

Works of friction? Originator-sponsor affiliation and losses on mortgage backed securities, with Christopher James, under review.

This paper examines how the severity of moral hazard problems on behalf of mortgage originators in the securitization process is related to the structure and performance of securitized pools of residential Alt-A mortgages created during the 2003-2007 period. We argue that the severity of moral hazard problems is likely to vary inversely with originator-sponsor and originator-servicer affiliation as well as originator concentration. We refer to the lack of affiliation and originator dispersion as measures of distance from loss. Overall, we find that, after controlling for borrower and deal characteristics, cumulative loss and foreclosure rates are significantly higher in pools in which originators are not affiliated with the pool sponsor or servicer and in pools with more originators (i.e., the loss distance is greater). We also find that the losses and foreclosures occur earlier in pools with greater distance from loss. While these relations are more prominent for deals structured during the 2006-2007 period, we find that the distance was also related to losses before the peak of the housing market. Consistent with investors recognizing the potential loss exposure from greater distance from loss, we find that the average yields are higher on mortgage-backed securities (MBS) issued on pools with greater distance. We also find that the percentage of securities rated AAA is decreasing in the distance. Finally, pools with greater distance are significantly more likely to employ overcollateralization accounts (that require the sponsor to have greater skin in the game). These results suggest that, while ex post investors might have misestimated their exposure to losses arising from incentive conflicts with the originator, ex ante frictions were reflected in the pricing and the structure of MBS.

Presentation (ppt, pdf)

Credit market conditions and the determinants and value of banking relationships for private firms, with Christopher James and Atay Kizilaslan, under review.

This paper examines the effect of credit market conditions and changes in bank lending standards on the availability and value of bank lines of credit for private firms. Overall, we find that tight credit conditions and bank lending standards are associated with declines in firms' access to bank credit but more so for private than for publicly traded firms. We also find private but not public firms hold more cash and substitute trade credit for bank loans when banks tighten lending standards. These two findings are consistent with private firms being rationed in tight markets. In addition, we find that bank lines of credit are associated with significantly higher private firm valuation multiples. Moreover, we find that the higher valuations of firms with bank lines of credit varies with bank lending standards, with relationships being associated with greater value when banks are more selective in their lending decisions. Overall, the evidence suggests that credit crunches like the one that began in 2007 are likely to have a disproportionate impact on firms with limited access to capital markets.

Conference Proceedings:

Lender control and the role of private equity group reputation in buyout financing, with Christopher James, FED Chicago Proceedings, May 2008, p. 296-319.

The information content of bank loan covenants, with Christopher James, FED Chicago Proceedings, May 2007, p. 148-182.

Referee for:

Journal of Financial Economics, Journal of Banking and Finance, Journal of Corporate Finance, Emerging Markets Finance and Trade, Revue Finance

Courses:

Math & statistics review (M.S. Finance, Koç University)

Bank financial management (MFIN 302, Undergraduate, Koç University)

Financial markets and institutions (MFIN 508, M.S. Finance, Koç University)

Financial institutions and capital markets (MFIN 514, M.S. Finance, Koç University)

Equity and capital markets (FIN 4504, Undergraduate, University of Florida)

Contents written by Cem Demiroglu
Last modified on February 24, 2010.