Working Paper No. 09-30 Creditor Control of Free Cash Flow

With free cash flows, borrowers can accumulate cash or voluntarily pay down debts. However, sometimes creditors impose a mandatory repayment covenant called “excess cash flow sweep” in loan contracts to force borrowers to repay debts ahead of schedule. About 17% of borrowers in our sample (1995-2006) have this covenant attached to at least one of their loans. We find that the sweep covenant is more likely to be imposed on borrowers with higher leverage (i.e., where risk shifting by equity holders is more likely). The results are robust to including borrower fixed effects or using industry median leverage as a proxy. The covenant is more common also in borrowers where equity holders appear to have firmer control, e.g., when more shares are controlled by institutional block holders, when firms are incorporated in states with laws more favorable to hostile takeovers, or when equity holders place higher valuation on excess cash holdings. These determinants suggest that the sweep covenant may be motivated by creditor-shareholder conflicts. Finally, we show that the covenant has real effects: borrowers affected by the sweep covenant indeed repay more debts using excess cash flows, and they spend less in capital investment and pay out fewer dividends to shareholders. * Email: [email protected] I have benefited from helpful discussions with Viral Acharya, Mitchell Berlin, and Greg Nini. I would particularly like to thank Greg Nini, David C. Smith, and Amir Sufi for generously making available the credit agreement contracts they collected. The views expressed here are those of the author and do not necessarily represent the views of the Federal Reserve System or the Federal Reserve Bank of Philadelphia. This paper is available free of charge at http://www.philadelphiafed.org/research-anddata/publications/working-papers/.