Managerial Risk Aversion

We noted earlier that shareholders like increases in project risk, because they help them at the expense of bondholders. However, it is not clear if managers really act on behalf of shareholders and thus like higher risk, too. After all, if the project fails and the firm enters financial distress, they might get fired themselves. Thus, managerial risk aversion is a natural counterbalance to the shareholders' incentives to increase risk. Bond Covenants:

A variety of bond covenants have developed to mitigate bondholder skepticism.

• Many bonds prohibit excessive dividend payouts.

• Many bonds prohibit large new debt issues, especially of shorter-term and of equal priority debt.

• Many bonds require the maintenance of certain financial ratios. For example, covenants may mandate maximum debt-equity ratios, maximum payout ratios, minimum earnings retention ratios, minimum liquidity ratios, and so on. These ratio restrictions can all help prevent the firm from taking on riskier projects.

If the covenant is broken, creditors can sue or demand their money back. Covenants are never perfect. It is just impossible to enumerate all the things managers can do. In addition, if the firm enters Chapter 11 bankruptcy, the law says that any new debt issued will automatically receive higher priority, no matter what the covenants of the original bond stated.

Bonds with strong covenants often have a "call" feature, that allows the firm to retire the bond before maturity at an agreed-upon price—and thereby free themselves of the covenant requirements. Corporate Reputation:

Covenants are inflexible, so they impose costs, too. For example, if the firm happens to come across a project with $1 billion in NPV, the covenants could prevent it from taking it. Again, a firm that fails to take all profitable projects in the future is worth less today. One alternative to formal covenants is for firms to build a less formal "reputation." This is not easy to do, but firms may realize that it is in their interest not to exploit current bondholders, because any future bondholders would henceforth definitely assume the worst behavior. Put differently, if managers were to take advantage of creditors today, then future financing costs would be so much higher that managers would rather not do so. Reputation is not perfect, though, especially if the advantage that can be taken of creditors today becomes very large. The most prominent example of broken reputation was R.J.R. Nabisco. In the 1980s, it was generally believed to be a safe investment for bondholders. However, when it was bought out in 1988 in the largest LBO ever, R.J.R. tripled its debt overnight, its outstanding bonds went from investment grade to junk grade, and bondholders experienced an announcement month loss of 15%. Convertible Bonds or Strip Financing:

The final way is to try to allow creditors to partake in the upside of equity. The most common such financing vehicles are convertible bonds. Again, they can limit the ex post expropriation of bondholders, while still preserving the firm's option to accept new projects. Instead of straight bonds with strong covenants, "convertible bonds" with weak covenants allow creditors to participate if a great new project were to come along. This reduces the risk expropriation problem. One of the following exercises will ask you to show how a convertible bond can reduce the expropriation. Strip financing, in which individuals purchase debt and equity in equal units, is a similar idea—it eliminates the incentives of shareholders to exploit themselves.

Units: A Unit is a combination of securities. It can consist of a debt security and an equity security. Thus, there is no difference in identity between shareholders and bondholders. However, if the firm pays interest, it shifts its tax burden to the unit owners. If the firm pays dividends, it shifts its unit owners' tax burdens to itself. More important, unless the buyers unbundle them, it does not matter to them if the firm expropriates bondholders at the expense of shareholders. Every bondholder is a shareholder! Note that this also puts a stark limit on the amount that bondholder expropriation may possibly destroy. After all, if it were that important, someone could just purchase the securities, and resell them as inseparable units. This cannot be too expensive, and so ex-ante bondholder expropriation costs cannot be too much in equilibrium.

In the real world, firms have to undertake a delicate balancing act. When they issue debt, it can only be issued at favorable terms when the firm can promise not to exploit bondholders after the bonds are issued. Even if such promises can be credibly made, they cause a loss of flexibility, which can be expensive. This can mean that the firm cannot issue debt—and thus that it has to forego some other beneficial effects of debt (such as tax advantages).

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