Literature Review and Hypotheses Development

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2. Literature Review and Hypotheses Development

A firm’s management matters to companies and investors. Prior research shows that managers influence firms’ strategy, disclosure policy, as well as operating and financing decisions. For example, Bertrand and Schoar 2003 show that managers develop unique individual-specific styles in operational and financing decisions, and exert idiosyncratic influence on firms ’ corporate decisions. We expect managerial ability to be negatively associated with bank-loan pricing for two reasons. First, high-ability managers are likely to select better projects and implement them more efficiently, leading to better future operating performance and lower default risk. This association between management and firm performance is intuitive and is also empirically supported. For example, prior research suggests that executive leadership can explain as much as 45 of an organization’s performance Day and Robert 1988. Orser 1997 finds that owners’ breadth of experience is positively associated with both strategic-planning practices and high performance. Barr, Seiford, and Siems 1993 and Leverty and Grace 2012 demonstrate that more competent managers are associated with lower likelihoods of bankruptcy in the banking and insurance industry. Chemmanur and Paeglis 2005 document that firms with better managers have stronger post-IPO operating performance because better managers are likely to better select and implement projects. Demerjian, Lev, Lewis, and McVay 2013 compare firms ’ performance before and after a new CEO is appointed and show that firms hiring better managers experience improvements in operating performance. As better firm performance should reduce the cost of debt Strahan 1999, an indirect connection exists between managerial ability and cost of debt. Second, high-ability managers have the potential to convey information more effectively, reducing information asymmetry between firms and lenders. In return, banks can assess 5 borrowers ’ financial reports more efficiently with lower information acquisition and processing costs, and thereby offer loans at a lower rate. Several studies provide evidence that managers significantly influence financial reporting. For example, Bamber, Jiang, and Wang 2010 find that managers affect voluntary financial disclosure. Baik, Farber, and Lee 2011 conclude that firms with high-ability managers issue more accurate forecasts compared with firms with low- ability managers and that the likelihood and frequency of management earnings-forecast issuance increases with managerial ability. In contrast to the above studies, Francis, Huang, Rajgopal, and Zang 2008 use media citations as a proxy for CEO reputation and find that more reputable CEOs are associated with poorer earnings quality. Francis et al. 2008 propose a matching hypothesis, arguing that firms with poor earnings quality have more demand for reputable CEOs. By contrast, Demerjian et al. 2013 reexamine the relation between managerial ability and earnings quality and suggest that Francis et al. ’s 2008 finding is partly due to the impact of fundamental firm characteristics on the accruals-quality measure. Using a modified accrual model, Demerjian et al. 2013 argue that high-ability managers are associated with higher persistence of earnings and accruals as well as higher-quality accrual estimations. Moreover, they find that firms with high-ability managers have fewer subsequent restatements and lower errors in bad-debt provisions. It is well established that accounting quality can mitigate the agency costs between managers and creditors, and in turn, is likely to be associated with bank-loan pricing. Ahmed, Billings, Morton, and Harris 2002, Zhang 2008, and Beatty, Ramesh, and Weber 2002 find that firms with more conservative reporting have lower cost of debt. Ashbaugh, Collins, and LaFond 2006 and Anderson, Mansi, and Reeb 2004 show that corporate governance factors affect the quality of firms’ accounting system and, in turn, are associated with the cost of debt. 6 Rajan and Winton 1995 suggest that asymmetric information and agency costs affect the price and terms of debt. Despite the positive effects of high-ability manager on firm performance and on disclosure quality, some researchers find that high-ability managers are associated with higher cost of equity Eisfeldt and Papanikolaou 2013; Mishra 2014. They argue that higher general managerial ability may lead to higher agency problems because a manager’s incentives may not be aligned with those of the firm and its shareholders. Also, high-ability managers are more likely to take risky projects and they can leave the firms when their outside employment options exceed their inside value if they stay in their current company. 2 Private loan lenders, however, are different from shareholders in several ways. First, the agency problems between management and creditors are different from those between management and shareholders. In particular, the priority of creditors is superior to that of shareholders in case of financial distress or bankruptcy. As a result, an action that decreases shareholders value may not necessarily increase creditors’ risk. Second, creditors are sophisticated institutional investors and care more about downside risk than shareholders. Prior literature has well documented the monitoring role of creditors to reduce firms ’ agency problems. Creditors have greater incentives and abilities to monitor management behaviors through debt contracting and should be able to better assess management ability than shareholders via their access to private information in their due diligence process. Third, many loan contracts include 2 Other relevant studies include Bierey and Schmidt 2016 and Bozanic 2016. Bierey and Schmidt 2016 identify RD and its interplay with legal protection as a potentially important characteristic in loan contracting. They also find that the absence of credit ratings is important. Thus, their study is at least indirectly related to ours. Bozanic 2016 compares the role of covenants in public and private debt and contrasts the ex-ante renegotiation opportunities in public debt versus the trip-wire role of covenants in private debt. 7 negative covenants that constrain companies from conducting projects risky to creditors. For example, borrowers usually are not allowed to conduct large merger and acquisition projects without creditors ’ permission. All factors mentioned above could lead to different effects of managerial ability on cost of debt than their effects on cost of equity. Based on the above discussion, our first and primary hypothesis stated in the alternative is: H1 : Higher managerial ability is associated with lower bank-loan pricing. Information asymmetry between lenders and borrowers is crucial in debt contracting. If information asymmetry is high, lenders will invest heavily in information production and exert costly effort in due diligence to better assess borrowers. After a loan is initiated, lenders still need to closely monitor the borrower to avoid suboptimal use of capital by borrowers. The information frictions, however, may be mitigated by high managerial ability if more capable managers are more likely to provide more transparent disclosure in the future. We expect the extent to which managerial ability affects bank-loan pricing increases with information asymmetry. From a borrower’s perspective, firms tend to adopt better management practices to reduce information asymmetry when having greater needs for external capital. From a lender’s perspective, banks have more incentives to screen the firm ’s quality and monitor the contract terms when the information asymmetry between borrowers and lenders is greater. When managerial ability of borrowers is high, lenders have more confidence that borrowers will provide better information in the future. Such enhanced disclosure quality will enable lenders to better monitor borrowers’ default risks. Therefore, our second hypothesis is as follows stated in the alternative: 8 H2 : The negative association between managerial ability and bank-loan pricing is more pronounced when information asymmetry is high. Bank-loan pricing is highly correlated with firms ’ bankruptcy risk. When bankruptcy risk is high, lenders ask for higher loan spreads to compensate for the risks of losing money in case of default. We expect that, in the case of lending to a high-risk borrower, lenders have high degree of uncertainty regarding the borrower’s ability to repay the debt. As a result, creditors rely more on the borrower ’s management team to generate adequate future cash flow and have stronger incentives to assess management quality. Higher ability managers can be considered as to be leading indicators of strong cash flow in the future. Therefore, our third hypothesis is as follows stated in the alternative: H3 : The negative association between managerial ability and bank-loan pricing is more pronounced when business fundamentals are weak. 3. Sample Selection and Research Design 3.1. Sample Selection and Data