Price Discovery and Dissemination of Private Information by Loan Syndicate Participants

1. Price Discovery and Dissemination of Private Information by Loan Syndicate Participants Robert M. Bushman Abbie J. Smith Regina Wittenberg-Moerman

2. Research questions Objective: To better understand the relation between information flows and the price discovery process in the loan and stock markets. • What are the determinants of the speed of price discovery in the syndicated loan market? • Explore the importance of syndicate structure and loan contractual terms in the price discovery process. • Provide insight into the timing of private information dissemination by borrowers to lenders. • Is price discovery in equity markets affected by the dissemination of a borrower’s private information? • Establish cross-market relations in price discovery driven by a firm’s debt agreements. • Explore the possibility that private information received in the loan market is exploited for insider trading in the stock markets.

3. The syndicated loan market • The syndicated loan market: • Primary loan market – market where syndicated loans are originated. • Secondary loan market – market where syndicated loans are subsequently traded. • Syndicated loan - loan provided by a group of lenders and is structured and managed by one or several banks known as arrangers. • Main secondary loan market participants - banks, loan participation mutual funds, Collateralized Loan Obligations, finance companies, pension funds and hedge funds. • Rapid growth of the syndicated loan market: • Starting in 1999, U.S. firms have obtained over $1 trillion in new syndicated loans each year, with $1.7 trillion in 2007. • Significant entry of nonbank institutional investors into the syndicated loan market.

4. Information distribution in the syndicated loan market • Syndicate participants receive confidential information: • Financial disclosures, covenant compliance reports, amendment and waiver requests, financial projections, plans for acquisitions. • Traded loans are not considered securities and thus are not governed by the Securities Acts of 1933 and 1934. • Syndicate participants can generally trade on syndicate-confidential information in a manner consistent with the appropriate standards of professional integrity and fair dealing: • The informed participant is expected to offer to reveal syndicate- confidential information to a counterparty. • Unless the informed participant reasonably believes that the counterparty has already received the information or the counterparty is sophisticated and understands the nature and importance of syndicate- confidential information.

5. Information distribution in the syndicated loan market (cont’d.) • Rule 10b-5 prohibits the purchase or sale of a security on the basis of material nonpublic information. • Strategies for dealing with the conflict between the public and private sides of the information wall: • “Chinese walls” - traders, salespeople and analysts do not receive private information. • Written procedures that preclude trading on private information received from the loan market. • The whole firm is kept on the public side by agreeing not to receive any material non-public information. • Concern: Syndicate participants (nonbank institutional investors, in particular) exploit their access to private information to engage in insider trading.

6. Anecdotal evidence • Standard & Poor’s (2007): • “…growing concern among issuers, lenders, and regulators that this migration of once private information into public hands might breach confidentiality agreements between lenders and issuers and, more importantly, could lead to illegal trading”. • “…mark-to-market pricing services often report significant movement in a loan price without any corresponding news. This is usually an indication that the banks have received negative or positive information that is not yet public”. • Institutional press on hedge funds: • [They] “use the same professional to trade all the financial instruments across a company's capital structure”. • “You can't put a Chinese wall through someone's head”. • “A hedge fund gets into the loan business by buying very small amounts of loan syndications … to get access to any information a bank would have access to”. • Movie Gallery: • Over the two days after a confidential conference call with lenders, despite the absence of any public news releases, the stock price dropped by 25%.

7. Prior research • Cross-market lead-lag relations: • Acharya and Johnson (2007): informed lenders exploit private information gleaned from clients to inside trade in the credit default swap market. • Allen and Gottesman (2006), Allen et al. (2004), Altman et al. (2008), Blanco et al. (2005), Hotchkiss & Ronen (2002), Longstaff et al. (2003) and Norden and Weber (2004). • Insider trading by informed lenders: • Ivashina and Sun (2007): institutional managers who participate in loan renegotiations trade in the firm’s stock and outperform other managers in the month following the loan renegotiation. • Massa and Rehman (2005): following a loan deal, the mutual funds of the conglomerate profitably adjust their stakes in the firms that borrow from the affiliated banks. • The role of institutional investors in the loan market: • Gatev and Strahan (2008), Jiang et al. (2008), Nandy and Shao (2007), Nini (2008).

8. Research design • Price discovery in the secondary loan market: • The direct flow of confidential information to loan market participants is likely to dominate price discovery in the loan market. • Characteristics that potentially influence the timing of private information dissemination: Relationship lending (Bharath et al., 2006, Sufi, 2007) Reputation of the arranger of syndication (Jones et al., 2005, Dennis and Mullineaux, 2000, Lee and Mullineaux, 2004, Sufi, 2007) Covenants (Allen et al., 2004, Standard & Poor’s, 2007, Bradley and Roberts, 2004). • Price discovery in the stock market: • Investigate whether price discovery in the stock market is timelier for firms with syndicated loan characteristics associated with relatively early private information dissemination from borrowers to lenders.

9. Information flows in the loan and stock markets

10. The measure of intra-period timeliness • Focus on the 63-trading-day time period that begins 60 trading days before and ends two trading days after firms’ quarterly earnings announcements. • Construct portfolios of firm-quarter observations based on firm and loan characteristics. • Intra-period timeliness is estimated by the area under the curve constructed by plotting for each of the 63 trading days in the period the cumulative buy-and-hold abnormal return up to that day, scaled by the cumulative buy-and-hold abnormal return for the whole period. • The statistical test establishes whether the curves for the two portfolios are statistically different from each other in a way that is consistent with differential price discovery.

11. Plot of IPT-loan-return for Relationship-lending and Non-Relationship-lending portfolios

12. Statistical test of differences in intra-period timeliness • The notion of the timeliness of information arrival: A higher proportion of the total cumulative abnormal return for the “fast” price discovery portfolio will occur earlier in the period relative to the “slow” price discovery portfolio. • That is, the order of arrival of the observed returns is crucial, because information would arrive relatively earlier for the timely portfolio and relatively later for the less timely one. • A permutation analysis is used to construct the distribution of the test statistic under the null that the ordering of return arrivals does not matter: • Randomize the ordering of the 63 return pairs (one return for each portfolio for each day) 1000 times, computing for each iteration, • Use sampling distribution to indicate the likelihood of observing under the null hypothesis.

13. Data • Loan Trade Database (Secondary loan trading) • Bid and ask price quotes, quote date and the number of market makers reporting price quotes. • DealScan (Primary loan market data) • Loan and syndicate characteristics, such as amount, covenants and syndicate structure. • Standard & Poor’s historical database • Credit ratings, watch list and outlook at the firm level. • Mergent FISD • Moody’s, Fitch or DPR Credit ratings at the firm level. • COMPUSTAT, CRSP, IBES, First Call

14. Plot of IPT-loan-return for Reputable-arranger and Non-Reputable-arranger portfolios

15. Plot of IPT-loan-return for Covenant and Non-Covenant portfolios

16. IPT-loan-return for portfolios based on firm and loan characteristics

17. The impact of the information features of lending arrangements, controlling for firm and loan characteristics

18. IPT-stock-return for portfolios based on firm and loan characteristics

19. IPT-stock-return for institutional portfolio • The total sample of institutional loans • Institutional loans after excluding traded loans

20. IPT-stock-return for institutional and non-institutional portfolios, controlling for firm characteristics

21. Analysis of Institutional portfolio, controlling for credit risk and information transparency measures

22. Conclusions • Price discovery in the secondary loan market is timelier for relationship loans, loans syndicated by a reputable arranger and loans subject to financial covenants. • Contributes to the literature on secondary loan market trading. • Timelier dissemination of private information to lenders in the loan market is associated with faster price discovery in the stock market when institutional investors are involved in the syndicated loans. • Extends the literature investigating lead-lag relations between prices across capital markets. • Contributes to the literature on insider trading by informed lenders. • Complements the literature on the role of institutional investors in the syndicated loan market.