Blocking Block Formation: Evidence from Private Loan Contracts

Does the structure of the borrower’s equity ownership matter in debt contracting? This paper addresses this question by examining change in control clauses. These clauses are pervasive in loan contracts, yet their terms are not boilerplate. Examining 14,940 contracts, we document significant heterogeneity in the use and size of ownership caps, which limit large equity block formation. Overall, our evidence indicates that the way equity capital is distributed matters to lenders. Lenders set lower caps to mitigate risks arising from power contests among shareholders, formation of a new (coordinating) block, potentially resulting in activism, and hostile takeover threats via toehold strategies. We confirm some of these effects using two quasi-natural experiments. Caps below 50% are associated with a drop in firm value but not in the cost of debt, consistent with exacerbated firm-manager agency costs. Finally, two findings shed light on ways creditors may influence corporate governance: the largest block size increases when these minority block restrictions expire, and the likelihood of withdrawing an announced buyback increases during the life of these loans. This paper was accepted by Bo Becker, finance. Supplemental Material: The internet appendix and data files are available at https://doi.org/10.1287/mnsc.2023.04224 .