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How Friendship Pays Off at the Lending Desk

Personal connections between borrowers and bankers produce better results for both sides.

(originally published by Booz & Company)

Title: Friends with Money (Fee or subscription required.)
Authors: Joseph Engelberg and Christopher A. Parsons (University of California at San Diego) and Pengjie Gao (University of Notre Dame)
Publisher:  Journal of Financial Economics, vol. 103, no. 1
Date Published: January 2012

When it comes to financing, it pays to have friends. That’s the view of the authors of this paper, who ask: Do the long-term personal connections between corporate executives or directors and their counterparts in banks affect the terms of their loan deals and the borrowers’ future performance? Their answer is a resounding yes, and in positive ways.

The danger of “friendly” transactions, of course, is that lenders could overlook the borrower’s flaws and strike ill-fated deals. But the personal links between the two sides could instead facilitate information flow, allowing banks to make better lending decisions and permitting borrowers to reduce their cost of capital. The evidence marshaled in the paper — better credit ratings and stock returns for connected borrowers — points to the latter outcome.

The authors analyzed about 20,000 commercial loans made to U.S. public companies between 2000 and 2007, involving 5,057 borrowers and 1,924 lenders. The authors also examined a list of organizations in which the 65,074 directors and executives at those firms and banks could have struck up a personal relationship — for instance, “if the president of Wachovia Bank and the chief executive officer (CEO) of PepsiCo attended college together, or if they overlapped in their first job after graduate school,” the authors write.

The authors focused on school and professional connections, and required that the links predate the lending by more than five years. Connected companies received substantially lower interest rates, fewer default covenants, and larger loans than their unconnected competitors.

After connected firms borrowed, their credit ratings improved, compared with those of the unconnected group. For example, of the 1,290 BB-rated companies that had syndicated deals with at least one connected bank, 22 percent posted better credit ratings, whereas 15 percent saw their ratings decline. In contrast, of the 1,880 BB-rated borrowers that were not connected, 11 percent improved and 25 percent declined. This pattern occurred in every credit category.

The results were even stronger, the authors say, for stock performance. Connected firms posted returns that were 3, 10, and 17 percent better, on average, than those of unconnected firms in the first, second, and third years, respectively, following the loan.

“Whether measured by future stock returns or credit ratings,” the authors write, “firms perform better after completing a deal with a personally connected syndicate, suggesting that instead of facilitating poor deals, firm–bank connections appear to reduce the risk.”

Bottom Line: Personal connections between borrowers and lenders lead to better financing terms, which results in improved performance. 

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