THE IMPACT OF POLITICAL CONNECTIONS ON FIRMS’ OPERATING PERFORMANCE AND FINANCING DECISIONS

We investigate the impact that the political connections of publicly traded firms have on their performance and financing decisions. Using a long‐term event study covering a sample of 234 politically connected firms headquartered in 12 developed and 11 developing countries from 1989 to 2003, we find that firms increase their performance and indebtedness after the establishment of a political connection. We also find that the political connection is more strongly associated with changes in leverage and operating performance for firms with closer ties to political power. Overall, our study confirms that politically connected firms gain easier access to credit and reap benefits in terms of performance from their ties with politicians.     

Individual political contributions and firm performance

We present evidence that individuals make political contributions strategically by targeting politicians with power to affect their economic well-being. Individuals in Congressional districts with greater industry clustering choose to support politicians with jurisdiction over the industry. Importantly, individual political contributions are associated with improvements in operating performance of firms in industry clusters. The relation between contributions and firm performance is strongest for poorly performing firms, firms closer to financial distress, and for contributions in close elections. The results imply that individual political contributions are valuable to firms, especially during bad economic times.     

Contracts Between Firms and Shareholders

Theory predicts the existence of explicit bilateral contracts between firms and expert shareholders. I assemble and analyze a large-scale data set of these contracts. Using block investments from 1996 to 2018, I find that these contracts involve mainly corporate owners and activist owners, and often specify covenants pertaining to financing, trading, directorships, dividends, joint ventures, corporate investment, financial reporting, and information access. I also find that some of the contract covenants are stated in terms of accounting information, and that the prevalence of these contracts is significantly positively associated with measures of information asymmetry between managers and shareholders. Overall, this study provides some of the first systematic evidence on explicit bilateral contracts between firms and shareholders.     

Management quality and the cost of debt: Does management matter to lenders?

This paper investigates the effect of organizational capital, typified by various management practices within a firm, on the cost of external debt financing. Using a sample of medium-sized manufacturing firms in the US, we find that better management practices enhance a firm’s external financing capacity by lowering the firm’s cost of bank loans. We do not find any evidence that the lower loan cost of a high-quality-management firm is associated with more restrictive non-price contract terms such as greater collateral requirements and stricter covenants. These results suggest that banks explicitly take into account the risk arising from poor management practices when pricing and designing debt contracts.     

The incentive to give incentives: On the relative seniority of debt claims and managerial compensation

We show that the relative seniority of debt and managerial compensation has important implications for the design of remuneration contracts. Whereas the traditional literature assumes that debt is senior to remuneration, there are in reality many cases in which remuneration contracts are de facto senior to debt claims in financially distressed firms and in workouts. We theoretically show that risky debt changes the incentive to provide the manager with performance-related incentives (a “contract substitution” effect). In other words, the relative degree of seniority of managers’ claims and creditors’ claims in case a bankruptcy procedure starts is crucial to determine the optimal incentive contract ex-ante. If managerial compensation is more senior than debt, higher leverage leads to lower power incentive schemes (lower bonuses and option grants) and a higher base salary. In contrast, when compensation is junior, we expect more emphasis on pay-for-performance incentives in highly-levered firms.     

Managerial effect or firm effect: Evidence from the private debt market

This paper provides evidence that the managerial effect is a key determinant of firms’ cost of capital, in the context of private debt contracting. Applying the novel empirical method developed by an earlier study to a large sample that tracks the job movement of top managers, we find that the managerial effect is a critical and significant factor that explains a large part of the variation in loan contract terms more accurately than firm fixed effects. Additional evidence shows that banks “follow” managers when they change jobs and offer loan contracts with preferential terms to their new firms.     

Fraud Allegations and Government Contracting

This paper examines whether fraud allegations affect firms’ contracting with the government. Using a data set of whistleblower allegations brought under the False Claims Act against firms accused of defrauding the government, we find that federal agencies do not reduce the total dollar volume of contracts with accused firms; however, they substitute approximately 14% of the harder‐to‐monitor cost‐plus contracts for fixed‐price contracts. This effect is concentrated in the procurement of services and explained by contract and service substitution. Finally, we find that after the conclusion of the investigation, the government reduces the contract dollar volume by approximately 15% for cases that resulted in a settlement. Our findings indicate that contract‐design changes are used to mitigate uncertainty in suppliers’ reputation.     

CEO and board chair roles: To split or not to split?

We examine the performance and compensation implications of firms' decisions to combine the roles of CEO and board chairman (duality). We document that firms that split the CEO and chairman positions due to investor pressure have significantly lower announcement returns and subsequent performance, and lower contributions of investments to shareholder wealth. Further, these performance outcomes are more negative for firms with higher predicted probabilities of duality based on a model of economic determinants of board leadership structure. We also find that pay-performance sensitivity in CEO compensation contracts are significantly lower following a split in the CEO and chairman positions, and significantly higher following a combination in these positions. Our evidence suggests that on average, board leadership choices by firms and market responses are consistent with efficiency arguments, and recent proposals for all firms to separate the CEO and chairman roles warrant more careful consideration.     

Public corruption and the allocation of government contracts

Public corruption in the government procurement process is rampant and its cost is huge, even among developed countries. Some scholars estimate that about 20%–30% of the values of government projects are lost due to public corruption. In this paper, we examine how public corruption impacts the allocation of U.S. federal contracts. Using the U.S. Department of Justice corruption convictions data and the federal contract data from 2000 to 2018, we find that firms located in more corrupt states receive more federal contract dollars, more important contracts in terms of their contributions to firm revenues, and contracts with higher visibility among federal contractors. We construct an influence/favoritism index that takes into account defense contracts, cost-plus contracts, and multi-year contracts, and document that the index is positively related to corruption levels. These results hold after we conduct several robustness tests, including 2SLS regressions, propensity-score matching analysis, and using alternative corruption measures. Our empirical findings are consistent with the hypothesis that corruption plays an important role in how federal contracts are allocated.     

Bank discrimination, holding bank ownership, and economic consequences: Evidence from China

This paper finds that compared with Chinese state-owned firms, non-state-owned firms have a greater propensity to hold significant ownership in commercial banks. These results are consistent with the notion that because non-state-owned firms are more likely to suffer bank discrimination for political reasons, they tend to address their financing disadvantages by building economic bonds with banks. We also find that among non-state-owned firms, those that hold significant bank ownership have lower interest expenses, and are less likely to increase cash holdings but more likely to obtain short-term loans when the government monetary policy is tight. These results suggest that the firms building economic bonds with banks can enjoy benefits such as lower financial expenses and better lending terms during difficult times. Finally, we find that non-state-owned firms with significant bank ownership have better operating performance. Overall, we find that firms can reduce discrimination through holding bank ownership.     

The politics of government investment

This paper investigates the relation between corporate political connections and government investment. We study various forms of political influence, ranging from passive connections between firms and politicians, such as those based on politicians’ voting districts, to active forms, such as lobbying, campaign contributions, and employment of connected directors. Using hand-collected data on firm applications for capital under the Troubled Asset Relief Program (TARP), we find that politically connected firms are more likely to be funded, controlling for other characteristics. Yet investments in politically connected firms underperform those in unconnected firms. Overall, we show that connections between firms and regulators are associated with distortions in investment efficiency.     

Renegotiation of financial contracts: Evidence from private credit agreements

Using a large sample of private credit agreements between U.S. publicly traded firms and financial institutions, we show that over 90% of long-term debt contracts are renegotiated prior to their stated maturity. Renegotiations result in large changes to the amount, maturity, and pricing of the contract, occur relatively early in the life of the contract, and are rarely a consequence of distress or default. The accrual of new information concerning the credit quality, investment opportunities, and collateral of the borrower, as well as macroeconomic fluctuations in credit and equity market conditions, are the primary determinants of renegotiation and its outcomes. The terms of the initial contract (e.g., contingencies) also play an important role in renegotiations; by altering the structure of the contract in a state contingent manner, renegotiation is partially controlled by the contractual assignment of bargaining power.     

Political connections and preferential access to finance: The role of campaign contributions

Using novel indicators of political connections constructed from campaign contribution data, we show that Brazilian firms that provided contributions to (elected) federal deputies experienced higher stock returns than firms that did not around the 1998 and 2002 elections. This suggests that contributions help shape policy on a firm-specific basis. Using a firm fixed effects framework to mitigate the risk that unobserved firm characteristics distort the results, we find that contributing firms substantially increased their bank financing relative to a control group after each election, indicating that access to bank finance is an important channel through which political connections operate. We estimate the economic costs of this rent seeking over the two election cycles to be at least 0.2% of gross domestic product per annum.     

Creditor control rights and firm investment policy

We present novel empirical evidence that conflicts of interest between creditors and their borrowers have a significant impact on firm investment policy. We examine a large sample of private credit agreements between banks and public firms and find that 32% of the agreements contain an explicit restriction on the firm's capital expenditures. Creditors are more likely to impose a capital expenditure restriction as a borrower's credit quality deteriorates, and the use of a restriction appears at least as sensitive to borrower credit quality as other contractual terms, such as interest rates, collateral requirements, or the use of financial covenants. We find that capital expenditure restrictions cause a reduction in firm investment and that firms obtaining contracts with a new restriction experience subsequent increases in their market value and operating performance.     

Corporate misreporting and bank loan contracting

This paper is the first to study the effect of financial restatement on bank loan contracting. Compared with loans initiated before restatement, loans initiated after restatement have significantly higher spreads, shorter maturities, higher likelihood of being secured, and more covenant restrictions. The increase in loan spread is significantly larger for fraudulent restating firms than other restating firms. We also find that after restatement, the number of lenders per loan declines and firms pay higher upfront and annual fees. These results are consistent with banks using tighter loan contract terms to overcome risk and information problems arising from financial restatements.     

Political relationships,global financing,and corporate transparency: Evidence from Indonesia

This study examines the role of political connections in firms’ financing strategies and their long-run performance. We view political connections as an example for domestic arrangements which can reduce the benefits of global financing. Using data from Indonesia, we find that firms with strong political connections are less likely to have publicly traded foreign securities. As a result, estimates of the performance consequences of foreign financing are severely biased if value-creating domestic arrangements such as political relationships are ignored. Connections not only alter firms’ financing strategies, they also influence long-run performance. Tracking returns across several regimes, we show that firms have difficulty re-establishing connections with a new government when their patron falls from power, leading closely connected firms to underperform under the new regime and subsequently to increase their foreign financing.     

Inside the black box: Bank credit allocation in China’s private sector

This study examines how the Chinese state-owned banks allocate loans to private firms. We find that the banks extend loans to financially healthier and better-governed firms, which implies that the banks use commercial judgments in this segment of the market. We also find that having the state as a minority owner helps firms obtain bank loans and this suggests that political connections play a role in gaining access to bank finance. In addition, we find that commercial judgments are important determinants of the lending decisions for manufacturing firms, large firms, and firms located in regions with a more developed banking sector; political connections are important for firms in service industries, large firms, and firms located in areas with a less developed banking sector.     

Political Party Affiliation of the President,Majority in Congress,and Sin Stock Returns

We find that in contrast to the stock market, which performs better during Democratic presidencies, “sin” stocks—publicly traded producers of tobacco, alcohol, and gaming—perform better during Republican presidencies and even more so when the Republican presidency is accompanied by a Republican majority in at least one chamber of Congress. We examine whether sin firms use contributions to establish connections with politicians and find that sin firms contribute more to Republican candidates and that these contributions are greater when Republicans are in power. We also find a positive relation between political contributions and future returns. The relation is stronger for contributions to Republicans.     

Interbank market integration, loan rates, and firm leverage

This paper investigates the effect of interbank market integration on small firm finance in the build-up to the 2007-2008 financial crisis. We use a comprehensive data set that contains contract terms on individual loans to 6047 firms across 14 European countries between 1998:01 and 2005:12. We account for the selection that arises in the loan request and approval process. Our findings imply that integration of interbank markets resulted in less stringent borrowing constraints and in substantially lower loan rates. The decrease was strongest in markets with competitive banking sectors. We also find that in the most rapidly integrating markets, firms became substantially overleveraged during the build-up to the crisis.     

The consequences of political donations for IPO premium and performance

This study explores the effect of directors' political contributions on IPOs' valuation and firm survival. We find that individual contributions by directors bring significant benefits to the IPO firms. Specifically, we show that political contributions of board members, particularly those of CEOs and founders, increase the IPO premium and the survivability of IPO firms. We find that the relationship between directors' political contributions and IPO premium is particularly strong among non-venture-backed firms, while the link between directors' political contributions and firm survival is more pronounced for venture-backed firms with strong corporate governance. Our findings are robust to endogeneity concerns and to alternative measures of political donations and IPO performance. Our results confirm the relevance of signaling and resource dependence theories.