Paper Example on Factors That Affect Debt Maturity in Private Firms

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Sewanee University of the South
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Research paper
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A wide range of information is available about the debt maturity structures of both public and private companies. The literature on this topic has identified many factors that affect the debt maturity structure. One of the main factors is the conflict of interest that usually occurs in most firms, and especially private family-owned firms. According to the agency theory, agency conflicts come as a result of the separation of control and the ownership in firms (Childs, Mauer, & Ott, 2005). Previous research has focused on how these conflicts have affected financial decisions in private firms. The studies have demonstrated that conflicts of interests usually emerge between managers and creditors (Childs et al., 2005). These conflicts often manifest themselves in the type of projects that the firm will take and how they will be financed. One of the ways to limit these conflicts is to use short-term debt. The short-term debts mitigate many agency problems since potential lenders will refuse to refinance the debt in case of any problems (Easterwood, & Kadapakkam, 1994). Additionally, the short-term debts give creditors the opportunity as well as the flexibility to monitor managers. Therefore short-term debts help in reducing conflicts between equity holders and creditors. When it comes to private firms, the decision on the debt maturity structure is highly influenced by the controlling shareholder (Aivazian, Ge, & Qiu, 2005). Usually, the controlling shareholder is the owner of the firm. Additionally, in such firms, the number of shares that each person owns may result in conflicts of interests among the shareholders hence affecting the debt maturity. Therefore, it is important to understand the factors that affect the financial decisions of a private firm especially its debt maturity structure.

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The sample of the study will consist of a group of family-owned firms since they possess the characteristics needed for the study. One of these characteristics is that the external financing decisions of such firms are greatly influenced by information asymmetry and control incentives (Bonfim, 2015). Additionally, family-owned firms are more likely to raise capital through debt financing rather than equity offerings. Finally, according to Bonfim (2015), most creditors view family-owned firms as more risk-averse hence prefer low-risk investments as per their non-risk behaviors. These characteristics are important in determining the factors that affect the debt maturity in private firms. The sample of the study will be obtained from the Orbis online database which contains comprehensive and updated information of different types of firms around the world.

The current study fills the research gap on financing decisions of firms in various ways. First, most previous research has focused on the factors that affect debt maturity structure in public firms. However, most firms are privately-owned hence the need to explore the financing decisions of private firms and what factors affect them. Secondly, the study will explain the role of debt maturity structure of firm in mitigating agency conflicts. This is of great significance since agency conflicts are common in most private firms around the world. Finally, the research will determine how private firms, particularly family-owned ones, alleviate information imbalance so as to acquire excellent debt contract terms from creditors. Previous research has identified that information asymmetry greatly influences the financial decisions of family-owned firms but few have focused on how the firms try to alleviate the information imbalance. Ultimately, the research will comprehensively identify the factors that affect the financing decisions of private firms and what characteristics creditors look at before deciding on the debt maturity.

One of the anticipated findings of the research is that family-owned firms prefer long-term debts as opposed to short-term. The reason for this is that the controlling shareholders of such firms are more risk-averse than those of non-family firms. This anticipated finding is supported by other studies that have identified reasons why private firms prefer long-term debt. One the reasons identified include equity retention as owners of the company prefer to maintain ownership as well as control of the firm (Barclay & Smith, 1995). Another reason for the preference of long-term debt is that it allows private firms to achieve operational and infrastructural improvement (Barclay & Smith, 1995). The second anticipated finding is that creditors will prefer to issue long-term debt to family-owned firms than non-family firms. This finding is in line with those of other research that has shown the tendency of creditors to issue long-term debt to family-owned firms since they perceive them as less risky (LopezGracia & SanchezAndujar, 2007). The confidence of creditors can be attributed to two factors. First, family reputation is usually liked the performance of the firms hence the tendency of firms to minimize conflicts of interest maintaining a good reputation and ensuring proper managerial risk taking (Anderson, Mansi, & Reeb, 2003). Secondly, the bankruptcy of family firms is linked to the personal bankruptcy of the owners since most owners use some of their personal finances in running the firm. Therefore, since the operations of the firm may have a direct correlation with the personal lives of the owners, they will be careful on what decisions they make. Finally, the presence of a subordinate shareholder in family-owned firms is likely to reduce its debt maturity. The reason for this is that there would be greater tendencies for the family group to find an agreement with respect to private profits (Lin, Ma, Malatesta, & Xuan, 2011). In such scenarios, most creditors will view the firms as having a higher risk of expropriation.

The findings of this research will be not only useful to family-owned firms but also other private firms in different regions of the world. Particularly, the research will be useful to firms that have higher ownership concentration, weak investor protection, capital markets that are dominated by banks, and limited avenues where they can access long-term debts outside banks. Creditors will also find the research useful as it will enable them to understand the various characteristics of private firms that they can use to determine debt maturity. Ultimately, such information will assist in the reduction of agency conflicts between equity holders and debt holders.

Literature Review

Recent financial literature has identified various factors that affect debt maturity structures in private firms. Some of these factors include agency conflicts, family control, information asymmetry, and firm characteristics. This section will review existing literature on these factors and how they affect debt maturity of firms.

Agency Conflicts and Debt Maturity Structure in Private Firms

Previous literature ascertains that there is a relationship between agency conflicts and debt maturity structure of firms. Most of the debt maturity structure literature has come up from Myers (1977) paper on the factors influencing corporate borrowing. In the paper, Myers provides a comprehensive theoretical framework hence gives a better understanding of the primary incentives that affect debt financing. Most of the relevant assertion relates to agency conflicts between equity holders and debt holders that come as a result of different risk appetites. Since debt holders seek a lot of assurance in the ability of a company to repay the obligations that it owes to them, they need extra incentives for any default risk on the loans that they have offered to the firms (Myers, 1977). On the other hand, equity holders will want to maximize the firms value by seeking activities that will add value and surpass expectations, maximize returns, and increase the value of holdings. The two interests of the debt holders and the equity holders result in conflicts between the two. The true face of the divergent views is clear in situations of higher risk, uncertainty, and leverage (Easterwood & Kadapakkam, 1994). For instance, when risky opportunities are available to firms that have leverage, the investment that comes from such investments may shift considerably away from equity holders towards debt holders who will want higher returns for the increased default risk that the firm would bring upon itself by borrowing to invest.

When the outstanding debt of a firm is large enough that it can affect its investment decision, it is known as debt overhang. A significant debt overhang makes debt holders capture a greater proportion of the firms future revenues. Consequently, firms may suffer from problems of underinvestment since management may decline investments with positive returns due to them perceiving that they will not add any benefits to the current equity holders (Myers, 1977). Such a situation is counterproductive for the firms in the long run since they gain value by the continued fulfillment of every investment opportunities that arise. According to Myers, firms can mitigate the disincentives to invest by reducing their debt maturity. This finding is supported by Barnea, Haugen & Senbet (1985).

Family-owned firms are mostly risk aversive hence are do not diversify their investments. Moreover, the owners of such firms are interested in maintaining their reputations. This tendency to build a good reputation makes the controlling equity holders reluctant to venture into risky projects. Therefore, according to agency theory, the large undiversified projects of family-owned firms reduces the risk of expropriation of creditors wealth (Faccio, Marchica, & Mura, 2011). Additionally, the firms will invest more conservatively hence reduce the scrutiny of debt holders. In turn, this will liberalize their choice in investments. Long-term contracts between debt holders and equity holders will, therefore, be necessary to promote investments in private family firms (Faccio et al., 2011). In this context, it is clear that family-owned firms will pose a lesser risk to creditors and hence reduce the conflicts between debt holders and equity holders. In turn, this results in higher debt maturity for such firms.

Family Control and Debt Maturity Structure

Whether family control brings benefits to all equity holders in a firm or serves the best interest of the family at the expense of shareholders outside the firm remains unclear despite many researchers addressing the topic. However, what has become clear is that family control may bring conflicts of interests among majority shareholders and minority shareholders. For example, controlling family members may use the resources of the firm to meet personal liquidity needs or become overly cautious due to lack of diversification and risk aversion (Croci, Doukas, & Gonenc, 2011). Whatever the case, families may use their control to divert resources or cut productive investments against the will of minority shareholders.

With regards to a firms finances, Anderson and Reeb (2003) argue that the firm owners heavily influence its financial decisions which will depend on their attitude towards the use of debt to fund their operations as determined by external environmental conditions. In this sense, the family will use their control to determine if a particular investment is of value to the firm (Croci et al., 2011). Two aspects characterize the value that the family puts on an investment prospect. First, family members will tend to make decisions while considering a certain reference point. Secondly, they will tend to be risk averse and choose investments that will likely benefit them. The heavy...

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