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Stapled Finance

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes to us from Paul Povel of the University of Houston, and Rajdeep Singh of the University of Minnesota.)

In our recently accepted Journal of Finance paper, Stapled Finance, we investigate the relatively new, but now quite common occurrence of a loan commitment that is ?stapled” onto an offering memorandum by the investment bank advising the seller in an M&A transaction. Stapled finance provides for credit at pre-specified terms to whoever wins the bidding contest for the asset or firm that is being put up for sale; but the winner is under no obligation to accept the loan offer.

We show that arranging stapled finance affects the bidding itself, by making it more competitive. We show that an appropriately designed stapled finance package increases the expected price that will be paid to the seller. Three characteristics are crucial for this to be beneficial for the seller. First, the stapled finance offer is optional: the winning bidder has the right, but not the obligation, to accept a loan whose terms have been fixed before the takeover contest started. Second, the stapled finance is a non-recourse claim, i.e., the debt is supported only by the target’s assets and cash flow, not by the other assets and operations that the winning bidder owns. Third, there are bidders who plan to hold the target as a portfolio company, i.e., who do not plan to integrate it into their other operations if they win. Our arguments do not rely on financial constraints of any sort; stapled finance is accepted by bidders for strategic reasons, even if they have sufficient internal or outside funds to pay for an acquisition.

In addition, we show that if the stapled finance package is designed optimally, then the investment bank providing it expects not to break even. The reason is that stapled finance is optional, so it is accepted only if the terms are attractive to the bidder?and therefore unattractive to the lender. This suggests that stapled finance that benefits the seller can be arranged only if it is possible to compensate the investment bank for its expected loss, for example with an up-front fee, or by retaining it for other fee-based services. It also suggests that stapled finance loans that investment banks and other financial institutions retained on their balance sheets should perform worse than buyout loans that were negotiated independently.

Being a fairly recent creation, stapled finance has not yet entered the academic mainstream, and therefore there is little existing empirical research. However, the institutional details about stapled finance are consistent with our results. In our paper, we discuss (informal) explanations for the popularity of stapled finance that practitioners provide, and how our results differ from predictions that follow from those explanations.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on September 28, 2009 (boomark / email).