Domestic lead arranger certification and the pricing of project finance loans

• Author: Gregory A. James,Frederick S. Ahiabor
• Published date: 01 January 2019
• Date: 01 January 2019
• DOI: http://doi.org/10.1002/ijfe.1654

Received: 27 April 2018 Revised: 13 July 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1654

RESEARCH ARTICLE

Domestic lead arranger certification and the pricing of

project finance loans

Frederick S. Ahiabor Gregory A. James

Department of Accounting and Finance,

Leicester Castle Business School, De

Montfort University, Leicester,UK

Correspondence

Gregory A. James, Department of

Accounting and Finance, Leicester Castle

Business School, De Montfort University,

Leicester, LE1 9BH, UK.

Email: gregory.james@dmu.ac.uk

MSC Classification: G20, G21, G15

Abstract

Using a sample of 1,270 project finance syndicated loan tranches arranged from

1998 to 2011 and worth over $300 billion, we estimate the causal impact of cer-

tification by domestic lead arrangers on the pricing of project finance loans in

emerging markets. Wehypothesize that, on average, domestic arrangers are bet-

ter able to structure and screen project finance deals, credibly communicate

the true value of a project and its underlying network of contracts, and mon-

itor the loan contract compared with foreign arrangers. If so, all things being

equal, domestic arranger certification should result in lower loan spreads com-

pared with foreign arranger certification. Our results support this hypothesis.

After controlling for project and loan characteristics and the potential endo-

geneity of the lead arranger's selection, we find that certification by domestic

arrangers causes a significant reduction in loan spreads across different indus-

trial categories and geographic locations of projects. This finding demonstrates

the economic value of domestic arranger certification in project finance lend-

ing. Our results suggest that, in the presence of information asymmetry between

project sponsors and participant lenders in the syndicate, certification by domes-

tic arrangers offers a superior mechanism to minimize search, information, and

monitoring costs.

KEYWORDS

asymmetric information, certification, emerging markets, financial intermediaries, loan pricing,

mandated lead arranger, syndicated lending, project finance

1INTRODUCTION

Over the past two decades, project finance (PF) has

become an increasingly popular vehicle for channelling

capital into emerging markets (Gatti, Kleimeier, Meg-

ginson, & Steffanoni, 2013). In 2017, the total value of

global PF transactions was worth $229.6 billion, based

on data compiled by Thomson Reuters Deals Intelligence

(Thomson-Reuters, 2017). Approximately $80.6 billion

(35%) of these deals were undertaken in emerging markets

to finance long-term infrastructure projects in transporta-

tion, water and sewage, power, oil and gas, and mineral

explorations. As Ansar (2012) points out, the surge in

the use of PF in emerging markets is partly underpinned

by an increasing involvement of homegrown, and often

state-backed, financial intermediaries (FIs).

According to Esty (2014), a PF transaction “...involves

the creation of a legally independent project company

financed with nonrecourse debt (and equity from one or

more corporations known as sponsoring firms) for the pur-

pose of financing investment in a single purpose capital

asset, usually with a limited life.” Financing is secured

150 © 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/ijfe IntJ Fin Econ. 2019;24:150–167.

AHIABOR AND JAMES 151

on the basis of the underlying project's ability to generate

enough cash flow for repayment. This absolves the spon-

sors from any future liability arising from project failure.

PF deals are typically structured as syndicated loans, led

by one or more mandated lead arrangers (MLAs). The role

of the lead arranger in PF is particularly critical because

the loan is nonrecourse. The lead arranger is appointed

by the sponsors through a competitive tendering process

(Della Croce & Gatti, 2014) and principally responsible for

undertaking due diligence. The lead arranger also exam-

ines the project company's network of contracts and invites

participant lenders to provide a share of the PF loan.

The noninvolvement of syndicate members in the due

diligence process induces asymmetric information at the

level of the lead arranger (Focarelli, Pozzolo, & Casolaro,

2008). The lead arranger is an “informed lender” who is

able to monitor and learn about the firm through unob-

servable and costly effort whereas potential participant

lenders in the syndicate are “uninformed lenders” who

rely on the information and monitoring provided by the

informed lender to make profitable investment in firms

(Holmstrom & Tirole, 1997). To overcome the problem

of moral hazard at the lead arranger level, given that

informed lender effort is unobservable, the lead arranger

must retain a stake in the borrowing firm to reassure the

syndicate members that the firm will behave diligently.

When the borrower requires more intense investigation

and monitoring, the lead arranger retains a larger portion

of the loan to commit to exerting costly effort. Another pos-

sible solution to this moral hazard problem is reputation.

Lead arrangers that retain a larger portion of the

loan or reputable lead arrangers communicate a mean-

ingful signal (see Brealey, Leland, & Pyle, 1977) about

the project's true value and the lead arranger's commit-

ment to monitoring, especially when dealing with new or

information-sensitive borrowers (Drucker & Puri, 2007).

Thus, the lead arranger facilitates a reduction in the loan

spread through a reduction in search and information

costs and the alignment of the lead arranger's incentives

with that of other members of the syndicate. Dennis and

Mullineaux (2000), Sufi (2007), Chaudhry and Kleimeier

(2015), and Lee and Mullineaux (2004) provide empirical

evidence that the syndicate structure is less concentrated

with arrangers syndicating a greater portion of the loan

when the borrowing firm is public, the loan amount is

large, and the arranger has a strong reputation. Vu and

Skully (2008), Ivashina (2009), and Nini (2004) show that

loan spreads are lower when the arranger discloses more

information to the syndicate members, holds a higher

share of the loan, has a strong reputation, and is local.

Kleimeier and Chaudhry (2015) find that foreign arrangers

in the U.S. syndicated loan market hold high lending

shares to overcome moral hazard driven by higher infor-

mation and effort costs. They show,however, that previous

interactions between borrowers and arrangers can reduce

moral hazard; hence, culturally distant arrangers are able

to form diffused syndicates.

A number of studies investigate arranger certification in

securities underwriting.1Underwriter syndication is used

to credibly commit against opportunistic behavior (the

possibility of banks using their lending-generated rela-

tionship to benefit themselves and the issuing firm at the

expense of investors) and to exploit their inside knowl-

edge to lower issuance costs for borrowing firm issuers

(Narayanan, Rangan, & Rangan, 2004). However, explain-

ing certification as an application of the inside knowledge

of the certifying agent obtained through prior transactions

with the issuer is probably not a valid argument for PF

(Gatti et al., 2013). This is because PF involves a newly

established project that is operationally separate from the

sponsors. In PF,as Gatti et al. (2013, p. 2) argue, “the ability

to certify arises from the superior ability of the arrang-

ing bank to structure and screen the deal set up by the

sponsors, as well as to later monitor the loan contract or

resolve financial distress situations.” Hence, Gatti et al.

(2013) examine lead arranger certification specifically in

the context of PF lending. Using a sample of 4,122 PF

loans arranged from 1991 to 2005, they find that PF loan

spreads are significantly lower for loans arranged by “pres-

tigious” arrangers (banks that have a high market share in

the PF loan market in the year or years prior to the signing

date of the loan) as compared with loans arranged by non-

prestigious lead arrangers. Furthermore, they show that

participating banks, rather than PF sponsors, “pay” for

the certification provided by prestigious banks by allowing

them to keep larger fractions of upfront arranging fees.

This paper builds on the work of Gatti et al. (2013) and

empirically examines the causal effect on loan pricing of

certification by domestic lead arrangers in emerging mar-

kets.2We hypothesize that the domestic certifying agent

has informational advantages in accessing so-called soft

information, that is, information that is difficult to com-

pletely summarize in a numeric score (Petersen & Rajan,

2002). As Corielli et al. (2010) show, lenders in PF rely on

the network of “nonfinancial contracts” (see Alchian &

Demsetz, 1972; Jensen & Meckling, 1976) as a mechanism

to control agency costs and project risks.3The literature

on foreign banking, which focuses primarily on the activ-

ities of foreign banks in emerging markets (e.g., Giannetti

& Ongena, 2012) and emphasizes the informational dis-

advantages faced by foreign banks, provides arguments

and evidence in support of this hypothesis. Foreign banks

have less local, market or firm specific information than

their domestic counterparts and must also overcome cul-

tural and bureaucratic barriers in the host country (see

Buch, 2003; Khanna & Palepu, 1999; Mian, 2006; Petersen