How Major Customers Affect Supplier Loan Yield and Covenants

Abstract

Using a sample of private loans issued to U.S. firms between 1994 and 2006, we examine whether lenders take into account the relationship of the borrower-supplier with its major customers when determining loan yields, dividend restriction covenant and the overall number of financial covenants at loan initiations. A supplier that is economically dependent on its major customers can import its customers' liquidity problems as well as succumb to pressure from its customers to engage in risk-shifting behaviors that expropriate the lender. We find evidence that lenders protect themselves from such liquidity contagion and expropriation by imposing higher loan yields, a larger number of financial covenants, and dividend restriction covenants on the supplier-borrower when the major customers have high risk and leverage. Yield also increases when the borrower relies on a greater number of major customers, when major customers contribute to a higher percentage of its sales, and when it has a shorter working relationship with its most important customer. These findings suggest that lenders consider additional sources of default risk of the borrower arising from important customer-supplier relationship when designing loan contracts to take into account additional monitoring costs, hold-up problems, and potential bailout benefits from the borrower’s major customers.

Keywords: economic links, financial covenants, loan yield, major customers, customer-supplier relationships, default risk

JEL Classification: G21, G32, G34, L14