Choice of Debt Source Event studies have shown that a company’s stock value rises when it announces a new bank relationship. To understand why this is important, we must step back and understand the economics of Commercial Banking.
Consider an entrepreneur with a new invention. Were she to raise capital from the market, she would have to disclose technical details - which might help competitors, and reduce probability of success.
A bank - as part of relationship building - can preserve secrecy.
Consider a company where the correlation between the value of assets-in-place and growth options is low. If such a company had outstanding bonds, and had a bad year, it might be forced into bankruptcy, even though it has valuable growth options. Renegotiation of debt contract would be optimal, but difficult with public lenders.
The importance of the difficulties and rewards from renegotiating credit may be seen in the activity of vulture investors. Vultures buy up the debt of companies on the verge of collapse. To the many small investors these bonds are worth little. But in the hands of a small number of like-minded investors, the value may be much higher.
A recent example of vulture activity is Iridium. This company was financed by equity from Motorola and the public, as well as bond holders. The company was unable to make payments on interest and principal commitments. Its bonds became virtually worthless. Vultures bought up the debt hoping to be in a strong bargaining position - and converting the debt into equity.
The reason vultures circled around Iridium is that they felt that its past profits (and inability to meet financial obligations) were unrelated to its potential (i.e., the vultures believed that Iridium still had potential.
Pierpont Morgan was an early vulture. In the late 19th century, creditors of a bankrupt company could dun the shareholders (before limited liability).
Given their expertise, and large individual exposure, banks are in a position to monitor management on an on-going basis. Even for large, well-known companies, like Anheuser-Busch, shareholders may feel that the relationship with a bank may reduce agency costs. (The large exposure eliminates the ``free-rider’’ problem of the capital markets.)