External Governance and Debt Structure

This paper examines how external governance pressure affects the type of debt that firms issue. Consistent with a governance mechanism substitution effect, we find that an exogenous increase (decrease) in governance pressure from the product (takeover) market has a significant negative (positive) impact on the use of bank (public debt) financing over public debt (bank loan) issuance. Tests using changes in the strictness of loan covenants provide corroborative evidence. These findings are consistent with the notion that firms endogenously substitute governance mechanisms and that demand for creditor governance depends on the relative strength of alternative external governance mechanisms. Received May 18, 2016; editorial decision November 11, 2017 by Editor David Denis.