Financial Advisor Reputation and the Cost of Debt: Theory and Evidence from Project Finance Loans

Abstract

An important puzzle in credit markets is why some firms use the services of financial advisors (FA) rather than undertake those tasks themselves. This paper examines, using theory and empirical evidence, whether the presence and the reputation of FA can act as a credible signal of project quality. Our theoretical model shows that, because of the structure of success fees, project lenders may worry that FA will try to sell them excessively risky projects, leading to higher costs of debt. Using Projectware data on project finance (PF) loans granted to public-private partnership projects arranged between 2001 and 2015, we test empirically and find strong support for our theoretical prediction. Indeed, our empirical results show that the presence and the reputation of FA are associated with higher costs of debt. Moreover, the evidence shows that FA presence and reputation are linked to higher project debt ratios. Overall, our findings suggest that the structure of success fees offers strong incentives to FA to focus on providing high debt levels rather on reducing asymmetric information between sponsors and lenders. Therefore, the presence and reputation of FA do not seem to be credible signaling devices for quality in the market for project finance loans.