Why are Institutional Loans More Expensive than Bank Loans? Evidence from the Syndicated Loan Market

Abstract

A recent development in the syndicated loan market has been the arrival of institutional investors, including hedge funds, private equity funds, and hybrid funds, as lenders. This paper asks several related questions regarding institutional participation in the syndicated loan market, and presents the first empirical analysis in the literature. We show that institutional investors participate in the syndicated loan market as it offers them a lucrative return. We find that institutional investors primarily lend to riskier borrowers, for riskier purposes such as leveraged buy-outs and takeovers, as opposed to commercial banks. Our results show that institutional loans have higher loan spreads (between 35 to 60 bps) than bank loans in the primary market, ceteris paribus. The higher riskiness of institutional loans however, does not fully explain this additional spread. Following information based theories, we argue and empirically show that this higher spread on institutional loans primarily serves as compensation to these investors for engaging in costly information production about borrowers, since institutions are uninformed investors in the syndicated loan market. We also show that borrowers are willing to pay the higher spread to institutional lenders as they are lenders of the last resort for these firms. Finally, consistent with the information production argument, our results show that the secondary loan market is primarily driven by trading on institutional loans; while on average only 6% of bank loans are traded, 30% to 35% of institutional loans are traded in the secondary market.