Cash Flows in Executive Compensation Contracts and Private Loan Pricing

This study investigates whether the use of cash flows as performance measures in borrowing firms' executive compensation contracts affects the pricing of bank loans. We hypothesize that linking executive pay to corporate cash flows serves as an ex ante incentive mechanism to motivate managers to improve cash flow generation. This incentive mechanism can alleviate lenders' concerns over debt delinquency and potentially reduces borrowing costs. Consistently, results show that using cash flows as performance measures is associated with lower yield spreads in newly originated loans, especially among financially constrained firms. In addition, using cash flows as performance measures leads to higher cash flows, consistent with cash-flow based performance evaluation improving cash flow performance. We also find that using cash flow performance measures reduces the need for external debt financing among financially constrained firms. The overall evidence supports the incentive effect of cash-flow-based performance evaluation being recognized and awarded by lenders in loan pricing decisions.