Conflict of Interests between Shareholders and Bondholders. An applicable situation to the Chilean market?

Nelson Escobar

Modern finance not stops surprising us. What sensed until recently, development and financial discipline are confirming. In particular the problem of Agency takes our attention this time.
Many dimensions of this conflict of interest you have seen addressed in the recent literature. One of them we will analyze through this paper.
The option pricing theory allows us to tackle decisions of capital structure from different points of view. We will focus on the conflict of interest produced between shareholders and bondholders.
Let us agree, however, that both shareholders and bondholders perform different functions and they have to maximize their objectives. This is the first edge of the conflict. Even though the shareholders are willing to assume more risky projects than the bondholders and eventually distribute large dividends that the bondholders would like to.
The value of equity can be modeled as a “CALL” option (ceteris-paribus) over the price of a company (“The Promise and Peril Of Real Options, A. Damodaran, Stern School of Business, NYU).
When increasing the variance (σ2) over the value of the company, it produces an increasing in the value of equity. In other words, shareholders will be predisposed to take more risky projects, and as a result they will improve the value of equity in prejudice of the bondholders and the value of the company. This produces a transfer of wealth from the bondholders toward the shareholders.
An extreme case of the previously exposed would occur if the shareholders could take a project with a slightly negative VPN. The reader could see some numerical examples related to this situation in the same above-mentioned article.
Likewise, from the boom of the sell and purchase of private companies, when these mergers are between companies which income and cash flow are not correlated (Diversification of Corporate Strategy), variance (σ2) tends to decrease, reducing the value of the merging firm. This favors the bondholder who will observe an increasing in their wealth in prejudice of the shareholder who will
experience a fall in their assets. Nevertheless, shareholders may partially or totally recover their losses, using their debt capacity or issuing a new debt.
Considering this theory in the Chilean market, ¿Do Pension Funds have clear that they do not have to invest in bonds and shares of the same company or subsidiary listed on the Stock Exchange? ¿Do they know the risk to which they are exposed to? ¿Is the Regulator body controlling the Pension Funds investment portfolios, in order to avoid a conflict?
According to the current legislation of the Pension Funds, they basically are able to invest the funds they manage, as defined in the D.L. N° 3.500 of 1980 and book IV, Title I, Letter A of the Investment of the Pension Funds and Provisions, Chapter II, specifically in the view of existing supplementary standards. Thus, this is not the opportunity of presenting legal arguments.
Currently, Pension Funds may invest a part of their funds in the shares listed in the Stock Exchange and debt instruments of private companies, previously approved by the regulatory body.
The reasons are obvious. Here is a conflict of interest where both investments are for one firm which is listed in the Stock Exchange and is also issuers of private debt.
While the shareholders enriched, bondholders will become impoverished. Net balance of zero. The Pension Funds make the private companies financially feasible, but the capitalizations accounts of the affiliates, generally, stay the same.
In the second case, from the existence of any of the listed merger companies, the regulator body must be in alert of the shareholder structure, as well as who are the bondholders of these companies, whether a debt issuance existed, in order to prevent a conflict of interest in the merger firm, as we have previously stated.

This is quite challenging.

Nelson Escobar Arguedas is Partner in GTD Financial Advisory. Nelson is a Civil Engineer from University of Chile and holds a Master in Business Administration and a Master in Financial Management. He has more than 23 years of professional experience developing strategic, financial and operational consulting.