EC 2725

February 2009

Financial Distress

Effi Benmelech
Harvard & NBER

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 Why Study Financial Distress?
• Ex Ante Reasons
– Distress costs are key elements of capital structure
theories (COFD are usually the negative side of debt).
– Efficiency of the environment in dealing with financial
distress (mostly legal system) affects the availability of
credit (e.g. creditor protection has been shown to affect
supply of credit and economic growth).
• Ex post Reasons
– Could be a key mechanism through which inefficient
firms exit.
• Are economically viable firm shut down?
• Are economically unviable firms kept afloat?
– If capital structure matters, it should matter most around
the birth and death of companies.

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 The Empirical Challenge

• Critical distinction between economic distress and

financial distress.
– Is the firm in financial distress because of a “wrong”
capital structure (e.g. too much debt), or does the
financial distress actually reflect economic distress.
• Very few papers were able to distinguish empirically
between financial and economic distress.

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 Symptoms of Financial (but also of Economic)
Distress
• High leverage (HLTs, LBOs), low interest coverage, large
fraction of short-term debt.
• Low credit rating, sudden unexpected drop in credit rating
(“fallen angles”).
• Default on debt covenants (e.g. quick ratio, interest
coverage).
• Default on promised debt payments.
• Bankruptcy filing (chapter 11, chapter 7), out of court
restructuring (“workouts”).
¾ But, are these symptoms of financial distress or merely a
reflection of economic distress?
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 Key Questions

• Two Types of questions to ask:

• Is financial (not economic) distress costly?
– Put differently, how does financial distress affect firm
policies (investment, wages, innovation)
• How costly is financial distress?
– Direct costs.
– Indirect costs.

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 Costs of Financial Distress

• Direct costs of financial distress (mostly in bankruptcy)

– Legal fees, trustee fees, professional service fees, etc.
• Indirect costs of financial distress (not necessarily in bankruptcy)
– Value of business that is lost because of the presence of debt
Examples
• Breakdown of intertemporal bargains
– trade creditors stop shipping
– customers fear warrantees will not be honored
– workers fear stigma and demand wage premiums
• Loss of intangible assets and strategic weakness
– The best employees may leave the firm and join its
competitors.
– The competitors “smelling blood” will become more
aggressive in their approach, e.g. price wars
• Conflicts of interest between D and E get worse
– Underinvestment (debt overhang)
– Overinvestment (risk shifting)

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 Resolving Financial Distress
• We can loosely categorize procedures for resolving
financial distress as:
1. Out-of-court restructuring – “workouts”
2. Chapter 11 Bankruptcy (structured bargaining)
3. Chapter 7 Bankruptcy (auction)

¾We will discuss these procedures next class.

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 How to Think about Financial Distress

1. The firm does not have to be in bankruptcy or in an out-of-court

restructuring procedure for costs of financial distress to be incurred.
2. Bankruptcies and out-of-court restructuring are transfers of ownership
and/or control.
3. Bankruptcies and out-of-court restructuring REFLECT bad
circumstances at the firm
• hospitalizing a patient reflects bad news about the patients
health, it’s not (generally) a cause of bad health
4. Indirect costs of financial distress are obviously born by shareholders.
5. Creditors pay bankruptcy costs when bankruptcy occurs, but
shareholders may bear much of the cost in the form of higher interest
rates

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 Anatomy of Financial Distress
(Asquith, Gertner and Scarfstein, QJE 1994)
• Study of 102 “distressed” companies that had issued junk bonds in 1976-1989.
• Distress defined as:
– Two years of interest coverage<1, or
– One year of interest coverage<0.8
• Of these firms, 76 take visible steps to restructure.
Restructuring options
• Restructure Liabilities
– Restructure bank debt
– Restructure public debt – exchange offer
– Raise new capital
• Restructure Assets
– Sell assets
– Merge
– Reduce capital expenditures (reduce investment)
• Bankruptcy
– Chapter 11
– Chapter 7
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 Anatomy of Financial Distress
Bank Debt Restructuring
• No debt forgiveness: no swaps for equity.

• Bank loosen the screws

– Covenant waivers
– Principal and/or interest deferrals
– Lower interest rates

• Banks tighten the screws

– Line of credit reductions
– Required loan repayments
– Increased collateral
– Higher interest rates

• Lend more, but rarely

– 7 cases
– In 4/7 in exchange for collateral on their entire loans

¾ Banks senior position makes them reluctant to give up much, if anything.

More likely to loosen the screws when there is less public debt.
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 Anatomy of Financial Distress
Public Debt Restructuring
• Despite potential holdout problems, exchanges are common
– 34 firms (93 issues)
– Large stakes, negotiated transactions
– More senior securities to discourage hold-outs.

• Key element of avoiding Chapter 11

– 9/34 successful file
– 33/42 unsuccessful file
– 12/13 failed file
Asset Sales and Capital Expenditures
• On average, sell 13% of assets
• Proceeds mainly to pay off senior bank debt
• At announcement of asset sale, share prices typically fall.
• Less likely to see asset sales in poorly performing industries and high leverage
industries (Shleifer and Vishny 1992)
• Capital expenditures cut by 66%.
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 Anatomy of Financial Distress
Bankruptcy

• 42 chapter 11 filings.

• Firms with more public debt issues more likely to file.

• Firms with more secured debt more likely to file.

• Firms with more bank debt less likely to file (not in this sample. But in Gilson,
John and Lang, JFE, 1990)

• Better firms neither more nor less likely to file.

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 Measuring Direct Costs of
Financial Distress
Warner (1977)
1. Estimates direct bankruptcy costs using 11 bankrupt railroads.
2. Bankruptcy takes an average of 13 years.
3. 2.5% to 5.4% of estimated market value of assets.

Weiss (1990)
1. Estimates direct costs for NYSE-AMEX firms that go
bankrupt 1979 – 1986.
2. Goes to 7 federal courts to get documents. Get documents on
37 firms, usable data on 31 firms.
3. As of fiscal year end before bankruptcy filing, measures
direct costs as a fraction of:
Market value of equity = 16.7%
Book value of debt plus market value of equity = 2.6%
Book value of total assets = 2.5%

Recent history
UAL paid over $350 million to lawyers, accountants, and consultants. 13

Enron paid over $1 billion (record high).

 Measuring indirect Costs of
Financial Distress

Altman (JF, 1984) estimates indirect costs of distress. He looks at:

change in earnings from three years before distress to distress.
Three years earnings shortfall = 25% of firm value.

1. Much larger than Warner and Weiss.

2. What do you think of this estimate?
3. Fundamental identification problem.

¾ Lots of other empirical work also based on economically

distressed firms

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 Is Financial Distress Costly? and How Costly is
Financial Distress?
• Difficult to answer given that financial distress and economic
distress are correlated.

• How do you know that financial distressed firms perform poorly

because they have too much debt or because the are bad firms?

¾ To answer this question, we would like to see firms get into

financial distress for reasons unrelated to their quality.

¾ Two cuts at Exogenous shocks to financial distress.

1. Cutler and Summers (Rand 1988): Texaco-Pennzoil

2. Andrade and Kaplan (JF 1998): Distressed among firms that undertook
Highly Leveraged Transactions (HLTs).
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 Cutler and Summers (Rand, 1988)

• In 1985, Pennzoil wins $3 billion lawsuit against Texaco for

Texaco’s acquisition of Getty (and its break-up of the Pennzoil-
Getty merger).
• Idea: Look at stock market value changes in response to
Texaco’s attempt to overturn judgment.
• Question: For judgments favoring Pennzoil, does value of
Pennzoil go up by the same amount that value of Texaco goes
down?
• Answer: No. value of Pennzoil only goes up by 17 cents for
every $1 drop in Texaco value. Not just a value transfer –
combined value goes down.
• Interpretation: Cost of financial distress.
– Lawyers fees?
– Wasteful spending by Pennzoil? 16
 Andrade and Kaplan (JF, 1998)
• Isolate firms that are purely financially distressed.
• Study nature, timing, determinants of costs of financial distress.
• By product: Can say something about HLTs of 1980s.

• Sample:
– 136 HLTs studied in Kaplan-Stein (1990 and 1993).
• Transaction value exceeds $90 million.
– Select those HLTs that experience financial distress:
• Default or restructure debt after difficulty in making payments.
– Identified 39 firms.
• 31 default, 8 restructure.
– Analyze 31 firms.
• 23 default, 8 restructure.
– Bias? Missing 8 firms. We may be missing losers. But also may be
missing winners with minor / unobserved restructuring. 17
 Andrade and Kaplan (JF, 1998) –cont’d

• Firm characteristics:
– Try to isolate sample of firms that are financially distressed, not
economically distressed.
– Indeed highly leveraged. EBITDA / Interest = 0.97
– But, EBITDA / Sales = 9.8% > Industry.
– Argue that distress is completely a result of leverage.
• With median industry leverage, firms would have coverage ratio of
3.9.
• Firms are financially distressed, but not economically distressed.
– Can reasonably attribute subsequent performance differences to financial
distress.
• Do two types of analyses:
– Overall effect of HLT.
– Effect of Distress.
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Andrade and Kaplan (JF, 1998) – cont’d
Timing / Definitions:

_______ Pre-HLT

| At HLT
|
Gains From HLT Post-HLT
| | Pre-Distress
| CFD
| |
_______ _______ Resolution
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 Andrade and Kaplan (JF, 1998) – cont’d

• Overall effect of HLT. Calculate change in value:

– Industry-adjusted returns:
• Positive, 12%, but not significant.
• Market-adjusted results similar.
– HLTs overall created value.
• Distressed HLTs slightly positive or zero.
• Non-distressed HLTs almost certainly positive.

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 Andrade and Kaplan (JF, 1998) – cont’d
• Effect of distress. Compare value at resolution to value at distress onset.
• Value at distress is est. capital value end of year before distress.
• EBITDA x Median industry EBITDA multiple and cash on hand.
– Value at resolution. Sum of
• value at resolution and
• interim cash flows from end of year before distress to resolution.
– Results (industry-adjusted):
• Average cost of distress 9.7% of pre-distress value.
• Median cost of distress 20.7% of pre-distress value.
• Small compared to Altman (1984):
– May overstate costs of distress.
• Value at year before distress does not reflect any negative shocks in
year of distress.
• Sample firms earn positive abnormal returns after resolution.
– See Eberhart, Aggarwal and Altman (1997). 21
 Andrade and Kaplan (JF, 1998) – cont’d
• Also look at changes in accounting performance.
– On the order of -10% to -20%.
– Consistent with valuation changes.
• In addition to quantitative analysis, perform qualitative analysis. Identify
evidence consistent with some CFD:
– Underinvestment?:
• Unexpected cuts in capital expenditures.
– Costs of illiquidity?:
• Undesired asset sales.
– No evidence of risk shifting / asset substitution.
– Agency problems?
• Costly managerial delay in restructuring.
– To extent they occur, costs concentrated after distress, but before
Chapter 11.
• I.e., Chapter 11 is beneficial / not harmful. 22
 Andrade and Kaplan (JF, 1998) – cont’d
• Summary and Implications:
– Identify financially not economically distressed firms.
• All firms have positive operating margins.
• Not successful as LBOs and HLTs.
– LBOs and HLTs created value overall.
• Even these unsuccessful HLTs created some value.
– Costs of pure financial distress exist.
• To extent costs exist, occur after distress, before Chapter 11.
– Implies that Chapter 11 is beneficial.
– Magnitude of CFD:
• Overall sample, best estimates 10% to 20% of value.
• Negligible for subset without economic shock.
• Upper bound estimates at 22% of value.
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Andrade and Kaplan (JF, 1998) – evaluation

– The key idea is that even small drop in operating profits can lead to
financial distress, even when firm is not really economically distressed –
seems reasonable.
– Accounting based results are interesting, how objective are the DCF
calculations?
– Hard to go from this evidence to a measure of the average costs of
financial distress.

¾ The main issue here is about selection: these firms did HLTs in part
because the costs of financial distress were anticipated to be low. If this
is the case then it is not surprising that the expected costs of financial
distress are found to be low – can this be generalized.

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