How Costly is Financial (not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed

Abstract

This paper studies thirty-one highly leveraged transactions~HLTs! that become financially, not economically, distressed. The net effect of the HLT and financial distress~from pretransaction to distress resolution, market-or industry-adjusted! is to increase value slightly. This finding strongly suggests that, overall, the HLTs of the late 1980s created value. We present quantitative and qualitative estimates of the~direct and indirect! costs of financial distress and their determinants. We estimate financial distress costs to be 10 to 20 percent of firm value. For a subset of firms that do not experience an adverse economic shock, financial distress costs are negligible.

Governance in Financial Distress and Bankruptcy

“…In their same study of 31 distressed HLTs, Andrade and Kaplan (1998) find no evidence of risk shifting or asset substitution, which they define as large investments in unusually risky capital expenditures, projects, or acquisitions. Overall, it remains somewhat debatable whether management engages in riskier investment on behalf of equity holders, or whether they act more conservatively as the firm becomes distressed.…”

“…In practice, since the optimal filing point is unobservable, we cannot readily determine whether filings are in fact delayed to the benefit of equity holders. In their empirical study of failures subsequent to highly leveraged transactions (HLTs), Andrade and Kaplan (1998) examine qualitative description of actions taken by 31 distressed firms, and find that 14 firms took actions that delayed the resolution of distress, and that the delay appears to have been costly for at least 9 firms. Adler, Capkun and Weiss (2006) suggest that the firm will be in worse financial condition at the time of filing if it has delayed (see Section III.b.…”

Snow and Leverage

“…The authors conclude that key triggers of renegotiation are fluctuations in borrowers' assets, financial leverage, the cost of equity capital, macroeconomic conditions, and the financial health of lenders. Andrade and Kaplan (1998) examine 31 highly leveraged transactions that later become financially distressed. In the majority of cases, the distress is resolved through Chapter 11.…”

On the value and determinants of the interest tax shields

“…This novel result is signi…cant because, while this primitive …rm characteristic has been studied substantially by the industrial organization literature in economics, it has received little attention in …nance as a determinant of corporate borrowing. 3 By highlighting the importance of the curvature of the production function, our work complements the extensive …nance literature studying the determinants of the interest tax shields and leverage. For instance, in line with our results, DeAngelo and Masulis (1980) …nd that the non-debt tax deductions (e.g., the operating costs and capital depreciation) are important determinants of the tax bene…ts of debt.…”