Repeated Dilution of Diffusely Held Debt

Abstract

Debt with many creditors is analyzed in a continuous-time pricing model of the levered firm in the presence of corporate taxes. We specifically allow for debtor opportunism in form of repeated strategic renegotiation offers and default threats. Dispersed creditors will only accept coupon concessions in exchange for guaranteed liquidation rights, e.g. collateral. The ex ante optimal debt contract is secured with assets which gradually become worthless as the firm approaches the preferred liquidation conditions, in order to allow for sufficient, but delayed renegotiability. Compared with singlecreditor debt, dispersed debt offers a larger debt capacity, and it is preferable ex-ante if the value of collateralizable assets is then reduced. Our model can explain credit risk premia in excess of those supported by a single creditor model with opportunistic renegotiation. Financial support for this project from the Financial Markets Group at the LSE and the hospitality of Tilburg University is gratefully acknowledged. We are grateful to seminar audiences at Aarhus, ESSEC, Groningen, LSE, Queen Mary and Westfield London, Mannheim, Odense, Rotterdam, Tilburg, Vienna, the CEPR Financial Markets Conference in Louvain-la-Neuve, and the CEPR Corporate Finance Conference in Courmayeur for helpful comments. We also wish to thank Sudipto Bhattacharya, Lara Cathart, Jon Danielsson, Darrell Duffie, Jan Ericsson, Martin Hellwig, David Webb and an anonymous referee for useful comments and advise. Any errors remain our responsibility.

Dynamic capital structure with callable debt and debt renegotiations

“…Anderson and Sundaresan (1996), Mella-Barral and Perraudin (1997), Hege and Mella-Barral (2005), and Hackbarth et al (2007): When liquidation is costly, the debt and equity holders have a common interest in saving the costs of bankruptcy. There are two key differences between our debt renegotiation model and the strategic debt service models.…”

Resolution of financial distress under Chapter 11

“…Hege and Mella- Barral (2005) and Hackbarth, Hennessy and Leland (2007) enrich the renegotiation framework by allowing for multiple creditors. Both works examine exchange o¤ers proposed by shareholders.…”

“…Equityholder' s plan D = (A; A) When the leader is the equityholder, the solution of problem (27)- (28) is obtained by o¤ering the lower bound on their payo¤ to both followers, as de…ned by (29). The optimal reorganization plan for the equityholder is therefore obtained by solving for y the following:…”

Distress Risk Premia in Stock and Bond Returns

“…See discussions on the limitation of research in Section 3.7. 8 Theoretical models have argued that the dispersed bond ownership with atomistic bondholders may make bond contracts effectively non-renegotiable (Hege and Mella-Barral (2005) and Bolton and Scharfstein (1996)). 9 Renegotiation frictions measure how easily renegotiations can be carried out.…”