Two Tales of Debt

Abstract

We analyze the heterogeneous nature of corporate debt contracts, some focusing on liquidation values of discrete assets whereas others on going-concern values of the business. Using handcollected data on firm attributes, we present several findings. First, firms on average have limited liquidation values. Second, companies with lower liquidation values have more debt backed by going-concern values and more intensive monitoring of firm performance. They have higher interest rates only for debt against discrete assets. Third, secured debt is not always tied to liquidation values of discrete assets. We present a model that matches the empirical findings, which demonstrates how creditor monitoring and covenants facilitate borrowing well beyond liquidation values.

Going-Concern Debt of Financial Intermediaries

“…A long literature investigates the role of discrete or tangible assets (Benmelech, Garmaise, and Moskowitz, 2005;Benmelech and Bergman, 2009;Chaney, Sraer, and Thesmar, 2012;Rampini and Viswanathan, 2013). Another set of work analyzes the importance of creditors' monitoring and control of borrowers' actions (Roberts and Sufi, 2009;Nini, Smith, and Sufi, 2012;Matvos, 2013;Green, 2018;Kermani and Ma, 2020b). Our paper provides evidence from financial intermediaries and shows the connection with results among nonfinancial firms.…”

“…By discrete assets, we mean assets that can be separated and repossessed on a standalone basis, such as securities, mortgages and other loans, and fixed assets in the case of financial intermediaries. This value is much larger compared to the case for non-financial firms, where the liquidation value of (non-cash) discrete assets is less than 25% of total assets in aggregate (Kermani and Ma, 2020b). Nonetheless, financial intermediaries do generate meaningful going-concern values from services (e.g., deposit franchise, commercial banking, underwriting, trading and market making, brokerage, etc.…”

“…The first category consists of debt against discrete assets, including repos, assetbacked and securitized debt; FHB advances (generally collateralized by mortgages); other debt against receivables, equipment, real estate, etc. This category is analogous to "asset-based debt" among non-financial firms studied in several recent papers (Lian and Ma, 2020;Ivashina, Laeven, and Moral-Benito, 2020;Kermani and Ma, 2020b). Debt against discrete assets has high priority claims against the liquidation value of these particular assets, but not against the firm value in general.…”

“…Another approach is to lend against the going-concern cash flow value of the firm, where creditors rely on the value of the business as a whole and the verifiability of cash flows. The prevalence of these two approaches is influenced by the nature of firms' assets and economic activities, and the latter often comes with strong creditor monitoring and control (Kermani and Ma, 2020b).…”

“…By going-concern debt, we refer to capital market debt that has claims against the firm as a whole, rather than any well-defined discrete assets (e.g., a financial institution may derive value from its franchise, services, networks, which are not captured by discrete assets). This concept is analogous to what is often called cash flow-based debt among non-financial firms (Lian and Ma, 2020;Ivashina, Laeven, and Moral-Benito, 2020;Kermani and Ma, 2020b). Here we use the term "going-concern debt" instead, since the debt of financial intermediaries has less emphasis on borrowers' measurable cash flow value.…”