Liquidation Value and Debt Capacity -- A Market Equilibrium Approach --

1. Liquidation Value and Debt Capacity-- A Market Equilibrium Approach -- Andrei Shleifer & Robert Vishny Presented by Marc Fuhrmann 19 Apr 2007

2. Why does asset illiquidity matter? • Asset illiquidity is a significant bankruptcy cost and therefore an important cost of leverage • Therefore, it is an important determinant of leverage and can explain variations across firms, industries, and time

3. What drives asset illiquidity? A general equilibrium explanation: • When firms with financial trouble sell assets, the most natural buyers are firms in the same industry • But, these firms are likely to be in similar trouble or regulations prevent them from buying the assets • Asset liquidations can have significant social costs • An automatic auctioning of bankrupt firms’ assets is suboptimal

4. A simple example: the bankrupt farmer • Imagine a farmer whose farm is not generating enough cash to cover its interest payments • He cannot reschedule his debt, nor borrow more • Farm is auctioned off • Three classes of potential buyers: • An outsider who will convert it into a baseball field • A neighbor, who will continue to use it as a farm • A “deep pocket” investor, who will hire a farmer to farm the land • The assets will be sold below their value in best use • This potential ex post loss is a strong incentive to avoid asset sales ex ante

5. A more formal model: Overview • Two firms • Two future states of the world: prosperity, depression • In prosperity, each firm has a negative NPV project that managers are inclined to accept due to private benefits • Debt overhang to prevent management from accepting the project • But, debt overhang has a cost in recession • Now, suppose one firm is hit harder by depression than the other and enters default

7. Let’s have a closer look at the seller… Three substantial assumptions: S1: Investment in prosperity has negative NPV: RP < IP S2: Period 1 CF is higher in prosperity even net of the investment: YD1 < YP1 – IP S3: The total CF is higher in prosperity even net of the investment: YP1 + YP2 + RP – IP > YD1 + YD1 Hart (1991) shows that the optimal capital structure here consists of senior debt due in period 2 and junior debt due in period 1.

8. We need several conditions to prevent investment in period 1: Together, two conditions can prevent the negative NPV investment: Condition 1: After paying debt, firm does not have enough money to invest: IP > YP1 – D1 Condition 2: Debt overhang must prevent the firm from raising enough capital: IP – YP1 + D1 > YP2 + RP – D2 Thus, the optimal debt levels would be: Condition 3: D1 = YP1 - IP + ε Condition 4: D2 = YP2 + RP + δ

9. In depression, these conditions prove problematic: Combining S2 and Condition 1, we obtain: YD1 < D1  the firm cannot meet its debt obligations in depression (condition 5) And S3 and Condition 2 imply: D1 – YD1 > YD2 – D2  the firm cannot raise enough cash to postpone liquidation (condition 6) We further assume that creditors force liquidation as soon as the company defaults on its payments

10. This leads to the first results: The liquidation price must be sufficient for the gains from avoiding the investment in prosperity to outweigh the losses from liquidation: πP(IP-RP) ≥ πD(YD2 – LD) (Condition 7) This can be rewritten as: (Condition 8)

11. Let us now look a the buyers Two potential buyers: • An outsider who can generate 2nd period CF of Cout and is not credit constraint (can bid up to Cout) • An insider who can generate 2nd period CF of Cins>Cout but may not be able to pay Cins Now, how much can the insider pay? We assume that the insider is nearly identical to the seller: B1: Investment in prosperity has negative NPV B3: Overall cash flow is higher in prosperity But, B2 is slightly different: 0 < yD1 – yP1 + iP < Cout (i.e. the buyer doesn’t face liquidation)

13. The buyer faces similar constraints as the seller: Debt levels that prevent prosperity investment: d1 = yP1 – iP + ε (condition 11) d2 = yP2 + rP + δ (condition 12) Now, at what price can the buyer buy the seller? Note: the buyer has to borrow to buy the seller The buyer is able to borrow provided that: lD < (yD1 + yD2) – (yP1 + yP2 + rP – iP) + Cins (condition 13) Finally, the gains of avoiding prosperity investment must outweigh the losses from not getting the liquidating firm: πP(iP – RP) > πD(Cins – liquidation price)

14. So, who gets the firm? The simplest case: • If lD > Cout, then the industry buyer gets the firm for the price of Cout • Efficient outcome More interestingly, however: • lD < Cout, but still large enough for investors to impose debt overhang • Outsider gets the seller, although it is the less efficient buyer

15. Some additional results • If both firms are using debt overhang, then the levels of debt are independent of the liquidation price • However, if the liquidation price falls or rises enough, it may be optimal for one or both firms to abandon debt overhang • Optimal leverage falls as liquidation value falls

16. Multiple equilibria are possible For certain parameter values, two equilibria are possible: First Equilibrium: Seller has no debt overhang (because of low liquidation price) • Buyer has a lot of debt overhang (because seller isn’t even for sale) Second Equilibrium Buyer has no debt to take advantage of acquisition opportunity Seller has a lot of debt, as bankruptcy is less costly This leads us to the concept of industry debt capacity: There can be considerable variation among firms, but the aggregate debt level will be approximately the same Example: the airline industry Another conclusion: deep-pocket investors play an important role in maintaining asset liquidity

17. Recall the importance of regulation • Foreign airlines are typically not allowed to acquire the assets of US airlines • Antitrust regulations prevent many within-industry takeovers

18. Now, why are asset sales so frequent? Firms frequently choose asset sales over debt rescheduling or raising additional funds. Why? • Both alternatives are (very) costly, too: • Rescheduling is costly to orchestrate given multiple lenders and increases uncertainty for the lenders (asset substitution problem) • It is extremely difficult (costly) for firms in financial distress to raise additional capital By comparison, asset sales have many advantages: • Reduce agency costs • Lessen conflict between creditors • Alleviate information asymmetries

19. Some cross-sectional predictions • Growth & cyclical industries are likely to be less levered • Small firms are likely to be less levered than large firms • Conglomerates are likely to be more levered than pure plays of the same size

20. Some time-series predictions • Liquidity is fairly persistent, but does change over time • “High markets are liquid markets” • Potential buyers have plenty of cash • Cash flows are somewhat persistent  currently high cash flows imply high cash flows for some time to come • More transactions in high markets than in low markets • Self-fulfilling liquidity • Buyers are attracted to liquid markets, thus further increasing liquidity • Second-order effect of industry-wide access to debt

21. An application: takeover waves • Takeover waves tend to occur in times of high liquidity • Several additional drivers in the 1980s: • Tax reasons (favorable depreciation rules) • Influx of foreign buyers • Relaxation of antitrust rules • This view is somewhat at odds with conventional merger wave explanation

22. Conclusions • Asset liquidation does not always allocate assets to their highest-value use • Optimal debt levels are limited by asset liquidity • Optimal leverage depends on the leverage of other firms in the industry • High markets tend to be liquid markets • Liquidity can explain, in part, the takeover waves of the 20th century