Ebook Business Risk Targeting and Rescheduling of Distressed Debt
When debt holders face a default payment, they have to decide whether or not to exercise their option to liquidate the assets of the distressed firm. By rescheduling their debt, they grant the firm a chance to face its obligations later. Creditors can also forgive due payment or proceed to a deep financial reorganization by swapping debt for equity.
Empirically speaking, maturity extension is however a very common form of distressed loans modification (see Asquith, Gertner and Scharfstein (1994) and Mann (1997)). This approach can appear sufficient when the distressed firm is economically viable. Longstaff (1990) also points the avoidance of immediate and significant liquidation costs as a sound incentive for debt holders to grant a delay. Harding and Sirmans (2002) demonstrate that the extension technique align the interests of debtors and creditors better than other methods. Whatever the motivation, all parties benefit from debt rescheduling.
This paper considers the equity holders’ behavior before a default to come. As long as debt holders possess no covenant limiting their creativity, debtors can take initiatives to act in the best of their interests. Because owners of the firm have only a limited liability, common wisdom suggests that the appropriate policy before liquidation is to take maximum risk. The picture is not so clear however when debt rescheduling is possible. The volatility of the firm’s assets belongs indeed to the set of variables used by debt holders to choose the extension maturity of rescheduled debt. So equity holders can be better off by adjusting the business risk appropriately.
This paper examines the volatility adjustment that may occur before the issuance of rescheduled debt. It contrasts with previous works that explore what happens ex post a debt issuance or how claimants bargain during financial reorganization. From these contributions, it is well understood that equity holders have incentives to behave strategically ex post the issuing of a corporate liability and this, in most cases, at the expense of debt holders. Among others, Jensen-Meckling (1976), Leland (1998), Ericsson (2000) and Décamps and Faure Grimaud (2000) insist on the asset substitution problem. Leland (1994) adds that debtors can decide not to refund the firm after the debt issuance. Anderson and Sundaresan (1996), Mella-Barral and Perraudin (1997) study cases where debtors propose take-it-or-leave-it offers based on the debt service to creditors. Mella-Barral (1999) investigates dynamics of default and debt reorganization. To our knowledge, the period preceding the issuance of rescheduled debt has not been considered.
To keep things tractable, this paper analyses first a parsimonious context and then develops it in different directions. In the simplest setting, anything can happen almost instantaneously at the maturity of the debt contract. Debt holders can reschedule their debt optimally; whereas equity holders can set the firm’s asset volatility in the best of their interests. The challenge here is to solve a simultaneous optimization problem. We show that equity obtained in rescheduling is a quasiconcave function of the firm’s business risk level and that there exists for equity holders an optimal volatility to target. Clearly, this property contrasts with the common wisdom that equity holders are risk loving in absence of monitoring devices (see Myers (1977), Green (1984)). We also find that debt holders do not necessarily suffer from the implied business risk targeting. Rather, creditors can only face opportunity costs. The precise picture depends on the firm’s contemporaneous asset volatility and the implied shift. We show that, when opportunity costs exist, magnitudes are comparable to agency costs faced by creditors in case of more classical asset substitution.
We then develop the parsimonious framework in a couple of directions. The first one investigates the complex relations existing between the time-to-maturity and the volatility equity holders should target. In a first step, we find that, at any point in time, the equity price is a not so-simple function of the firm’s asset volatility in terms of convexity. Simulations reveal however that a certain business risk level can still appear more valuable than other alternatives some times before maturity. When time-to-maturity decreases and potential rescheduling become more and more perceptible, equity holders have incentives to shift the business risk of the firm to a finite level.
In lines with intuition, as the time-to-maturity lengthens, standard features are recovered and the maximum risk possible should be favoured by equity holders. In a second step, we question the precise timing of business risk shifting. We propose a couple of adjustment schedules that depend on how equity holders understand they can benefit from rescheduling. Differences appear however minor since both imply a regime switch in the firm’s asset volatility some time before contractual maturity. As a final step, we examine effects of an early meeting triggered by creditors that can lead to early financial restructuring.
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