Liquidation Value and Debt Capacity -- A Market Equilibrium

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

   Andrei Shleifer & Robert Vishny

        Presented by Marc Fuhrmann
                19 Apr 2007
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
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
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:
    1. An outsider who will convert it into a baseball field
    2. A neighbor, who will continue to use it as a farm
    3. 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
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
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.
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
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
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)
Let us now look a the buyers
Two potential buyers:
   1.   An outsider who can generate 2nd period CF of Cout and is not
        credit constraint (can bid up to Cout)
   2.   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)
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)
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
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
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
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
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
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
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
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
                   Conclusions
1.   Asset liquidation does not always allocate assets to
     their highest-value use

2.   Optimal debt levels are limited by asset liquidity

3.   Optimal leverage depends on the leverage of other
     firms in the industry

4.   High markets tend to be liquid markets

5.   Liquidity can explain, in part, the takeover waves of the
     20th century