Reputation, renegotiation, and the choice between bank loans and publicly traded debt

We model firms' choice between bank loans and publicly tradeddebt, allowing for debt renegotiation in the event of financialdistress. Entrepreneurs, with private information about theirprobability of financial distress, borrow from banks (multiperiodplayers) or issue bonds to implement projects. If a firm isin financial distress, lenders devote a certain amount of resources(unobservable to entrepreneurs) to evaluate whether to liquidatethe firm or to renegotiate its debt. We demonstrate that banks'desire to acquire a reputation for making the 'right' renegotiationversus liquidation decision provides them an endogenous incentiveto devote a larger amount of resources than bondholders towardsuch evaluations. In equilibrium, bank loans dominate bondsfrom the point of view of minimizing inefficient liquidation,.however, firms with a lower probability of financial distresschoose bonds over bank loans.     

Strategic Actions and Credit Spreads: An Empirical Investigation

Do strategic actions of borrowers and lenders affect corporate debt values? We find higher bond spreads for firms that can renegotiate debt contracts relatively easily. Consistent with theories of strategic debt service, the threat of strategic default depresses bond values ex ante, even though there may be efficiency gains from renegotiation ex post. However, the economic significance of the net effect is small, suggesting that bondholders have considerable bargaining power. The effect of strategic actions is higher when creditors are particularly vulnerable to strategic threats, including risky firms with high managerial shareholding, simple debt structures, and high liquidation costs.     

The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in theUnited States and model bankruptcy as a strategic decision.We analyze a firm's choice between liquidation under Chapter7, renegotiation of the debt contract in a workout, and reorganizationunder Chapter 11 of the bankruptcy code. Our premise is thata financially distressed firm chooses its action in order tominimize the loss in value caused by the well-known over- andunder-investment problems. We show that the firm initiates aworkout when it faces under-investment, and commences Chapter11 when it faces over-investment. Some of the results are: (i)in default, total firm value and equity value increase uponthe announcement of a workout and decrease upon the announcementof Chapter 11; (ii) firms with shorter maturity of debt aremore likely to reorganize in a workout; (iii) among the firmsthat renegotiate their debt contract, the proportion of firmsentering Chapter 11 is higher for firms in mature industriesthan for firms in growth industries.     

The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in the United States and model bankruptcy as a strategic decision. We analyze a firm's choice between liquidation under Chapter 7, renegotiation of the debt contract in a workout, and reorganization under Chapter 11 of the bankruptcy code. Our premise is that a financially distressed firm chooses its action in order to minimize the loss in value caused by the well-known over- and under-investment problems. We show that the firm initiates a workout when it faces under-investment, and commences Chapter 11 when it faces over-investment. Some of the results are: (i) in default, total firm value and equity value increase upon the announcement of a workout and decrease upon the announcement of Chapter 11; (ii) firms with shorter maturity of debt are more likely to reorganize in a workout; (iii) among the firms that renegotiate their debt contract, the proportion of firms entering Chapter 11 is higher for firms in mature industries than for firms in growth industries.     

Determinants of Bank Debt in a Continental Financial System: Evidence from Spanish Companies

We test hypotheses about the structure of corporate debt ownership and the use of bank debt by firms in a civil‐law country, Spain. We focus on bank debt effects in the presence of information asymmetries and agency costs, and on efficient versus inefficient firm liquidation. We find that the relation between growth opportunities and bank financing is not as strong as the one found in common‐law countries, that there is a positive relation between firm size and the proportion of bank debt used, and that firms closer to bankruptcy and highly leveraged are more likely to use bank debt.     

The effects of bank relationships on firm private debt restructuring: Evidence from an emerging market

Our paper seeks to examine the direct benefit of bank relationships for a distressed borrower by assessing its influence on the success of firm private debt restructuring. We find that a distressed firm with a stronger bank relationship has a greater probability to successfully restructure its debt through private renegotiation. Accordingly, an analysis of credit rating recovery provides complementary evidence on the factors of successful debt restructuring. A duration analysis of the length of time needed for a debt restructuring to be completed is fully consistent with our documented results. We conclude that in a bank dominated financial system like Taiwan's where firms are heavily bank-dependent, the bank-firm relationship is of crucial importance to the success of financially distressed firms in private debt restructuring.     

Can the Trade-off Theory Explain Debt Structure?

We examine the optimal mixture and priority structure of bankand market debt using a trade-off model in which banks havethe unique ability to renegotiate outside formal bankruptcy.Flexible bank debt offers a superior trade-off between tax shieldsand bankruptcy costs. Ease of renegotiation limits bank debtcapacity, however. Optimal debt structure hinges upon whichparty has bargaining power in private workouts. Weak firms havehigh bank debt capacity and utilize bank debt exclusively. Strongfirms lever up to their (lower) bank debt capacity, augmentwith market debt, and place the bank senior. Therefore, thetrade-off theory offers an explanation for: (i) why young/smallfirms use bank debt exclusively; (ii) why large/mature firmsemploy mixed debt financing; and (iii) why bank debt is senior.The trade-off theory also generates predictions consistent withinternational evidence. In countries in which the bankruptcyregime entails soft (tough) enforcement of contractual priority,bank debt capacity is low (high), implying greater (less) relianceon market debt.     

Entrepreneurial finance: Banks versus venture capital

We analyze how entrepreneurial firms choose between two funding institution: banks, which monitor less intensively and face liquidity demands from their own investors, and venture capitalists, who can monitor more intensively but face a higher cost of capital because of the liquidity constraints that they impose on their own investors. Because the firm's manager prefers continuing the firm over liquidating it and aggressive (risky) continuation strategies over conservative (safe) continuation strategies, the institution must monitor the firm and exercise some control over its decisions. Bank finance takes the form of debt, whereas venture capital finance often resembles convertible debt. Venture capital finance is optimal only when the aggressive continuation strategy is not too profitable, ex ante; the uncertainty associated with the risky continuation strategy (strategic uncertainty) is high; and the firm's cash flow distribution is highly risky and positively skewed, with low probability of success, low liquidation value, and high returns if successful. A decrease in venture capitalists’ cost of capital encourages firms to switch from safe strategies and bank finance to riskier strategies and venture capital finance, increasing the average risk of firms in the economy.     

Investment and liquidation in renegotiation-proof contracts with moral hazard

In a long-term contract with moral hazard, the liquidation of the firm can arise as the outcome of the optimal contract. However, if the future production capability or market opportunities remain unchanged, liquidation may not be free from renegotiation. Will the firm ever be liquidated if we allow for renegotiation? This paper shows that the firm can still be liquidated even though liquidation is not free from renegotiation in the long-term contract. In addition to liquidation, the renegotiation-proof contract generates important features of the investment behavior and dynamics of firms observed in the data.     

Valuation of defaultable bonds and debt restructuring

In this paper we develop a contingent valuation model for zero-coupon bonds with default. In order to emphasize the role of maturity time and place of the lender's claim in a firm's debt hierarchy, we consider a firm that issues two bonds with different maturities and different seniorage. The model allows us to analyze the implications of both debt renegotiation and capital structure of a firm on the prices of bonds. We obtain that renegotiation brings about a significant change in the bond prices and that the effect is dispersed through various channels: increasing the value of the firm, reallocating payments, and avoiding costly liquidation. Moreover, the presence of two creditors leads to qualitatively different implications for pricing, while emphasizing the importance of bond covenants and renegotiation of the entire debt.     

Good cop,bad cop: Complementarities between debt and equity in disciplining management

We demonstrate an inherent conflict between ex ante efficient monitoring and liquidation decisions by outside claimholders. We show it can be useful to commit to inefficient liquidation when monitors fail to produce information: this provides stronger incentives to monitor. The implication for firm capital structure is that more information is generated about firm prospects – and hence firm value increases – when a firm’s cash flow is split into a ‘safe’ claim (debt) and a ‘risky’ claim (equity) compared to when a single claim is sold. We also derive the optimal allocation of control rights between safe and risky claims. This partially resolves the Tirole (2001) puzzle as to why firms issue multiple securities that generate ex post conflicts of interest.     

Implications of Debt Renegotiation for Optimal Bank Policy and Firm Behavior

This paper analyzes the problems associated with the renegotiation of debt contracts involving a bank (the lender) and a firm (the borrower) when the latter is operated by a risk averse manager. Firms undertake risky projects with loan capital borrowed from the bank. When a firm cannot pay off a loan it is technically bankrupt. Both the borrower and the lender may however experience a Pareto-improvement in their positions by renegotiating the loan. By renegotiating the terms of the debt the financially distressed firm can avoid the stigmatization of bankruptcy and the bank can avoid the costs of seizing the borrower's assets. However, our main finding is that, from the bank's point of view, renegotiating as a policy of recovering loan payments may be inefficient in practice because of false bankruptcy claims and moral hazard problems associated with exposure of the borrowing firm to the risk of default. We present a solution to the false bankruptcy claim problem that involves a mixe d strategy between asset seizure by the bank and debt renegotiation.     

Asset redeployability and the choice between bank debt and public debt

A firm with less redeployable assets, which are assets that have fewer alternative uses outside the firm, is more likely to borrow from banks than issue public debt. These findings are consistent with firms with less redeployable assets valuing the ability to renegotiate bank debt contracts instead of selling assets in the event of default. Consistent with this mechanism, firms with lower asset redeployability sell fewer assets following covenant violations. Our results contribute to work on the determinants of which debt markets a firm chooses to borrow from and the role that banks play as intermediaries.     

The choice between informal and formal restructuring: The case of French banks facing distressed SMEs

This empirical paper investigates the paths leading to the resolution of financial distress for a sample of small and medium-sized French firms in default, focusing in particular on their decisions between bankruptcy and informal (out-of-court) renegotiations. The procedure is depicted as a sequential game in which stakeholders first decide whether to engage in an informal renegotiation. Second, conditional on opting for renegotiation, the debtor and its creditors may succeed or fail in reaching an agreement to restructure the firm’s capital structure. We test different hypotheses that capture (i) coordination and bargaining power issues, (ii) informational problems, (iii) firm characteristics, and (iv) loan characteristics. The empirical implementation is based on sequential LOGIT regressions. First, we find that the likelihood of informal renegotiations increases with loan size and the proportion of long-term debt. These two results support the argument that size matters when deciding whether to opt for informal renegotiation. Second, the probability of a successful renegotiation decreases when (i) the bank in charge of handling the process is the debtor’s “main” creditor and when (ii) the firm is badly rated and its management is considered faulty. Third, the estimations show that collateral plays a significant role in the first stage of the renegotiation process. However, it does not impact the likelihood of success in reaching a renegotiated agreement. Finally, some banks are clearly better than others at leading successful renegotiation processes.     

Bank Debt,Flexibility, and the Use of Proceeds from Asset Sales

In the theory of financial intermediation, bank debt is often characterized as being more readily renegotiable than public debt. Banks are also conjectured to gain valuable non-public information through closer monitoring. Given these features, bank debt can theoretically be more flexible than public debt and can lead to better investment/liquidation decisions. We investigate this possibility using a sample of firms facing the important decision of whether to reinvest the proceeds from asset sales or whether to distribute the proceeds to debtholders. While higher levels of leverage are associated with an increased probability of distributing proceeds to creditors, this relationship is significantly muted for bank debt as opposed to public debt. This finding is consistent with the conjecture that bank debt provides enhanced flexibility when compared to public debt. Further we find that asset sale announcement period abnormal stock returns are increasing in firms’ use of bank debt, but not public debt. This suggests that market participants believe that banking relationships are leading to better decision making for this particular type of investment/liquidation decision. We find no significantly different effects of bank vs. public debt on the initial decision to undertake an asset sale in the first place. Thus, in the context of asset sales, the main observable difference arises in the use of proceeds decision, rather than the initial asset sale decision.     

Incomplete contracts,renegotiation, and the choice between bank loans and public debt issues

In a two-period model where an investment project is funded with standard debt, the probability distribution of final cash flow is determined, at the interim date, by an unverifiable state of nature together with a choice by the controlling party (entrepreneur or creditor). With a control allocation contingent on a noisy default signal, renegotiation may improve efficiency in two ways: (i) reduce excessive risk-taking – due to the entrepreneur's moral hazard – through debt forgiveness; (ii) avoid the costs of financial distress associated with excessive liquidation or underinvestment by debt-holders, by letting them receive an equity stake in the firm. Such efficiency gain is an advantage of bank loans over publicly traded debt, given that the former are more easily renegotiated than the latter. The difference between the two types of debt is increasing in the degree of contractual incompleteness (noise present in the default signal) and in the portion of project value accounted for by future discretionary investment options.     

Banks as lenders and shareholders: Evidence from Japan

This paper examines the effects of the main bank's equity–debt structure, (i.e., equity stakes and debt claims) on firm performance and financial policies in Japan over the period 1977–1987. Results show that firms with main bank equity stakes have lower performance than those without. However, among firms with main bank equity stakes, the equity–debt structure of claims has a positive effect on firm performance. The positive effect of the main bank's equity–debt structure is found to be greater in group-affiliated firms than in independent firms. The main bank maximizes its own interests by charging a higher interest rate when its equity stakes are relatively less than its debt claims and by prompting firms to pay more dividends when its equity stakes are relatively high.     

Secured and unsecured debt in creditor-friendly bankruptcy

This article develops a continuous-time asset pricing model for valuing corporate securities in the presence of both secured and unsecured debt. We consider a framework where creditors dominate the negotiation process. This is consistent with the increasing influence of creditors in bankruptcy. We show that the unsecured creditors are incentivized to liquidate the firm prematurely relative to the first-best threshold. However, if the firm’s liquidation value is very low, it should complement its secured debt with unsecured debt as a form of insurance to avoid early liquidations. Our results have important implications for the debt structure and the resolution of financial distress of modern firms with substantial intangible assets.     

The impact of firm size on bank debt use

I use a sample of US firms to examine the determinants of the concentration of bank debt in total debt. The results indicate that the factors vary by size of the firm. A small- to medium-sized firm has a high concentration of bank debt when it has a low level of discretionary spending. In contrast, a large firm has a high concentration of bank debt when it is difficult for outsiders to observe. The results support the Diamond [J Polit Econ 99 (1991) 689] reputation view that a firm faces different debt choices as it grows. When evaluating bank regulations, policymakers should consider the importance of the reputation-building services, which a bank provides to businesses.     

DETERMINANTS OF CAPITAL STRUCTURE IN BUSINESS START‐UPS: THE ROLE OF NONFINANCIAL STAKEHOLDER RELATIONSHIP COSTS

According to the finance literature, nonfinancial stakeholders (NFS), such as customers, suppliers, and employees, take into account their expected liquidation costs when dealing with a firm. In this framework, firms can influence their probability of liquidation by choosing an appropriate capital structure. Also, the literature suggests NFS bargaining power may affect firm financing decisions. In the current article we investigate these ideas for initial financing decisions by business start‐ups, where ex ante failure risk is high and NFS must decide whether to make relationship‐specific investments. We find that start‐ups imposing larger costs on their NFS following liquidation significantly reduce leverage. This effect is strengthened when suppliers have greater bargaining power. We also document a marginally negative effect of NFS liquidation costs on the proportion of bank loans. Finally, business start‐ups rely less on bank loans when customers and suppliers are in a powerful bargaining position.