Financial distress and corporate risk management: Theory and evidence

This paper extends the current theoretical models of corporate risk-management in the presence of financial distress costs and tests the model's predictions using a comprehensive data set. I show that the shareholders optimally engage in ex-post (i.e., after the debt issuance) risk-management activities even without a pre-commitment to do so. The model predicts a positive (negative) relation between leverage and hedging for moderately (highly) leveraged firms. Consistent with the theory, empirically I find a non-monotonic relation between leverage and hedging. Further, the effect of leverage on hedging is higher for firms in highly concentrated industries.     

Bankruptcy risk,costs and corporate diversification

This paper studies the impact of diversification on firms that file for Chapter 11 bankruptcy. Prior research suggests that diversification affects both the probability and costs of distress. Treating bankruptcy as a special case of distress, we find that diversification reduces the likelihood of bankruptcy and liquidation in Chapter 11, which is consistent with the coinsurance hypothesis. However, we observe higher bankruptcy costs as measured by time spent in Chapter 11 and inefficient segment investment for diversified firms. Our evidence is consistent with the idea that diversification provides benefits to managers in terms of job security rather than to firms. Our findings may help firms to make diversification decisions and creditors determine lending policies toward different forms of organizations.     

Asset liquidity,corporate investment,and endogenous financing costs

We analyze how the liquidity of real and financial assets affects corporate investment. The trade-off between liquidation costs and underinvestment costs implies that low-liquidity firms exhibit negative investment sensitivities to liquid funds, whereas high-liquidity firms have positive sensitivities. If real assets are not divisible in liquidation, firms with high financial liquidity optimally avoid external financing and instead cut new investment. If real assets are divisible, firms use external financing, which implies a lower sensitivity. In addition, asset redeployability decreases the investment sensitivity. Our findings demonstrate that asset liquidity is an important determinant of corporate investment.     

Creditor rights and corporate risk-taking

We propose that stronger creditor rights in bankruptcy affect corporate investment choice by reducing corporate risk-taking. In cross-country analysis, we find that stronger creditor rights induce greater propensity of firms to engage in diversifying acquisitions that are value-reducing, to acquire targets whose assets have high recovery value in default, and to lower cash-flow risk. Also, corporate leverage declines when creditor rights are stronger. These relations are usually strongest in countries where management is dismissed in reorganization and are also observed over time following changes in creditor rights. Our results thus identify a potentially adverse consequence of strong creditor rights.     

Should corporate debt include a rating trigger?

Recent corporate debt offerings have included a covenant specifying a pre-determined payment to debtholders when the debt is downgraded. We examine the incentive for equityholders to increase firm risk (and the associated costs) when debt includes a “rating trigger.” Equityholders of firms with a low-risk profile and operating flexibility choose debt with a trigger, while equityholders of firms with a high-risk profile and less flexibility choose regular debt. A trigger that requires an equity infusion better mitigates conflicts between equityholders and debtholders than a trigger paid by liquidating assets. A trigger that increases the coupon rate is not optimal.     

Tracking down distress risk

This paper shows that exposure to aggregate distress risk is the underlying source of the premiums for the Fama-French size (SMB) and value (HML) factors. Using a unique data set of aggregate business failures of both private and public firms from 1926 to 1997, I build portfolios that track news about future firm failures. These tracking portfolios optimally hedge aggregate distress risk and earn a Capital Asset Pricing Model (CAPM) alpha of approximately −4% a year. Both HML and SMB predict changes in future failure rates. Small stocks have lower returns than large stocks and value stocks have lower returns than growth stocks when the market expects an increase in future failure rates. Finally, a two-factor model with the market and the tracking portfolio for aggregate distress as factors does as well as the Fama-French three-factor model in pricing the 25 size and book-to-market sorted portfolios.     

Tournament incentives, firm risk, and corporate policies

This paper tests the proposition that higher tournament incentives will result in greater risk-taking by senior managers in order to increase their chance of promotion to the rank of CEO. Measuring tournament incentives as the pay gap between the CEO and the next layer of senior managers, we find a significantly positive relation between firm risk and tournament incentives. Further, we find that greater tournament incentives lead to higher R&D intensity, firm focus, and leverage, but lower capital expenditures intensity. Our results support the hypothesis that option-like features of intra-organizational CEO promotion tournaments provide incentives to senior executives to increase firm risk by following riskier policies. Finally, the compensation levels and structures of executives of financial institutions have received a great deal of scrutiny after the financial crisis. In a separate examination of financial firms, we again find a significantly positive relation between firm risk and tournament incentives.     

Labor unemployment risk and corporate financing decisions

This paper presents evidence that firms choose conservative financial policies partly to mitigate workers' exposure to unemployment risk. We exploit changes in state unemployment insurance laws as a source of variation in the costs borne by workers during layoff spells. We find that higher unemployment benefits lead to increased corporate leverage, particularly for labor-intensive and financially constrained firms. We estimate the ex ante, indirect costs of financial distress due to unemployment risk to be about 60 basis points of firm value for a typical BBB-rated firm. The findings suggest that labor market frictions have a significant impact on corporate financing decisions.     

The role of state and foreign owners in corporate risk-taking: Evidence from privatization

Using a unique database of 381 newly privatized firms from 57 countries, we investigate the impact of shareholders' identity on corporate risk-taking behavior. We find strong and robust evidence that state (foreign) ownership is negatively (positively) related to corporate risk-taking. Moreover, we find that high risk-taking by foreign owners depends on the strength of country-level governance institutions. Our results suggest that relinquishment of government control, openness to foreign investment, and improvement of country-level governance institutions are key determining factors of corporate risk-taking in newly privatized firms.     

Liquidity risk of corporate bond returns: conditional approach

We study the exposure of the US corporate bond returns to liquidity shocks of stocks and Treasury bonds over the period 1973–2007 in a regime-switching model. In one regime, liquidity shocks have mostly insignificant effects on bond prices, whereas in another regime, a rise in illiquidity produces significant but conflicting effects: Prices of investment-grade bonds rise while prices of speculative-grade (junk) bonds fall substantially (relative to the market). Relating the probability of these regimes to macroeconomic conditions we find that the second regime can be predicted by economic conditions that are characterized as “stress.” These effects, which are robust to controlling for other systematic risks (term and default), suggest the existence of time-varying liquidity risk of corporate bond returns conditional on episodes of flight to liquidity. Our model can predict the out-of-sample bond returns for the stress years 2008–2009. We find a similar pattern for stocks classified by high or low book-to-market ratio, where again, liquidity shocks play a special role in periods characterized by adverse economic conditions.     

Risk management,corporate governance,and bank performance in the financial crisis

The recent financial crisis has raised several questions with respect to the corporate governance of financial institutions. This paper investigates whether risk management-related corporate governance mechanisms, such as for example the presence of a chief risk officer (CRO) in a bank’s executive board and whether the CRO reports to the CEO or directly to the board of directors, are associated with a better bank performance during the financial crisis of 2007/2008. We measure bank performance by buy-and-hold returns and ROE and we control for standard corporate governance variables such as CEO ownership, board size, and board independence. Most importantly, our results indicate that banks, in which the CRO directly reports to the board of directors and not to the CEO (or other corporate entities), exhibit significantly higher (i.e., less negative) stock returns and ROE during the crisis. In contrast, standard corporate governance variables are mostly insignificantly or even negatively related to the banks’ performance during the crisis.     

Financial constraints,board governance standards,and corporate cash holdings

This study examines whether financial constraints and board governance play substitution roles in lowering agency concerns in corporate cash holdings. Using four firm-specific characteristics of financial constraints and 28 forward-looking board governance standards, we find that board governance mitigates agency concerns in cash holdings more significantly for financially less-constrained firms. Consistently, financially less-constrained firms increase the level of board governance and adopt more board governance standards. A natural experiment with the 2007 financial crisis provides robustness to our findings. Our evidence suggests that financial constraints interrelate with the effectiveness of board governance on corporate cash holdings.     

Internal corporate governance,CEO turnover,and earnings management

The likelihood and speed of forced CEO turnover – but not voluntary turnover – are positively related to a firm's earnings management. These patterns persist in tests that consider the effects of earnings restatements, regulatory enforcement actions, and the possible endogeneity of CEO turnover and earnings management. The relation between earnings management and forced turnover occurs both in firms with good and bad performance, and when the accruals work to inflate or deflate reported earnings. These results indicate that boards tend to act proactively to discipline managers who manage earnings aggressively, before the manipulations lead to costly external consequences.     

Ultimate ownership and control in Russia

I investigate ultimate control and ownership patterns in Russian publicly traded companies. I show that these companies are controlled either by the state or by anonymous private owners. Federal and regional governments’ control is exercised through extensive use of pyramids. Private owners widely exploit legal loopholes that allow them to mask their holdings and identities through nominee and foreign offshore arrangements. The comparison of formal and informal ownership disclosure reveals that the typical anonymous owners are insiders and that in virtually all cases the market participants “know” who the real owners are. Collectively, the evidence suggests that the legal weaknesses in disclosure requirements are important determinants of country-specific ownership and control structures.     

Seasoned equity offerings,market timing,and the corporate lifecycle

Both a firm's market-timing opportunities and its corporate lifecycle stage exert statistically and economically significant influences on the probability that it conducts a seasoned equity offering (SEO), with the lifecycle effect empirically stronger. Neither effect adequately explains SEO decisions because a near-majority of issuers are not growth firms and the vast majority of firms with high M/B ratios and high recent and poor future stock returns fail to issue stock. Since without the offer proceeds 62.6% of issuers would run out of cash (81.1% would have subnormal cash balances) the year after the SEO, a near-term cash need is the primary SEO motive, with market-timing opportunities and lifecycle stage exerting only ancillary influences.     

Capital structure,credit risk,and macroeconomic conditions

This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.     

How do family ownership,control and management affect firm value?

Using proxy data on all Fortune-500 firms during 1994–2000, we find that family ownership creates value only when the founder serves as CEO of the family firm or as Chairman with a hired CEO. Dual share classes, pyramids, and voting agreements reduce the founder's premium. When descendants serve as CEOs, firm value is destroyed. Our findings suggest that the classic owner-manager conflict in nonfamily firms is more costly than the conflict between family and nonfamily shareholders in founder-CEO firms. However, the conflict between family and nonfamily shareholders in descendant-CEO firms is more costly than the owner-manager conflict in nonfamily firms.     

Bank connections,corporate investment and crisis

Against the backdrop of a severe financial crisis and extensive restructuring of the financial sector, we investigate the evolution and determinants of connections between firms and banks, and the impact of bank connections on corporate investment. Our study examines Thai non-financial companies during 1995–2000, a period straddling the East Asian Financial Crisis of 1997–1998. Before the crisis, bank-connections are common and associated with significantly lower sensitivity of corporate investment to internal cash flow. After the crisis, and following substantial changes in bank ownership and governance due to financial-sector reforms and restructuring, far fewer firms are bank-connected and connections no longer affect investment–cash flow sensitivity.     

Earnings management in Malaysian IPOs: The East Asian crisis, ownership control, and post-IPO performance

We find evidence of income-increasing earnings management in Malaysian IPOs, which occurs primarily for IPOs during a period of severe economic stress (the East Asian crisis). Within the high-ownership-concentration Malaysian market, post-IPO control concerns also appear to constrain IPO earnings management: owners seem willing to accept reduced IPO proceeds and signaling opportunities to increase the likelihood of retaining control of the company post-IPO. The requirement to provide a profit guarantee does not seem to greatly affect earnings management. IPO companies engaging in aggressive income-increasing earnings management have significantly worse market-based performance than their more conservative counterparts, but again only for IPOs issued during the economic crisis period. Overall, the results suggest that personal liquidity concerns are an important factor in IPO decisions during the economic crisis.     

Capital structure,executive compensation,and investment efficiency

This paper examines how the similarity between the executive compensation leverage ratio and the firm leverage ratio affects the quality of the firm’s investment decisions. A larger leverage gap (i.e., a bigger difference between these two ratios) leads to more investment distortions. Managers with more debt-like compensation components tend to under-invest, whereas managers with larger equity-based compensation engage more in over-investment. Furthermore, investment distortion is likely to increase the equity (debt) value when compensation leverage is lower (higher) than firm leverage. These findings suggest that managers can deviate from an optimal investment policy to increase the value of their portfolio, and that a lower leverage gap can reduce agency costs.