Why Do Some Firms Continue Excessively?

Why Do Some Firms Continue Excessively? Mohammad M. Rahaman∗

July 2008

Abstract

With declining performance a time may come when the firm is worth more dead than alive. Yet, a plethora of evidence shows that some firms continue excessively even when it is optimal (in the sense of value preservation) to liquidate or reorganize the existing structure of the firm. In a simple economic framework, I show that excessive continuation by the equity holders arises out of the incomplete contracting problem since all possible ex-post outcome contingencies cannot be stipulated into the debt contract. This problem can be eliminated if outsiders make an offer equal to the reservation payoff that makes equity holders indifferent between continuing and relinquishing the ownership of their firm. In a complete contracting environment, when debt covenants are optimally enforced, equity holders’ payoff equals their outside option and the firm’s assets are allocated to the users with the highest value for these assets. Furthermore, I show that debt maturity, assets liquidity (free cash flows), principle-agent conflict and assets substitution can either exacerbate or mitigate the phenomenon of excessive continuation by affecting the reservation payoff of the equity holders. Some of the results have interesting empirical implications.

JEL Classification: G33, G34 Key Words: Excessive Continuation, Financial Distress ∗ Department of Economics and Rotman School of Management, University of Toronto, email: [email protected]. I thank Varouj Aivazian, Sergei Davydenko and Simiao Zhou for many helpful comments and suggestions. All remaining errors are mine.

M.M. Rahaman

1

Excessive Continuation

Introduction

One of the most difficult decisions a firm must make is whether to remain in business. As the performance declines a time may come when releasing the assets to outsiders with higher-valued uses of the assets is optimal than continuing their operations within the existing boundary of the firm. Stockholders with control over that decision may not always do so because they have an incentive to continue operating their firm even when the liquidation value of the firm exceeds its operating value. DeAngelo, DeAngelo and Wruck (2002) provide a case study of L.A. Gear which was a top performer in the late 1980s but later experienced a sharp decline. L.A. Gear was able to continue its money-losing operations for many years due to its liquid asset structure, long debt maturity, low ongoing debt payments, and the lack of restrictive bond covenants. The L.A. Gear case illustrates that managers of distressed firms have significant discretion over the timing of reorganization, and the creditors may not in some cases impose reorganization even when witnessing the destruction of their value in unprofitable going concern operations. Consistent with this observation, Davydenko (2007) finds that a large proportion of firms that are so distressed that they appear below their theory-predicted “default boundary” in practice are able to avoid default or delay it for many years. Using a sample of distressed firms worth more dead than alive, Davydenko and Rahaman (2006) find that most of them continue operations long after the optimal exit time. The failure to liquidate costs the typical sample firm over three years 8.7% of its assets in lost earnings relative to the industry median.

These empirical regularities raise an important theoretical question of why some firms continue excessively more often than others. To this end, D´ecamps and Faure-Grimaud (2002) analyze the incentives of the equity holders of a leveraged company to shut it down in a continuous time, stochastic environment. They show that the firm as an ongoing concern has an option value but equity and debt holders value it differently. Equity holders’ decisions exhibit excessive continuation and reduce the firm’s value. Mella-Barral (1999) shows that excessive continuation is likely when the ongoing debt service is low. On the contrary, when the debt service is too high, the firm is liquidated too early, as equity holders become unwilling to keep their option alive by servicing the debt. Morellec (2001) studies how covenants and asset liquidity affect the liquidation and downsizing decision of levered firms.

In this paper, I extend the excessive continuation literature to several important dimensions. Using a simple economic framework I show that excessive continuation by the equity holders arises out of the incomplete contracting problem since all possible ex-post outcome contingencies cannot be stipulated into the debt contract. This problem can be eliminated completely when outsiders offer a payoff equal to the reservation

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M.M. Rahaman


payoff of the equity holders that make them indifferent between continuing and relinquishing the ownership of the firm. In a complete contracting environment, when debt covenants are optimally enforced, creditors can force reorganization with certainty in a bad state because the outside option of the equity holders coincide with their reservation payoff and assets of the firm are allocated to the highest value user. Furthermore, I show that debt structure, debt maturity, assets liquidity (free cash flows) and principle-agent agency problem can either exacerbate or mitigate the excessive continuation of distressed firm by affecting the reservation payoff of the equity holders. More specifically, I show that principle-agent agency problem can be advantageous in preserving creditors’ value depending on the severity of financial distress of the firm.

This paper contributes to the literature of firm reorganization by identifying some additional sources of the excessive continuation problem in the incomplete contracting environment with some interesting empirical implications. The rest of the paper proceeds as follows. Section II describes the setup of the simple model. Section III outlines the first best outcomes that arise from the simple set up. Section IV describes and solves the equity holders’ problem and section V generates some of the implications that arise out of the equity holders’ decision problem. Section VI introduces a simple extension of the basic framework and finally section VII concludes paper.

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Environment

In this simple framework I assume that the agency of the firm consists of equity holders, managers and debt holders. All agents are risk neutral and care about the current value of their infinite horizon payoff structure. Each agent is interested in maximizing the objective function:

E0

X ∞

β t U (Yt )

(1)

t=0

where β ∈ (0, 1) is the discount factor, Yt is the instantaneous income at date t, U (Y ) is the instantaneous utility function and E0 is the expectation taken at time 0. By risk neutrality we can rightly assume that U (Y ) = Y . I assume that in each period firm could be in either of the two possible states i ∈ {1, 2} with fixed distribution of firm values Fi (.). I assume that F2 (.) > F1 (.), that is F2 (.) stochastically dominates F1 (.) in the first order for all possible realizations of firm values. States evolve according to a Markov transition process πij denoting the probability of Fj (.) in the next period given the realization of Fi (.) in this period. I also assume that π22 > π12 , that is probability of staying with the better distribution is greater than the probability of moving to it.

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In each period, equity holders can decide whether to continue or release the firm’s assets to outsiders for alternative uses, i.e. relinquish the ownership of the firm. However, due to incomplete contracting not all possible outcome contingencies cannot be stipulated into the debt contract, which allows equity holders to stave off reorganization if it is incumbent upon them with probability q ∈ [0, 1] even when reorganization is desirable from the perspective of the debt holders. When q = 1 equity holders can avoid reorganization with certainty and when q = 0 debt holders can force reorganization with certainty. Incomplete contracting also means that ρ ∈ (0, 1) fraction of the firm value is spent on managerial perks and hence reduces the disposable value to be distributed among the corporate stakeholders. It (ρ) can also be interpreted as an index that shows the extent to which managerial objectives diverge from those of the equity holders’.

The value of the firm (Zit ) if the equity holders continue and assets remains within the firm is given by:

Zit = (1 − ρ).Pit + β

2 X

πij Ei Z 0

(2)

j=1

where Pit is the total earnings of the firm in state i and period t and Z 0 is the future realization of firm value. I assume that outsiders’ valuation of the firm (St ) in any given state is given by an exogenous process and St is what the current stakeholders of the firm get when the firm releases the assets to outsiders. In the case of exit, value of debt in the firm is given by Ft , which is typically the face value of debt. If instead, the equity holders continue and the assets remain within the firm the value of debt in the firm is given by Dit . The payoff to the creditors (dit ) and equity holder eit thus can be written as, respectively:

dit

eit

  D it  min(S , F ) t t   Z −D it it  max(S − F , 0) t t

=

=

if the equity holders continue if the equity holders exit if the equity holders continue

(3)

if the equity holders exit

I assume that in a bad state firm’s assets are worth more outside the firm than within the firm. This implies that Z1t < St and Z2t > St . The aggregate payoff (Yit ) of the equity holders and the debt holders can be written as (with a little bit of algebra):

Yit

=

  e +d it it  max(S − F , 0) + min(S , F ) t t t t

if the equity holders continue if the equity holders exit

or Yit

=

  Z it  S

if the equity holders continue if the equity holders exit

t

4

(4)

M.M. Rahaman

3


First Best Allocation of Firm’s Assets

In their first best use assets of the firm should be assigned to the parties with the highest value for those assets. Thus, optimal allocation of assets of the firms must maximize the value of assets at each date t and state i. In other words, optimal allocation must solve the objective function: " max E0 Zit ,Z2t ,St

∞ X

t

β Yit × Ii=1 +

t=0

∞ X

# t

β Yit × Ii=2

(5)

t=0

where Ii∈{1,2} is an indicator function. Ii∈{1,2} equals 1 if state is i ∈ {1, 2} otherwise it returns 0. Given our assumption that in a bad state assets are worth more outside the firm than within the firm, i.e. Z1t < St and Z2t > St , the first best allocations are trivially:

Yit

dit

eit

  S t =  Z 2t   min(S , F ) t t =  D 2t   max(S − F , 0) t t =  Z −D 2t

2t

if state i=1 if state i=2 if state i=1 if state i=2 if state i=1

(6)

if state i=2

From this simple setup it is obvious that when the firm continues operation in a bad state (i = 1) assets are being sub-optimally placed within the firm since the outsiders have higher value for these assets than the insiders and consequently value is being destroyed from the social planner’s perspective. On the other hand, when the firm continues in a good state (i = 2) assets are being optimally placed within the firm since the insiders have higher-valued use for these assets than the outsiders. Excessive continuation occurs in this set up, when the firm is in a bad state (i = 1) but continues its operation nonetheless. However, only the equity holders have control over the decision to continue or release the assets to outsiders as long as they can honour their obligations to the debt holders. Equity holders have their own incentive problem and thus may not always agree with the first best allocation of the assets of the firm.

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4


Equity Holders’ Continuation Decision Problem

I assume that the firm is always at the risk of exit. In each period, equity holders receive an offer wit drawn from the fixed distribution Fi (w) to sell the assets of their firm to outsiders. They can either accept the offer and release the assets to outsiders or they can continue to operate the assets within the firm. The risk neutral equity holders maximize the objective function:

max E0

X ∞

{w}

β t yit

(7)

t=0

where yit is the payoff to the equity holders and is given by:

yit

  V (w) i =  U (w) i

if equity holders accept the offer if equity holders reject the offer and continue

wi 1−β

Vi (w)

=

Ui (w)

2 X 0 πij Ei Jj (w ) = wi (1 − q) + q (1 − ρ)Pit − C + β j=1

Jj (w0 )

=

max Vj (w0 ), Uj (w0 )

(8)

where q ∈ [0, 1], as before, measures the extent to which equity holders can stave off liquidation/reorganization even when it is optimal from the debt holders’ perspective to liquidate/reorganize the firm; C is the debt obligations equity holders must honor if they want to continue without declaring bankruptcy. For longer maturity debt C tends to be smaller because equity holders only have to pay off the interest payment while for shorter maturity debt C tends to be larger because debt payment consists of interest as well as principle amount of the debt. By explicitly looking at payoffs at different states we can write: V1 (w)

=

V2 (w)

=

w1 1−β w2 1−β

U1 (w)

=

w1 (1 − q) + q (1 − ρ)P1t − C + β

2 X

Jj (w )

Jj (w )

π1j E1

0

j=1

U2 (w)

=

w2 (1 − q) + q (1 − ρ)P2t − C + β

2 X j=1

6

π2j E2

0

(9)

M.M. Rahaman


It is obvious that without any market imperfection it must be the case that w1 = max St − Ft , 0 and w2 = Z2t − D2t . It is straight forward to show that Vi (w), Ui (w) and Jj (w0 ) are increasing in w. Moreover Vi (w), Ui (w) and Jj (w0 ) are non-decreasing in i and

1 1−β

> 1 − q since q ∈ [0, 1] and β ∈ (0, 1). Hence, for

each i there is a reservation payoff Ri for risk neutral equity holders satisfying Vi (Ri ) = Ui (w). Thus, we can write: R1 1−β R2 1−β Jj (w0 )

=

2 X w1 (1 − q) + q (1 − ρ)P1t − C + β π1j E1 Jj (w0 )

=

2 X w2 (1 − q) + q (1 − ρ)P2t − C + β π2j E2 Jj (w0 )

j=1

j=1

=

  

0

w 1−β Rj 1−β

if w0 > Rj if w0 ≤ Rj

By simplifying the expressions and solving for R1 and R2 we get the following: 0 R1 = w1 (1 − q) + q (1 − ρ)P1t − C + ψ1 (w ) 0 R2 = w2 (1 − q) + q (1 − ρ)P2t − C + ψ2 (w ) Z ∞ Z ∞ β 0 0 0 0 0 ψ1 (w ) = π11 (w − R1 )dF1 (w ) + π12 (w − R2 )dF1 (w ) 1−β R1 R2 Z ∞ Z ∞ β 0 0 0 0 0 π21 (w − R1 )dF2 (w ) + π22 (w − R2 )dF2 (w ) ψ2 (w ) = 1−β R1 R2

(10)

Reservation payoffs R1 and R2 are necessary to induce the equity holders to accept the offer to release the firm’s assets to outsiders for alternative uses in state 1 and 2, respectively. The higher the reservation payoffs, the more outsiders need to offer to the existing equity holders to relinquish their ownership of the firm. The reservation payoff (Ri ) is an expectation over payoffs from involuntary liquidation wi (1 − q) and voluntary continuation q (1 − ρ)Pit − C + ψi (w0 ) . The expectation is taken over q ∈ [0, 1], the index of suboptimal covenant structure (incomplete contracting environment). In this framework, any changes in the debt structure, covenant structure, free cash flows and principle-agent conflicts affect the reservation payoffs in either states and that in turn affect the likelihood of the equity holders either to accept or reject the offer to relinquish their ownerships in the existing firm.

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5


Some Results

From this simple model of equity holders’ continuation decision problem of whether to accept or reject an offer several testable hypotheses can be developed. I focus mostly on the bad state of the world where firm’s assets are worth more outside the firm than within the firm and also because in my economic framework the excessive continuation problem can arise only when the firm is in the bad state.

Result 1: R2 > R1 . Equity holders demand more to relinquish their ownership to outsiders in good states than in bad states. This implies that firms in good financial and economic health are less likely (not surprisingly) to liquidate or reorganize than firms in weak financial and economic conditions. 0 0 Proof: R2 − R1 = (1 − q)(w2 − w1 ) + q (1 − ρ)(P2t − P1t ) + ψ2 (w ) − ψ1 (w ) . By the first order stochastic dominance of F2 (.) over F1 (.) we have F1 (w) > F2 (w) which implies that w2 > w1 and ψ2 (w0 ) − ψ1 (w0 . Furthermore, (P2t − P1t ) > 0 by assumption. Together these imply that R2 > R1 . Result 2: q = 0 ⇒ R1 = w1 and q = 1 ⇒ R1 = q (1 − ρ)Pit − C + ψ(w0 ) . When contracting environment is complete in the sense that debt covenants are optimal (q = 0) debt holders can force liquidation/reorganization in bad states since the reservation payoff of the equity holders converges with the first best payoff. By contrast, if there are no covenants at all (q = 1) reservation payoff of the equity holders is independent of the first best payoff. Equity holders always continue. And finally, when the contract ing environment is incomplete q ∈ (0, 1) equity holders continue excessively in a bad state with positive probability.

Result 3: For q ∈ (0, 1), R1 = w1 if and only if ψ1 (w0 ) − w1 = C − P1t , where ψ1 (w0 ) − w1 is the expected excess surplus from continuing in a bad state and C − P1t is the additional cash firm needs to burn to be able to continue after pacifying the debt obligation. As long as the expected excess surplus from continuing in a bad state exceeds the needed cash burning, there will be excessive continuation in bad state. That is, firms with liquid asset structure (more free cash flows) can liquidate their assets to get the needed cash that can eventually fuel the excessive continuation problem in bad states.

Result 4:

∂R1 ∂C

< 0. The size of the current debt obligations matter for excessive continuation. If current

debt obligations are larger, the reservation payoffs from liquidation/reorganization is lower and the equity holders are more likely to release the assets to outsiders in a bad state than continuing. This also means

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M.M. Rahaman


firms with longer maturity debt, which are typically characterized by lower current debt obligations, is more likely to continue in a bad state than firms with shorter maturity debt, which are typically characterized by higher current debt obligations. ∂ψ1 (w0 ) ∂ψ1 (w0 ) q β 1 1 Proof: ∂R × ∂R = 1−β π11 (−1)(R1 − R1 ) + ∂C = q − 1 + ∂R1 ∂C = − 1− ∂ψ1 (w0 ) q . We can calculate ∂R1 ∂R1 R∞ 0 ) β ∂R1 π11 R1 (−1)dF1 (w0 ) = 1−β π11 (1 − F1 (R1 )) < 0. This implies that 1 − ∂ψ(w ∂R1 q > 0 and hence ∂C < 0. Result 5:

∂R1 ∂ρ

= 0 if P1t = 0;

∂R1 ∂ρ

> 0 if P1t < 0;

∂R1 ∂ρ

< 0 if P1t > 0. Agency conflicts between

managers and equity holders have varying effects on excessive continuation depending on how severely the firm is distressed in a bad state. In a severely distressed firm (P1t < 0) equity holders may be oblivious to managerial actions because the firm has very little chance of recovery. In that case, excessive continuation is purely driven by managerial opportunism. On the contrary, if the firm is distressed but there is also hope for recovery (P1t > 0) divergence of managerial and shareholders’ objective lowers the reservation payoff and hence decreases the possibility of excessive continuation. When managerial and equity holders objectives converge, reservation payoff from reorganization increases and thus also increases the possibility of excessive continuation.

Proof:

6

∂R1 ∂ρ

= q − P1t +

∂ψ1 (w0 ) ∂R1

×

∂R1 ∂ρ

=−

q 1−

∂ψ1 (w0 ) q ∂R1

P1t . Since

q 1−

∂ψ1 (w0 ) q ∂R1

> 0 the result follows.

A Simple Extension: Risk Shifting

I consider a simple extension of the setup above to investigate the risk-shifting (asset substitution) agency problem of debt on the excessive continuation phenomenon [Jensen and Meckling (1976)]. I assume that equity holders can affect the scale but not the location of the future payoff Jj (w0 ). In that way, equity holders can have the abilities to impose greater risk on the future realizations of firm values. It can be captured using a simple mean-preserving spread and by defining: Jbj (w0 ) = Jj (w0 ) + γ Jj (w0 ) − Ei Jj (w0 )

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(11)

M.M. Rahaman


One can easily show that Ei Jbj (w0 ) σi2 Jbj (w0 )

= Ei Jj (w0 ) = (1 + γ)2 σi2 Jj (w0 )

(12)

By choosing γ ∈ [0, ∞) equity holders can get the same mean payoff but can alter the variability of the payoff, i.e. inflict more risk on the payoff. With this variation we can solve for the reservation payoffs that make equity holders indifferent between continuing and liquidating/reorganizing as: = w1 (1 − q) + q (1 − ρ)P1t − C + ψb1 (w0 ) b2 = w2 (1 − q) + q (1 − ρ)P2t − C + ψb2 (w0 ) R Z ∞ Z ∞ β b1 )(1 + γ) − b1 )dF1 (w0 ) dF1 (w0 ) ψb1 (w0 ) = π11 (w0 − R (w0 − R 1−β R1 R1 Z ∞ Z ∞ b2 )(1 + γ) − b2 )dF1 (w0 ) dF1 (w0 ) +π12 (w0 − R (w0 − R R2 R2 Z ∞ Z ∞ β 0 0 b1 )(1 + γ) − b1 )dF2 (w0 ) dF2 (w0 ) π21 (w − R ψb2 (w ) = (w0 − R 1−β R1 R1 Z ∞ Z ∞ 0 0 0 0 b b +π22 (w − R2 )(1 + γ) − (w − R2 )dF2 (w ) dF2 (w ) b1 R

R2

(13)

R2

It can be seen from the solution that the reservation payoffs are affected by future changes in the payoff structure. However, the scaling parameter γ does not affect the current revenues at all.

Result 6:

b1 dR dγ

> 0. Abilities of the equity holders to take on more risk alter the future payoff distribution

and leads to a higher reservation payoff to liquidate/reorganize. This risk shifting attitude of the equity holders makes first-best liquidation/reorganization less likely but makes excessive continuation more likely. It also increases the expected equity payoff at the expense of the current payoff of the existing debt holders.

b1 − w1 (1 − q) − q (1 − ρ)P1t − C + ψb1 (w0 ) . By implicit function theorem Proof: Let us define f ≡ R

1−

β qπ11 1−β

∂f ∂γ ∂f b ∂R 1

0

∂ ψ1 (w ) . We can show that ∂f = −qψ1 (w0 ) < 0 and ∂γ = ∂γ R∞ b − γ − F ( R ) dF1 (w0 ) > 0 . These together imply the result. 1 1 R1

we can write

b1 dR dγ

= −

b

10

∂f b1 ∂R

ψ1 = 1 − q ∂∂R b = b

1

M.M. Rahaman

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Conclusion

A central issue in finance is how to liquidate/reorganize firms that are worth more dead than alive when it is optimal to do so. Failure to reorganize in a timely manner leads to an excessive continuation problem, a potentially destructive phenomenon for firm value. Empirical evidence in finance shows that firms do continue excessively and it costs dearly to the creditors of the firm. Theoretically, we are beginning to understand why some firms can finance their excessive continuation more often than others and are able to postpone the inevitable reckoning for so long.

In this paper, I look at the problem from the incomplete contracting perspective and show that excessive continuation can only arise when debt covenants are sub-optimal (incomplete contracting environment). When debt covenants are sub-optimal, the agency problem between the managers and the shareholders have varying but interesting implications for excessive continuation. When distressed firm appears to be beyond recovery, shareholders seem to be oblivious to managerial actions and excessive continuation is solely driven by managerial opportunism. However, when there are chances of recovery for the firm, agency problem between the managers and the shareholders actually work in favor of the creditors by lowering the reservation payoff of the equityholders and thus lowering the possibility of excessive continuation. Finally, when managerial and shareholders’ interests coincide excessive continuation becomes more likely. Furthermore, I find that low current debt obligations, longer debt maturity, more liquid assets (more free cash flows) and the abilities of the equityholders to inflict greater risk on firm value can increase the likelihood of excessive continuation problem.

These results suggest that excessive continuation problem can be viewed essentially as a problem of incomplete contracting. When all possible ex-post outcome contingencies cannot be stipulated into the contract (debt covenants), the presence of certain firm characteristics, such as low debt service, liquid assets, managerial and shareholders agency conflicts and asset substitutions (risk shifting), can enable a distressed firm to continue more excessively than others. Some of these insights have already been shown in the empirical literature and the others remain to be tested.

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References [1] Davydenko, Sergei A., 2007, When Do Firms Default? A Study of the Default Boundary, Working paper, University of Toronto. [2] Davydenko, Sergei A. and Mohammad M. Rahaman, 2006, Excessice Continuation and the Costs of Flexibility in Financial Distress, Working paper, University of Toronto. [3] D´ecamps Jean-Paul, and Antoine Faure-Grimaud, 2002, Excessive Continuation and Dynamic Agency Costs of Debt, European Economics Review, 46, 1623-1644. [4] Mella-Barral, Pierre, 1999, The dynamics of default and debt reorganization, Review of Financial Studies 12, 535-578. [5] Morellec, Erwan, 2001, Asset Liquidity, Capital Structure, and Secured Debt, Journal of Financial Economics, 61, 173-206.

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