Paper Spotlight: Private Equity and the Resolution of Financial Distress

Edith S. Hotchkiss

David C. Smith

Per Strömberg

 

 

 

 

 

 

 

Leveraged buyouts by private equity funds have been a constant, and growing, phenomenon in corporate finance over the last two decades and their importance is likely to increase in the post-COVID world. Empirical literature on this subject has explored various angles, but one unanswered question is whether the high leverage used in private equity (PE) buyout transactions contributes to the disproportionately high default rates among buyout targets. In the paper “Private Equity and the Resolution of Financial Distress,” Edith S. Hotchkiss, Per Strömberg and David C. Smith investigate how PE ownership correlates with the probability of default and resolution of financial distress, a relationship that is, theoretically speaking, unclear. One can argue that actions that boost the short-term returns to PE owners, increasing leverage to pay large dividends as an example, could drain liquidity and put PE-owned firms at higher default risk. But there is an opposite argument to be made as well: PE sponsors could help avoid defaults or resolve financial distress, thus preserving firm value, because of their expertise and skill. The authors find a series of interesting results that will help the literature understand better this relationship. First, they find that PE-backed firms have higher leverage and default at higher rates than other companies borrowing in leverage loan markets. This said, conditional on contemporaneous leverage, default rates are not significantly higher for PE-owned firms. These results suggest that it is leverage, rather than PE-backing specifically, that could be the key driver of default probabilities. Second, among leveraged borrowers that experience a default, PE-backed firms restructure more quickly and are less likely to be liquidated. Third, PE owners are more likely to retain control post-restructuring than other pre-default owners, often by infusing capital as firms approach distress. Overall these results suggest a very nuanced view of PE investors and their potential impact on subsequent target firms’ default: while PE investors contribute to more defaults due to the high leverage they put on companies’ balance sheets, such cost is reduced by the PE investors’ intrinsic abilities and skills in dealing with and managing financial distress.

Spotlight by Andrew Ellul
Photos courtesy of Edith S. Hotchkiss, David C. Smith, and Per Strömberg

Forthcoming Papers

“Sharing R&D Risk in Healthcare via FDA Hedges” by Adam Jorring, Andrew Lo, Tomas J. Philipson,
Manita Singh, and Richard T. Thakor

“Information asymmetry, financial intermediation, and wealth effects of project finance loans” by Andrew Ferguson and Peter Lam

Paper Spotlight: The Effect of Taxation on Corporate Financing and Investment

Hong Chen

Murray Z. Frank

Despite the large theoretical literature that asserts the importance of taxes on corporate investment and financing decisions, the empirical literature often fails to demonstrate the effects of taxes in a convincing way. One reason for the discrepancy could be measurement error in variables. In “The Effect of Taxation on Corporate Financing and Investment,” Hong Chen and Murray Z. Frank take issue with the theoretical predictions themselves. They construct a model with a household and a firm that are both infinitely-lived. The government collects taxes from both parties. In the steady-state equilibrium of the model, many personal taxes are irrelevant to corporate decision-making, and other forms of taxation affect particular corporate decisions only. Specifically, (i) a small change in many personal taxes (including on consumption, dividend, or capital gains) has no effect on the firm’s investment or financing policies, (ii) a small change in the personal tax on interest income affects leverage but not investment, and (iii) a small change in the corporate tax rate affects leverage and investment, but not the interest rate on corporate debt. The first-order conditions pin down the optimal policies of the firm and the consumer, and the authors show that in a steady-state equilibrium, these conditions are not affected by some of the tax rates (significantly, including the dividend tax rate). A numerical example shows the change in the steady-state equilibrium outcomes to a change in various tax rates. If the theory on tax effects does not match the data, perhaps the theory needs to be reconsidered, and this paper represents an important step in that direction.

Spotlight by Uday Rajan
Photos courtesy of Hong Chen and Murray Z. Frank

Call for Papers and Proposals: RCFS Winter Conference 2022

The 2022 RCFS Winter Conference is now accepting submissions. Please see the Call for Papers and the Call for Registered Reports/Proposals on “Finance for the Greater Good” for more details. The conference, which features a dual submission option with RCFS, will take place February 19-20, at the Margaritaville Hollywood Beach Resort in Florida.

The sponsoring editors are Andrew Ellul, Isil Erel, Camelia Kuhnen, and Robert Marquez. The submission deadline is November 19, 2021, for papers and December 5, 2021, for registered reports.