Using data on defaulted firms in the United States over the period 1982 to 1999, we show that creditors of defaulted firms recover significantly lower amounts in present-value terms when the industry of defaulted firms is in distress. We investigate whether this is purely an conomic-downturn effect or also a fire-sales effect along the lines of Shleifer and Vishny (1992). We find the fire-sales effect to be also at work: Creditors recover less if the industry is in distress and non-defaulted firms in the industry are illiquid, particularly if the industry is characterized by assets that are specific, that is, not easily redeployable by other industries, and if the debt is collateralized by such specific assets. The interaction effect of industry-level distress and asset-specificity is strongest for senior unsecured creditors, is economically significant, and robust to contract-specific, firm-specific, macroeconomic, and bond-market supply effects. We also document that defaulted firms in distressed industries are more likely to emerge as restructured firms than to be acquired or liquidated, and spend longer in bankruptcy.
The magnitude of the deadweight costs of corporate defaults is an important determinant of capital structure in several corporate finance theories. The empirical literature has, however, found that the direct – administrative and legal – costs of formal bankruptcy are rather small (see, for example, Altman, 1984, and Weiss, 1990). Hence, the literature has shifted its att ention to indirect costs arising from the loss of intangibles and growth opportunities, bargaining inefficiencies, and fire-sale liquidations during industry-wide distress. This paper is concerned with the last of these effects. Industry-wide distress can affect a defaulted firm along two dimensions: First, industry distress is invariably associated with a downturn in economic prospects which lowers the economic worth of the defaulted firm’s assets. Second, the fire-sales or the industry-equilibrium notion developed by Shleifer and Vishny (1992) suggests that the prices at which assets of the defaulted firm can be sold depends on the financial condition of the peer firms.
Both of these effects lower the amount recovered by firm’s creditors and thereby affect the ex-ante debt capacity of firms. In this paper, we shed light on the issue of whether defaulted firms, and, in turn, their creditors, are affected by industry distress purely through the economic-downturn channel or (also) through the fire-sales channel. We do so by studying comprehensively the empirical determinants of creditor recoveries using the data on observed prices of defaulted securities in the United States over the period 1982–1999. Our analysis of creditor recoveries complements the existing literature on asset sales that also has attempted to test the fire-sales channel (see the discussion of related literature below).
From an econometric standpoint, the issue of disentangling the economic-downturn effect from the fire-sales effect is inherently a tricky one. However, the industry-equilibrium theory has precise implications in terms of where the industry distress effect should be stronger in terms of other industry conditions and characteristics. In particular, Shleifer and Vishny argue that fire sales are more likely under the following conditions: if the industry has more specialized assets along the lines of Williamson (1988), that is, assets that have few alternative uses outside the industry, and if the industry is concentrated resulting in a less han perfect market for active bidding in cash auctions of assets. Furthermore, these effects should be stronger if the firm’s competitors in the same industry are experiencing distress, liquidity problems, and/or are highly levered restricting their ability to raise additional financing.
In contrast, it is not clear that the economic-downturn effect would affect industries and firms differentially in this manner. In a nutshell, under the fire-sales hypothesis, the researcher should find a strong interaction effect of industry-level asset-specificity and concentration with industry-level distress on firm-level debt recoveries. We employ several variants of these interactions in our empirical tests. It is important to note that asset sales or firm liquidations are endogenously less likely to be seen when the industry is in distress. However, even in the absence of asset sales or liquidations, the anticipation of low prices for asset sales can confer greater bargaining power to equity holders in writing down creditor claims. Alternatively, the lack of a sufficiently liquid market for asset sales or firm-level acquisitions can render the firm’s distress a long-drawn process, and creditors may recover less in present-value terms due to a slower resolution of bankruptcy. In either case, the adverse interaction effects hypothesized above should be stronger for those creditors who have weaker bargaining power and whose priority and security make them vulnerable to fluctuations in the liquidation price of firm’s assets.