How Costly is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed

Abstract

This paper studies twenty-nine highly leveraged transactions (HLTs) of the 1980s that subsequently become financially distressed. High leverage, not poor firm performance or poor industry performance, is the primary cause of financial distress for these firms -- all of the sample firms have positive operating income at the time of distress. These firms, therefore, are financially distressed, not economically distressed. We estimate the effects of this financial distress on value, the costs of financial distress, and their determinants. From pre-transaction to distress resolution, the sample firms experience a marginally positive change in (market- or industry-adjusted) value. The net effect of the HLT and distress, therefore, is to leave value slightly higher. Operating margins of the distressed firms increase immediately after the HLT, decline when the firms become distressed and while they are distressed, but then rebound after the distress is resolved. Consistent with some costs of financial distress, we find evidence of unexpected cuts in capital expenditures, undesired asset sales, and costly managerial delay in restructuring. Quantitative measures of the magnitude of the costs of financial distress, however, indicate that the costs are modest on average. To the extent they occur, the costs of financial distress that we identify are heavilyconcentrated in the period after the firms become distressed, but before they enter Chapter 11. We conclude the paper with an analysis of the determinants of the costs of financial distress. These costs are related to initial HLT capital, but are not related to the complexity of the firm's capital structure, to the time spent in distress or default, or to industry performance.

JEL Classification: G3