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Excess Returns to Troubled Debt Restructurings:
the Size/Book-to-market Effect or Unexpected Benefits?
Mine H. Aksu*
SabanciUniversity , Istanbul, Turkey
This paper examines the excess returns to financially distressed firms that attempt to restructure their debt privately with their creditors. As suggested by the economics of the restructuring transaction and option pricing theory, significantly positive announcement and post-announcement excess returns accrue to shareholders as their firms renegotiate. In line with the net benefits/information hypothesis, the announcement provides an unexpected, favorable signal that is stronger for larger firms whose financial distress has already been disseminated. The finding of an anomalous-signed, positive (negative) size (book-to-market) effect confirms that the abnormal returns are not an artifact of the size and book-to-market effects on returns.
Key words: debt restructuring, financial distress, size, book-to-market ratio, information markets
JEL classification: G14, G33
** GraduateSchool of Management, SabanciUniversity, 34956 Orhanli/Tuzla, Istanbul, Turkey.
Phone: +90(216)483-9678; Fax: +90(216)483-9699; e-mail:
I. Introduction
As a distinct stage in the financial distress continuum, troubled debt restructurings (TDR)[1] have been acknowledged as viable, less costly alternatives to formal reorganizations under Chapter 11 (Haugen and Senbet, 1988; Gilson et al., 1990; Brown et al., 1993; Franks and Torous, 1994; Chatterjee et al., 1995). However, prior market based research has consistently found a negative or insignificant market reaction to various financial distress related announcements, including TDR. Since their objectives were different, these studies on TDR have used (sub)samples that were either too narrow, small, or non-homogeneous, resulting in findings that ambiguous in terms of the overall market reaction to a TDR announcement.[2]
For example, Brown et al. (1993) and Chatterjee et al. (1995) examine, respectively, exchange offers and tender and exchange offers of only public debt and find a positive market response only in some of their subsamples. Aintablian and Roberts (2000) investigate the market reaction in a subsample of only 18 debt restructurings within an overall sample of 122 new loan announcements and renewals. Since the focus of the Gilson, John, and Lang (1990) and Gilson (1990) studies is to investigate the choice between private and legal forms of restructurings in financially distressed firms, their sample consists of a heterogeneous group of poorest performing CRSP firms that have announced a debt service default, out-of-court restructuring, or bankruptcy within a year of a restructuring attempt. They report negative, but significantly different excess returns for private workout firms that subsequently file for bankruptcy and those that do not. This heterogeneity in their sample has made it hard to infer whether their results are driven by the firms’ TDR, their prior default, their subsequent bankruptcy, or the fact that they are firms with inherently poor earnings prospects. As a result, whether a TDR announcement is associated with an overall increase in shareholder wealth is an empirical question that has not been clearly answered yet.Furthermore, none of the market based studies on TDR have tested or controlled for the size (market value of equity-MVE) and book-to-market equity (BTM) anomalies in returns that are confounding return factors, especially in studies on financially distressed firms (see e.g., Fama and French, 1993-1998).
The main objective of this study is threefold: (1) to measure the overall market response to an average first-time TDR announcement and the returns to shareholders over the restructuring interval; (2) to investigate if the observed abnormal returns are related to the firm-size and/or BTM effects on returns; (3) to assess the informational source of the gains to shareholders by exploiting the ambiguity in the expected market reaction in TDR firms of different sizes and BTM.
For the first inquiry, this study specifically isolates financially distressed debtors that have announced their first-time intention to privately restructure their debt. A positive market reaction is predicted based on the economic implications of a restructuring transaction and the option pricing theory, which suggest that a privately negotiated debt reduction or delay relief is informative and beneficial to the debtor firm. Under this net benefits/information hypothesis, a positive market response is attributed to: (i) the perceived cash-flow implications of the benefits of a TDR in excess of its costs and (ii) the "surprise" nature of the announcement leading to a favorable change in expectations about these firms’ prospects. Market reaction tests performed on both the TDR sample and a matched sample of non-TDR, non-bankrupt firms indicate that the market reaction is positive and that shareholder wealth gains continue during the post-announcement restructuring interval.
The second inquiry is related to the confounding return factors that need to be controlled for in market-based studies that investigate long-term returns, especially those on financially distressed firms. Prior research has provided considerable empirical evidence that MVE and BTM are the two firm characteristics that best explain the variation in average stock returns and that small capitalization, high BTM “value” stocks earn higher returns than large, high priced “glamour” stocks, both in the US and abroad (see for ex., Fama and French, 1993; Barber and Lyon, 1997, Pontiff and Schall, 1998; Fama, 1998). A compelling argument for the size and BTM anomalies in returns has been that they are proxies for additional risk factors that covary with financial distress (Chan and Chen, 1991; Fama and French, 1992, 1993, 1995; Lewellen, 1999). Hence, the higher returns to TDR firms that are, on average, small-to-medium size risky firms with high BTM ratios, may just be compensation for their higher systematic risks. Accordingly, I also evaluate the size/BTM hypothesis, the null hypothesis for the confounding effects, to corroborate that the excess returns are due to the announcement and net benefits of TDR and not these ex-ante firm characteristics, which were neither tested nor controlled for in prior studies on TDR. To evaluate the sensitivity of the observed market response to these competing explanations, I explicitly investigate size and BTM related patterns in the time series of excess returns in the TDR and control samples and in cross-sectional multivariate regressions. The results confirm that the positive excess returns are not a spurious result of the misspecification of the one-factor expected return generating model which fails to account for these additional risk factors.
In addition to its use as a control for confounding effects, the size/BTM related cross-sectional analysis also helps in assessing the informational source of the shareholder gains. As mentioned above, the return anomalies literature has found that size has a negative relationship with financial distress and with returns. On the other hand, prior research has also observed a positive relationship between size and both pre-announcement information availability and equity deviations from absolute priority rule (APR) in favor of equıty, which are also expected to effect the returns to TDR firms.[3] I exploit this ambiguous relationship of size with returns to further test the above mentioned two competing groups of hypotheses. Under the null hypothesis for the confounding effects, one would expect to find a stronger size and BTM effect on returns in the smaller, more marginal firms and a negative (positive) coefficient for the size (book-to-market) variable in the cross-sectional regressions of excess returns, in both the TDR and control samples. On the other hand, higher deviations from APR, observed more often in private, rather than legal, restructurings and in larger firms than smaller ones (Franks and Torous, 1994), suggest greater wealth transfers to equity in larger TDR firms. Furthermore, since size also proxies for the extent to which firm-specific information is disseminated (Atiase, 1985), a TDR announcement may be perceived as an unexpected, favorable signal for larger TDR firms whose financial distress is more likely to have been disseminated prior to the announcement. These information and APR violation arguments lead to the expectation of an anomalous-signed positive size and negative BTM effects in the TDR sample. Indeed, I find an anomalous-signed size and BTM effect in only the TDR sample and higher excess returns to TDR firms with larger pre-announcement price declines and other publicized distress signals. The results support the net benefits/information hypothesis.
The study has several contributions. First, the finding of positive excess returns for a clean sample of TDR firms adds to the literature on the "benefits" of financial distress (Jensen, 1989) and private workouts as an optimal way of coping with financial distress. Second, the effect of size, BTM, and prior distress information on the returns to TDR firms is tested for the first time in literature. The overall market response and the size/BTM/information related cross-sectional differences are useful to investors who want to invest in financially distressed firms and to any other stakeholder groups such as the employees, unions, auditors, and lenders. Finally, the finding of a negative pre-event excess returns (CAR) followed by a persistent positive post-announcement CAR adds a new event to the medium-term return anomalies literature.
The rest of the paper proceeds as follows. Section two discusses the expectations about the direction of the market reaction and generates the testable hypotheses. Sample selection, design and methodology issues are covered in section three. In section four, the financial characteristics of and the excess returns to the sample of TDR firms are compared with those of the control sample. In section five, the market response in size/BTM related partitions of the TDR sample is examined and value-relevance of prior distress information is extended as an explanation for the observed anomalous-signed size and BTM effects. Additional sensitivity tests are also performed by regressing the excess returns on size and book-to-market ratio, conditional on the firm being a TDR or control firm. The final section summarizes and discusses the results.
II. A priori expectations and the derivation of the specific hypotheses
The economic consequences of a debt restructuring transaction, the option pricing theory and prior research on TDR motivate the following testable hypothesis, expressed in the alternative form:
H1: On average, positive excess returns accrue to the shareholders of a debtor TDR firm upon
the announcement of a first-time TDR attempt.
A. The Economic Substance of Private Workouts
The announcement of a TDR may embody two conflicting signals about a debtor’s prospects. Although a TDR is a timely and unequivocal signal of financial distress with its direct and indirect recontracting costs (Weiss, 1990; Gilson, 1997), the firm has revealed positive information that, at this stage, it is not going to file for bankruptcy. Furthermore, the debtor is the beneficiary of the TDR transaction. Upon consummation of the restructuring, the outstanding debt is exchanged with assets or securities that have a lower fair market value than its current carrying value or the contract terms are favorably altered such that the present value (PV) of the debt is reduced. As a result, debt-service related cash flows are improved, debt which has reached non-optimal levels is reduced, and an economic gain is involved. An efficient market should incorporate these favorable changes in assessing the solvency, financial flexibility, and the probability of bankruptcy of a TDR firm as of the announcement date. To the extent that the expected value of the positive information revealed to the market outweighs the negative information, firm value is expected will increase.
B. Equity's Call Option on the Firm's Assets
The shareholders of financially distressed TDR firms may either abandon their assets or choose their option to remain a going-concern and adapt their assets to higher return uses. In the latter case, if the creditors have the incentives to let them continue as residual claimants, a private workout is negotiated.[4] A TDR can then be viewed as an option that favorably revises the terms of the initial contract on the firm's future cash flows. The effect of a TDR on the market value of outstanding equity and debt claims can thus be analyzed more formally within the framework of the general option pricing model (Black and Scholes, 1973), where the value of equity (S) is expressed as a function of the value of the underlying firm assets (V), the standard deviation of their returns (σ), the face value of the debt (B), the risk-free interest rate (rf), and the time to maturity (T). Despite its limitations and simplicity, Galai and Masulis (1976) comparative statics analysis is used here to predict the effect of different types of TDR undertaken by the sample firms on the variables of the model, S = s(V,T,B,σ):[5]
δs δs δs δs δs
0 ── 1, ── <0, ── >0, ── >0, ── > 0(1)
δV δB δrf δσ δT
Since TDR firms are highly leveraged, the probability that the market value of the assets will exceed the face value of the debt is low, making the value of equity insensitive to changes in the value of the assets. The first partial implies that to the extent the concessions given by creditors reduce the PV of outstanding debt, the proportion of the change in the value of the assets captured by the stockholders is expected to increase.
A common contract revision is the reduction in the principal owed (B) through debt exchanged with equity, new debt or assets that have a lower market value than the face value of the canceled debt. Indeed, 55%, 41%, and 38% of the 86 sample firms restructured some debt in these respective categories.The second partial implies that there will be more asset value left for the stockholders as (B) decreases. Another concession is the extension of the maturity date which has a a similar value increasing effect on S since it reduces the PV of the outstanding debt. 68% of sample firms had some debt whose principal or interest payment dates were postponed. An increase in the risk-free rate, rf, should also have a positive (negative) effect on the value of equity (debt). Another type of TDR allows a reduction in the contractual risk adjusted interest rate (ra), and 6% of the sample firms restructured some debt in this manner. A reduction in the nominal rate is considered here as a proxy for an increase in rf since both would reduce the risk premium and hence the return to lenders. Finally, given the stockholders' limited liability, (σ) allows for the possibility of payment to stockholders even when expected returns from assets are not sufficient to cover (B). Furthermore,(σ) becomes a more important factor in pricing in firms with higher default risk. Since this variable is unobservable, the change in the standard deviation of the market adjusted returns as a result of the announcement is used here as a proxy. This measure increases from 0.00532 in the 300-day estimation period to 0.00683 in the (-3,+40) event window, about twice the increase in the control sample. Given the assumption that the firm's asset value is independent of its capital structure, the partial effects on debt will have the opposite signs. Hence, these changes in the variables of the call option are also expected to lead to a wealth transfer from creditors, consistent with APR violations observed in both private and legal restructurings. [6]
C. Prior Empirical Research on Private Workouts
There is ample evidence that a TDR is beneficial to the shareholders of a debtor firm. Aksu (2004) discusses the implications of several other valuation theories based on cash-flows, earnings, book-value, and leverage, the fundamental variables directly effected by the TDR transaction, to predict the positive effect of a TDR on firm value and to motivate the market reaction and value-relevance tests. Several studies have found that the direct and indirect cost of a private workout is lower than that of a Chapter 11 reorganization (see, e.g., Jensen, 1989; Gilson et al. 1990; and Franks and Torous, 1994). Furthermore, although the announcements of covenant violations, defaults and bankruptcies are unambiguously associated with significant negative abnormal returns (see, e.g., Beneish and Press, 1995; Gilson et al., 1990; Clark and Weinstein, 1983), Gilson et al. (1990) report still negative, but significantly different excess returns for TDR firms that have and that have not filed for bankruptcy within a year. Brown et al. (1993) and Chatterjee et al. (1995) find positive excess returns in about half of their subsamples. Finally, Franks and Torous (1994) find higher APR deviations in private restructurings (9.5% of firm value), compared to formal ones (2.3%).[7]
Gilson et al. (1990) is the only study known to the author that has measured the average market response to a TDR announcement. They investigate a debtor firms' incentives to choose between private and legal forms of TDR during the 1978-1987 period. As relative restructuring costs, they report negative, but insignificant, 2-day announcement wealth losses of -1.6 % to -3 % in their successful TDR sample and -6.3 % to -8.7 % for their unsuccessful control firms that file for Chapter 11 within a year. I attribute the difference between the results of the two studies to their different objectives and, thus, different samples. Given the authors' choice of the comparison sample, i.e., TDR firms that file under Chapter 11, their conclusion that stockholders fare better in private workouts than in bankruptcy is not surprising, and they themselves note that the larger price declines in their bankrupt sample may be due to a selection bias if these are the firms with lower earnings prospects. Also, it is likely that their results are downward biased due to their announcement day and sample selection procedures.[8]