Abstract: Very few firms issue equity to refinance their debt in distress. This simple observation has an important effect on the predictions of capital structure models. A model in which highly-levered firms needing external finance must issue debt explains the overall underleverage puzzle, fully replicates the ‘fat’ right tail of cross-sectional leverage distribution, and produces realistic default probabilities across firms with different leverage values. The model succeeds even if bankruptcy costs are only 10% of firm’s assets, whereas the model that allows for equity issuance requires bankruptcy costs to exceed 60% in order to generate plausible average leverage.
Abstract: This paper addresses two puzzling empirical results in the capital structure literature: why leverage and profitability are negatively correlated, and why investments are explained by the cash flow in a regression controlled for the market-to-book ratio. The paper derives a model, in which firms are heterogeneous in the quality of their investment opportunities. Firms with ex-ante better investment opportunities 1) issue less debt that is not dedicated to finance invest- ments, and 2) are able to raise debt at a smaller rate conditioning on the leverage, which results in a smaller leverage over time in this group of firms. Firms with ex-ante better investment opportunities also invest more, have greater ex-post profitability and greater cash flows. The model presented in the paper is simple and tractable, yet it gives a very good quantitative fit to the data.
Alexander Belyakov, Economics of Leveraged Buyouts: Theory and Evidence from the UK Private Equity Industry.
Abstract: Empirical analysis of a sample of companies with private equity (PE) ownership in the UK shows that PE firms act as deep-pocket investors for their portfolio companies, rescuing them if they fall in financial distress. In contrast, external financing is expensive for companies without PE-ownership in financial distress. The paper builds a model that shows how companies form rational expectations about the costs of financial distress, and how these expectations affect ex-ante policies. The model explains the empirically-observed differences in how companies with and without PE-ownership invest, pay dividends, and issue debt. In particular, the model quantitatively explains the difference in leverage of companies with and without PE-ownership. The model shows that greater tax-shield benefits and superior growth of PE-backed companies can explain 6.4% of the abnormal return of PE firms. The conclusion that follows from the paper, however, is that abnormal returns PE firms cannot be replicated by other investors.