May 7, 2020

Debt overhang is looming: Is it curable?

Many businesses are in financial troubles due to reduced economic activity caused by Covid. Governments are taking actions to help firms survive through these hard times ranging from tax holidays to government loans and credit guarantees. But when economic activity resumes, firms will emerge with high levels of debt accumulated during the crisis, leading to a well-known problem: debt overhang. What is debt overhang and how can it be cured?

To illustrate debt overhang, consider a firm that generates uncertain income. Operating income is 50 in the good state of the world but only 40 in the bad state of the world. Both states happen with equal probabilities. The firm accumulated lots of debt during the crisis: it owes 50 to its creditors. You can think of all these numbers as per month cash flows or as the present value of future cash flows; both interpretations are equivalent in this simple example. One can see that in the good state the firm is just able to repay its debt, and its net income (operating income minus debt repayment) is zero. In the bad state, the firm cannot fully repay creditors: it defaults, repays 40 to creditors, and net income is again zero.

Now, suppose economic activity has resumed and the firm has a good investment opportunity. The firm can make an investment at a cost of 7 to increase its operating income by 10 (discounted for time and risk). Therefore, the investment has a positive NPV equal to +3, so investing is efficient. However, the firm's owner will decide not to invest, because part of the benefits of the investment will accrue to creditors, not to her. To see why, suppose the firm's owner pays the investment outlay of 7 out of her pocket. In the good state, operating income is 60, so after repaying creditors the firm's owner earns 10. In the bad state, operating income is 50, so after repaying creditors the firm's owner earns nothing. The expected profits for the firm's owner is 5, which is less than the initial cash outlay of 7.

Conclusion: the firm does not invest even thought investing is ecomically efficient (the NPV is positive). The reason is that the benefits of the investent in the bad state accrues to creditors and not to the firm's owner. This source of economic inefficiency is called debt overhang: it reduces corporate investment below its optimal level.

Is debt overhang curable? One idea would be to recapitalize the firm: fresh equity could be raised from the current firm's owner or from new investors. But just like the firm's owner does not want to invest because the investment value in the bad state is captured by creditors, she does not want to inject fresh equity because its value in the bad state would be captured by creditors. A similar conclusion applies to raising equity from new investors and to raising debt from new creditors.

Conclusion (bis): debt overhang prevents raising new equity or new debt.

A solution that might work is to renogiate the debt with creditors, but in practice it is often difficult to do so, especially for small businesses.

The government can help. A first type of effective government policies are direct and indirect subsidies such as tax holidays and partial unemployment schemes as we are seeing in France and other countries. Going back to our simple example, the effect of subsidies is to increase operating income, let's say by 10. It is helpful because the returns on investment now accrues to the firm's owner even in the bad state. Indeed, profits are now 10 in the good state and 0 in the bad state if the firm does not invest, and profits are 20 in the good state and 10 in the bad state if the firm invests. Therefore, investing increases expected profits by 10, which exceeds the initial investment outlay of 7. The NPV of the investment now accrues entirely to the firm's owner, so now she decides to invest. Problem solved!

Another effective policy is a credit guarantee. To understand these policies, notice that the firm is not able to raise new debt to finance the investment. The reason is that if new creditors are junior to current creditors, they face exactly the same problems as shareholders. New creditors financing the investment would end up subsidizing current creditors: they would lend 7 but obtain an expected repayment of 5 at most. A credit guarantee by the government works as follows: it guarantees new creditors that the government will repay the loan if the firm is not able to repay. New creditors therefore agree to lend since the loan is now riskless from their perspective. Again, problem solved!

Of course, there is no free lunch: government policies that can alleviate debt overhang have significant fiscal costs. But we can make two observations on these fiscal costs. First, they may well be lower than the economic damages they prevent. Second, the fiscal cost of credit guarantees may be lower than that of unconditional subsidies, because the credit guarantee is triggered only in the bad state, whereas unconditional subsidies entail payments by the government in all states of the world.

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