Financial crises, debt overhang, and firm growth in transition economies

ABSTRACT

We examine the effects of the global financial crisis of 2008 and the European debt crisis of 2011 on the relationship between capital structure, investments, and performance for Eastern European companies. While the existing literature documents how firms’ investments are sensitive to the availability of internal funds and to debt holdings, we further investigate whether this investment sensitivity also translates in different levels of performance, and document that capital structure indeed has both a direct and an indirect effect, mediated by the capital expenditure channel. We show that firms with higher financial flexibility experience higher investments and returns on capital. Over-levered firms instead suffer from a debt overhang condition, forcing them to curb investments, and consequently experiencing lower performance. Overall, we provide evidence on the importance of capital structure and financial flexibility on investments and performance, showing the real consequences of the debt overhang condition on firm value creation. Firms should therefore aim at maintaining adequate financial flexibility in order to be able to pursue future profitable investment opportunities, and avoid the under-investment problem arising from a debt overhang situation.

KEYWORDS:

• Capital structure
• debt overhang
• financial crises
• financial flexibility
• firm performance

JEL CLASSIFICATION:

• G00
• G30
• G32

Disclosure Statement

No potential conflict of interest was reported by the author.

Notes

¹ Bekaert et al. (2013) show that equity market integration in Europe was achieved mainly during the accession phase to the EU, while the launch of the European Monetary Union (EMU) and the adoption of the Euro had a non-significant impact. In order to join the EU, Eastern European countries had to sign the Maastricht Treaty, which prescribes the free movement of goods, capital, people and services between EU members. Moreover, they had to implement in their national laws the prescriptions of the EU directives, including those aimed at harmonizing the regulation of capital markets and financial services. As a consequence, joining the EU implied that foreign investors had free access to equity markets, and that regulation was in the same line as that of advanced European economies, resulting in effective protection of transparency and property rights. In the end, this allowed for an increase in the supply of equity capital for domestic firms.

² See Appendix A for a thorough description of how we estimate a firm-specific measure of excess debt.

³ See, among others, Hubbard (1998); Malmendier and Tate (2005); McNichols and Stubben (2008); García-Sánchez and García-Meca (2018).

⁴ We deflate nominal values using 2010 as the base year.

⁵ For a thorough description of how the index is calculated, see Ohlson (1980).

⁶ See, among others, Ramezani, Soenen, and Jung (2002) for a discussion on how to measure firm value creation.

⁷ On the contrary, the most common alternative metric, the return on equity (or ROE), depends crucially on financing decisions, since it measures the returns produced for shareholders only. Therefore, two companies with the same operating performance but a different capital structure would produce different values of ROE. In our analysis, we want to test whether leverage policies affect operating performance, and therefore we need a performance metric that, in its calculation, is independent of capital structure.

⁸ Note that NED is a dummy variable equal to one if excess debt is negative. Recall also that excess debt is negative when a firm’s leverage is below the target, so that in this case an increase in excess debt indicates that a firm is moving closer to the target. As a consequence, a positive coefficient, if statistically significant, would imply a positive effect of leverage increases.

⁹ See Hovakimian and Li (2011) for a thorough description of the estimation procedure and the potential consequences of failing to account for the look-ahead bias.

¹⁰ We deflate nominal values using 2010 as the base year.

¹¹ Note that, in order to preserve space and for an easier readability of Table A1, we only report the coefficients for the statistically significant interactions between time fixed effects and the dummy Euro.

¹² Recall that a more positive WC indicates lower net operating liabilities, and vice-versa. The negative coefficient therefore indicates that higher operating liabilities (i.e. a lower WC) were associated with higher financial debt.