Capital structure and corporate performance in recessions

As we saw above, the theoretical predictions for the effect of capital structure on performance were somewhat disparate. Pecking-order and debt overhang theory predicts a negative relationship, as did the product market theories. On the other hand, capital opportunity cost theory predicted a positive relationship between debt levels and performance outcomes.

For normal years, overall empirical findings suggest that there is a negative relationship between debt levels and future growth (Rajan & Zingales, 1995; Gupta,1969; Titman &

Wessels, 1988; Chen & Zhao, 2001). Some, however, find a positive relationship (Barton &

Gordon, 1988). Largely, it seems predictions from pecking-order and debt overhang theory hold firm in empirical investigations. Empirical investigations of capital structure’s effect on profitability have yielded rather disparate findings. Some authors find that leverage has a positive relationship with profitability (Abor, 2005; Gill, Biger, Mathur, 2011). Others find that high leverage is associated with reduced profits (Hurdle, 1974; Shubita & Alsawalha, 2012). One explanation for the disparity in findings could be the different methods and data used in the analysis.

However, we are more concerned with the impact of capital structure during recessions. In the empirical studies we have reviewed, highly leveraged firms appear to be more severely affected by recessions. Geroski and Gregg (1996) find that firms with high levels of debt relative to total assets were more vulnerable in recessions. As we discussed above, their vulnerability construct encompassed both output growth and profit rates, indicating that highly leveraged firms suffer in both performance dimensions during downturns. Similar to Geroski and Gregg, Lien and Knudsen (2012), measuring recessionary impacts on demand reductions and credit constraints using survey data, find that industry-adjusted debt level was the most influential factor in determining vulnerability among Norwegian firms.

Campello et al (2010) find that financially constrained firms, i.e. firms unable to further increase their debt ratio, to a larger extent reduced investments, number of employees and marketing expenditures relative to unconstrained firms during the 2008-2009 recession.

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Though they do not explore the capital structure characteristics of credit constrained firms, it seems natural to assume that the reason they are denied further credit is an already high debt ratio. Campello et al. further show that three aspects of credit constraints drove the negative relationship between debt and performance: limited credit availability, higher costs of external funds and difficulties in retaining or establishing new lines of credits with banks. They do not investigate the impacts on profitability and growth, but the increased interest rates indicate that profitability should suffer as a consequence of being highly leveraged during recessions.

Furthermore, the reduction in investments, employees and marketing expenditure should intuitively induce a reduced growth relative to more moderately leveraged competitors.

Braun and Larrain (2004), when performing analyses on industry level, found that industries that are more dependent on external finance are more severely affected during recessions.

Using a sample of multiple manufacturing industries in more than a hundred countries, they find that output growth rates are disproportionately reduced for industries where high debt levels were the ‘norm’. Additionally, they discover that this leverage effect is exacerbated by capital market inefficiencies. In other words, the less effective capital markets were, the worse the impact on high-leverage industries.

Similar predictions as the ones discussed above are presented by Opler and Titman (1996).

They find that firms with a high debt to assets ratio lose market shares to less leveraged firms when faced with financial distress. They argue that this negative growth is partly attributable to customer and competitor actions, not only downsizing decisions by managers. Zingales (1998) show that exogenous shocks affected highly leveraged firms more heavily. He argues this is caused by predatory pricing of competitors viewing leveraged firms as easy targets for a price war. These findings coincide with the conclusions made by Chevalier (1995a; 1995b), who investigated competitive behavior among supermarket stores and found that prices tended to drop following leveraged buyouts. She argues that this is caused by predation on the buying firm, which experiences a sharp increase in debt levels following the buyout. In a related stream of research, Titman & Wessels (1988) investigate the effects of leverage on customer and supplier relations. They find that firms which can potentially incur high liquidation costs among stakeholders tend to choose lower debt ratios.

How can we explain the empirical findings above? Seen in light of debt overhang theory, the findings of Geroski and Gregg (1996), Lien and Knudsen (2012) and Campello et al. (2010)

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might indicate that recessions further increase the cost of financing investment projects with debt. For example, firms with high debt levels, who have already incurred high risk in the eyes of debtors, should face even steeper interest rates during downturns. As we saw above, this is directly supported by Campello et al. (2010). In the debt overhang model, this exacerbates the underinvestment problem, since debtors now retain even more of a project’s potential profit. Highly leveraged firms are therefore forced to forgo even more investment prospects with positive NPV, reducing growth. In light of this theory, recessions should therefore a greater reduction in profitability and growth relative to more modestly leveraged firms.

These findings can also be seen in light of trade-off theory. Recessions are likely to reduce the optimal debt ratio of firms, as creditors risk perceptions increase, effectively raising bankruptcy costs. This should lead firms to attempt a reduction in debt ratio, but this is costly and takes time. Meanwhile, their profitability performance is likely to suffer.

The findings of Braun and Larrain (2004) indicate that the underinvestment problems predicted in pecking-order theory is exacerbated by recessions. That decreased financial market efficiency further reduces growth might indicate that the preference of internal capital is strengthened during downturns.

The findings in Opler and Titman (1996), Zingales (1993) and Chevalier (1995a; 1995b) indicate recessions aggravate the mechanisms of capital structure on product market outcomes we presented in chapter 2.1.2.3. The findings from Titman and Wessels (1988) point in a similar direction. Their results indicate that firms anticipate that credit constraints exacerbate the mechanisms of switching costs and asset specificity.

In sum, it seems downturns exacerbate many of the theoretical mechanisms of how capital structure might affect growth. These findings point to a clear negative relationship between debt levels and growth and profitability during recessions. When comparing our discussion to the Modigliani-Miller theorem, it could be argued that recessions put further distance between the ‘real’ world and the one Modigliani and Miller imagined.

When formalizing our discussion into hypotheses, we have

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H.3.a: Debt has a negative effect on corporate growth performance during recessions.

H.4.a: Debt has a negative effect on corporate profitability performance during recessions.

Similar to the relationships in growth, we expect non-linearities in the effects of capital structure. This is perhaps most evident when looking at debt overhang theory, which implies that there exists some threshold before underinvestment problems start to arise. Above this threshold, we should intuitively expect the negative effects of debt to be increasingly negative. Firms with particularly high debt levels should therefore be relatively more severely affected.

H.3.b: During recessions the negative effect of debt on growth performance increases exponentially with debt levels.

H.4.b: During recessions the negative effect of debt on profitability performance increases exponentially with debt levels.