Introduction Model Data and Variables Results

Advanced Corporate Finance

Lecture 3
Conflicts of Interests and Market Liquidity in Bankruptcy
Auctions: Theory and Tests
Per Stömberg, Journal of Finance, 2000

Alexander Schandlbauer

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 Introduction Model Data and Variables Results

Problem of designing efficient bankruptcy laws

U.S. Chapter 7
I Liquidation. Example: Cash auctions
I Problem: Inefficiencies arising from transaction costs and market
liquidity

U.S. Chapter 11
I Reorganizations and structured bargaining
I Problem: Costly. Bargaining procedure frequently results in long
and wasteful negotiations. Absolute priority often violated.

Main research question: How important are the inefficiencies of

cash auctions economically?

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 Introduction Model Data and Variables Results

What are cash auctions in bankruptcy?

Upon entering bankruptcy:
Firm immediately ceases to exist
Control of the assets of the firm is transferred to a trustee
I Task: sell the assets for as high a price as possible
∗ piecemeal
∗ going concern
The proceeds from the assets are distributed to the claimants
I Absolute priority rule

Advantage:
Cash options separate the decision of how assets should be
used from the problem of how the proceeds should be distributed

Disadvantage:
Inefficient liquidations may arise, e.g. when the market for the
firm’s assets is illiquid
I timing of distress often coincides with an industry-wide downturn

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 Introduction Model Data and Variables Results

What does this paper do?

Combines theoretical model + empirical tests

Model
I 2 different bankruptcy outcomes:
∗ Liquidate operations (assets are sold to new owners, either piecemeal
or as a going concern)
∗ Operations sold back to pre-bankruptcy manager (= owner): involves
negotiations of existing bank loan, very similar to debt restructuring (!)
I Main theoretical prediction: When the market for the firm’s assets is
less liquid: asset sale-backs are more common

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 Introduction Model Data and Variables Results

What does this paper do?

(Continued)

Empirical results
I 205 Swedish cash auction bankruptcies of owner-managed firms
I Results support the model. Probability of sale-back is
∗ negatively related to asset market liquidity
∗ positively related to quality of incumbent management
I If the firm is liquidated rather than sold back: expected loss in
liquidation is between 23 and 39%
∗ Result suggests that fire sale liquidations are frequently avoided in
cash auctions
∗ as sale-backs are particularly common for firms facing illiquid asset
markets

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 Introduction Model Data and Variables Results

Model

3 decision making agents:

I bankruptcy trustee
I incumbent owner-manager
I bank
Bank debt B
Other passive creditors: Senior S and Junior J
Initially the firm just entered bankruptcy: control of a
court-appointed trustee
I Objective: maximize revenue from selling assets & distribute
proceeds according to the absolute priority rule
∗ first S, then B, finally J

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 Introduction Model Data and Variables Results

Sequence of events

Trustee: sell assets

I to either new owners (”liquidation”) or
I back to owner-manager (”sale back”)
Manager borrows funds from bank: submit a bit for assets: P
I If continued: the assets of the firm generate: X̃ , E(X̃ = µm )
If liquidated: random asset value at t=1: L̃, E(L̃ = µl )
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 Introduction Model Data and Variables Results

The sale-back decision (I)

Trustee’s choice at time 0: sell assets back to manager if P > µl

Expected payoff to bank
I in asset sale back: Πm
I in liquidation: Πl
Bank’s choice: prefer sale-back to liquidation if Πm > Πl
I If sale-back: bank lends the manager P ≥ µl in exchange for a
claim on the future cash flow X̃
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 Introduction Model Data and Variables Results

The sale-back decision (II)

Liquidation only occurs if the continuation value is not sufficient

to persuade the bank to finance the manager’s bid
I Bank captures all surplus in the sale-back

Asset sale-back: Maximum expected payout to the bank:

I the continuation value of the firm
+ the payoff on the bank’s original loan in a sale back
− the new funds lent to finance the sale-back
I Πm = µm + max( min(B, P − S) , 0) − P
| {z }
paid back to: bank or senior claimant
I Price is set as low as possible: P = µl

Liquidation: Expected payoff on the bank’s original loan

I Πl = E[max(min(B, L̃ − S), 0)]

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 Introduction Model Data and Variables Results

The sale-back decision (III)

Remember: Πm = µm + max(min(B, µl − S), 0) − µl and Πl = E[max(min(B, L̃ − S), 0)]

Asset sale-back occurs if: Πm > Πl

I µm ≥ µl + ν(B, S, L̃)
∗ ν(B, S, L̃) = (exp. payoff on bank loan in liquidation) − (payoff on
bank loan in sale-back)

Bankruptcy auction outcome will be affected by

I the value of the assets under continuation vs. liquidation (µm & µl )
I the firm’s debt structure via ν(B, S, L̃)
∗ ν(B, S, L̃) > 0 : bias towards liquidation
∗ ν(B, S, L̃) < 0 : bias towards asset sale-back
I the firm’s debt structure via q = S/(S + B)

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 Introduction Model Data and Variables Results

Market liquidity and management characteristics

Aim: Endogenize the exp. continuation and liquidation values µm and µl

Price the manager is willing to pay: V

Value of the assets to potential other outside users: (1 − Θ) V
I Θ: degree to which the assets are industry specific
Trustee: search for buyers
I industry insider: probability (1 − p) : V
I industry outsider: probability p : (1 − Θ) V
I expected proceeds from liquidation:
µl = (1 − p)V + p(1 − Θ)V = (1 − pΘ)V
Owner-manager: expected NPV of assets if sold-back: µm = QV
I Q: quality of the manager

Asset sale-back occurs if: µm > µl + ν(B, S, p, Θ, V , Ĩ)

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 Introduction Model Data and Variables Results

Empirical predictions
Remember: µm = QV and µl = (1 − pΘ)V

Main empirical predictions: QV > (1 − pΘ)V + ν(B, S, p, Θ, V , Ĩ)

Corollary 2: The probability of a sale-back will be increasing in

I the quality of the manager (Q)
I the probability that a liquidation will invoke a sale to an industry
outsider (p)
I the specificity of the assets (Θ)

Corollary 1: The probability of a sale-back is decreasing ind the

proportion of senior to non-junior debt

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 Introduction Model Data and Variables Results

Data: Descriptive statistics of sample bankruptcies

Tables 1 + 2

205 Swedish bankruptcy cases between 1988 - 1991

Relatively small firms:
I on average: 42 employees and sales of $5.5 million
Sample is comparable to other samples: no selection bias

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 Introduction Model Data and Variables Results

Variables (I)

Choice of state variables that determine the sale back decision:

Simplifying assumptions as µm > µl + ν(B, S, p, Θ, V , Ĩ) is
nonlinear:
I Management quality (Q) (remember: µm = QV )
I State variables for market liquidity (remember: µl = (1 − pΘ)V )
∗ p: prob. of having to sell assets to outside user
∗ Θ: value of assets to outside user
I Sale-back bias (ν)

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 Introduction Model Data and Variables Results

Variables (II)

Management quality:
I Performance relative to industry peers: EBITDA/sales
I Negative information about manager: bank initiated filing

Market liquidity
I Industry distress: ICR < 1 or bankruptcy w/i one year
I Value of assets to outsider: specific vs. non-specific assets

Sale back bias

I Calculate S, B and J

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 Introduction Model Data and Variables Results A) Sale-back decision B) Liquidation outcomes C) Economic significance

A) Analysis of the sale-back decision

A short introduction to a probit estimation

Goal: to estimate the sale-back condition:

QV > (1 − pΘ)V + ν(B, S, p, Θ, V , Ĩ)
Probit estimation:
I The dependent variable takes a binary outcome (can only take two
values)
∗ yes/no, man/woman, heart attack/no heart attack
I Estimate the probability that an observation will fall into a specific
one of the categories
I Researchers often report the marginal effect, which is the change
in y* for each unit change in x

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 Introduction Model Data and Variables Results A) Sale-back decision B) Liquidation outcomes C) Economic significance

A) Main results: Probability of liquidation

Probit estimation (Table 5); remember: QV > (1 − pΘ)V + ν(B, S, p, Θ, V , Ĩ)

The liquidation probability decreases in the state variables for

managerial quality
Market liquidity plays an important role
Structure of financial claims affect the bankruptcy outcome
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 Introduction Model Data and Variables Results A) Sale-back decision B) Liquidation outcomes C) Economic significance

A) Analysis of the liquidation outcomes

Probability of Liquidation:
Liquidations occur less often when the risk of fire sales is high
1 when the industry is more distressed
2 when the fraction of non-specific assets is low

If 1 and 2 truly proxy for illiquid asset markets, these variables would
also affect the probability of:
finding an alternative industry buyer (Table 6)
realized liquidation values (Table 7)

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 Introduction Model Data and Variables Results A) Sale-back decision B) Liquidation outcomes C) Economic significance

B) Main results: Probability of an outsider sale

Probit estimation (Table 6)

Probability of a liquidation sale to an outside party should

depend on how hard it is to find an industry insider willing to bid
for the assets
This should in turn depend on whether the industry firms are in
financial distress

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 Introduction Model Data and Variables Results A) Sale-back decision B) Liquidation outcomes C) Economic significance

B) Main results: Estimation of the liquidation values

Table 7

Open question: Are the sales to industry outsiders really fire

sales that result in lower liquidation values?
Answer: Regression on what determines liquidation values

Sales to outsiders yield lower liquidation values especially when

the bankrupt firm has fewer nonspecific assets

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 Introduction Model Data and Variables Results A) Sale-back decision B) Liquidation outcomes C) Economic significance

A) + B) Summary of the main findings:

Asset sales are more likely when industry distress is high and the
amount of nonspecific assets are low
Conditional on liquidation, the sales to industry outsiders
I are more likely when the industry is more distressed
I yield lower liquidation values

→ Bankruptcy sales-backs to incumbent management are used to

avoid inefficient liquidations

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 Introduction Model Data and Variables Results A) Sale-back decision B) Liquidation outcomes C) Economic significance

C) Economic significance
Table 8: Point estimates of expected fire-sale costs using fitted values obtained using the previous
coefficient estimates

Probability of liquidation resulting in an outsider sale (p): 70%

I 6% higher for sale-backs b/c more distressed industries & fewer
nonspecific assets
The loss in value from having to sell to an industry outsider (Θ)
I 29% to 52%
Estimated expected fire-sale liquidation costs (p * Θ):
I 23% - 39%; 8% higher for the sale backs compared to liquidations
I measure of the efficiency gain from being able to avoid fire sale
liquidations by selling the firm back to incumbent owner-manager
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 Introduction Model Data and Variables Results A) Sale-back decision B) Liquidation outcomes C) Economic significance

Conclusion

A sale of assets back to incumbent management is shown to be

relatively more likely when the bank benefits more from the sale-back
than a liquidation at the expense of other creditors.

The indebtedness of the firm’s of industry and the degree to which

assets are specific
1 increase the probability of a sale-back
2 decrease the expected liquidation value conditional on liquidation

Asset fire-sales and resales to management can lead to striking

inefficiencies in the cash auction system.

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