Financial Distress as a Selection Mechanism: Evidence from the United States

Abstract

This paper analyzes financial distress as a selection mechanism. We follow the process of financial distress from its onset to its resolution for a sample of 102 firms that enter financial distress between 1979 and 1983. Only a little more than one-third of firms survive as independent companies. The main selection pressure comes from the acquisition market. Poor operating performance is not tolerated for long. The number of firms reporting negative operating income declines dramatically within a few years after the onset of financial distress, mainly due to the large number of firms that are acquired. A firm's short-run and long-run survival probability is positively affected by its operating performance, and the effect appears to be relatively strong. The only other factor systematically increasing a firm's survival probability is the willingness of creditors to take an equity stake in the firm. The roughly one-third of firms that survive financial distress as independent companies appear to be economically viable. They perform about as well as the industry median firm after emerging from financial distress and have overcome their financial difficulties within a median time of less than 3 years. Overall, the evidence suggests that there is substantial asset reallocation away from poorly performing firms and relatively little excessive continuation of inefficient firms.

Keywords: financial distress, bankruptcy, Chapter 11, survival, mergers and acquisitions

JEL Classification: G32, G33, G34