Disagreement and Capital Structure Complexity
33 Pages Posted: 27 Nov 2018 Last revised: 13 Mar 2019
Date Written: February 1, 2019
In the post-financial crisis period, many corporate bankruptcies involve complicated, fragmented capital structures characterized by many layers of debt and complex legal entity structures with many subsidiaries. Why do capital structures evolve this way, given that they make distress more costly to resolve? I suggest an answer based on the notion that investors may disagree about the value of assets that back loans. When such disagreement exists, firms have the incentive to exploit it by issuing claims that are targeted to subsets of the assets that investors are more optimistic about. This capital structure fragmentation can minimize the borrower's cost of funds ex-ante by maximizing creditors' perceived recoveries, but it can be socially inefficient, because it creates costly valuation disputes in bankruptcy. I show that disagreement about collateral values can cause inefficient liquidations. I also find that reorganizations, in which pre-bankruptcy creditors receive securities in the ongoing firm, allows parties to continue "agreeing to disagree" about the value of their entitlements. This can promote settlement and reduce costly litigation over valuation, relative to selling the firm as a going concern for cash.
Keywords: bankruptcy, capital structure, disagreement, valuation, subsidiaries
JEL Classification: G32, G33, K22
Suggested Citation: Suggested Citation