Is Leverage an Invitation to Bankruptcy?

Abstract

High-debt ratios that factor in leveraged buy-outs, recapitalizations, highly leveraged mergers and stock repurchases are a source of concern in the press and public-policy circles. Yet they can be a virtue because they provide strong incentives for efficiency, even where the specter of bankruptcy is concerned.

Even where bankruptcy does occur, debt and insolvency can serve a very important control function to replace what seems to be the failed model in which the public board of directors monitors management and its strategy directly. The recent case of Revco, the largest LBO to go into bankruptcy, exemplifies this point. The deal may have been poorly structured to begin with. In addition, however, Revco managers pursued a strategy to upgrade the company's drugstores to department stores. The strategy failed, but the high debt load prevented Revco from pursuing the flawed project for long because insolvency and bankruptcy allowed the creditors and owners to replace managers and facilitate abandonment of the strategy. Such rapid change in management and strategy is highly unlikely to occur under the usual public-director/low-leverage control model of the typical American corporation.

Keywords: Insolvency, bankruptcy, efficiency