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E-MailHarry DeAngelo is Kenneth King Stonier Chair at the Marshall School of Business, University of Southern California. This post is based on a recent paper by Professor DeAngelo; Andrei S. Gonçalves, Ph.D. candidate at The Ohio State University; and René M. Stulz, the Everett D. Reese Chair of Banking and Monetary Economics at The Ohio State University and NBER.
Deleveraging is central to capital structure dynamics, yet systematic analysis of the phenomenon is limited to a handful of prior studies that examine changes in average leverage for samples of firms selected to have high and/or recently increased leverage ratios. Having a more complete understanding of the nature and extent of deleveraging is of first-order importance for corporate finance research where the Holy Grail is an empirically credible theory of capital structure. This issue is also important for macroeconomics where there is a need to understand corporate deleveraging in more normal times to have a baseline for gauging its hypothesized major role in generating periods of serious economic torpor such as the Great Depression, Japan’s Lost Decades, and the Great Recession.
In this paper, we examine corporate deleveraging using a firm-level longitudinal approach, and reach sharply different conclusions from prior studies, whose findings suggest that firms with high leverage tend to deleverage only modestly.
We find that most nonfinancial firms go through large-scale deleveraging episodes at some point in their histories, and that these episodes are typically focused on attaining low leverage capital structures while simultaneously building substantial cash balances. We also find that the extent of deleveraging from firms’ all-time peak market-leverage ratios reflects, to a remarkable degree, managerial decisions to repay debt and retain earnings. For our sample, passive deleveraging episodes—defined as cases in which leverage ratios fall, but not because of actions by managers—are the exception, not the rule. Deleveraging from all-time peak to subsequent trough generally plays out over a multi-year horizon, often after a recession.
Financial trouble is pervasive among firms at their historical leverage peaks and there is considerable heterogeneity in subsequent deleveraging outcomes, with attenuated deleveraging linked to financial distress. Almost 22% of firms are delisted due to distress at peak or in the next four years. Firms that are delisted in the four years after peak, whether due to distress or acquisition, typically have leverage ratios throughout their brief post-peak periods that are well above the leverage ratios at the post-peak trough of firms that are not delisted. Most of the latter firms deleverage to safe financial condition, restoring ample financial flexibility in terms of low leverage, high cash balances, and negative net debt.
Market leverage (debt/(debt + equity market value)) is 0.543 at the all-time peak and 0.026 at the later trough for the median among 4,476 nonfinancial firms with at least five years of post-peak data on Compustat. For these firms, deleveraging from peak to trough takes a median of six years, with about one third (33.2%) paying off all debt they had at peak market leverage (ML) and well over half (60.3%) deleveraging to negative net debt. Decisions to repay debt and retain earnings together account for a remarkable 93.7% of the peak-to-trough decline in ML for the median firm in this sample.
The cumulative deleveraging impact of earnings retention is substantial, especially from initially high to moderate market leverage and when firms increase debt while moving from peak leverage to trough. We also find that large-scale deleveraging is usually a slow process, which reflects the fact that retention, which can occur no faster than earnings arrive, is an important contributor to leverage reductions. These facts indicate one cannot understand capital structure dynamics without taking into account a firm’s retention policies.
Firm leverage is highly path dependent. We find that a simple model with a firm’s peak ML and ML at the prior trough has roughly twice the power to explain ML at the post-peak trough than a model with industry ML, firm profitability, and other variables traditionally used to explain leverage. The R2s are 36% and 19% respectively, and the gap becomes larger still with an R2 of 52% for the simple model augmented by information about whether a firm has had only a short time to deleverage, e.g., due to distress-related delisting soon after peak. The implication is that the key to explaining whether ML at the outcome of deleveraging is relatively high or low is knowledge of how high ML was at the peak and at the prior trough and whether the firm has had time to work its leverage back down.
Our findings are consistent with firms deleveraging to replenish financial flexibility, and are hard to reconcile with materially positive leverage targets as in traditional (corporate tax/distress cost) tradeoff theories of capital structure. At the same time, our findings point to an empirically important role for the distress-cost side of the tradeoff in the latter theories.
More generally, our findings highlight the need for theories that (i) can explain why most firms proactively deleverage from historical peak to near-zero market leverage (and negative net debt) after having had similarly conservative financial policies before peak, (ii) treat financial flexibility as a valuable and transitory element of financial policy, (iii) recognize the benefits of internally generated equity capital obtained through earnings retention, and (iv) have empirically important dependencies among leverage, cash-balance, and earnings-retention decisions.
The paper can be downloaded here.
