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E-MailRüdiger Fahlenbrach is Swiss Finance Institute professor at Ecole Polytechnique Fédérale de Lausanne (EPFL) College of Management; Kevin Rageth is Swiss Finance Institute doctoral student at EPFL; and René M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics at the Fisher College of Business at The Ohio State University. This post is based on their recent paper, forthcoming in The Review of Financial Studies.
In our forthcoming Review of Financial Studies publication (available here), we examine the value of financial flexibility for large, publicly listed companies in the US during the initial phase of the COVID-19 crisis.
The COVID-19 shock led to a dramatic temporary decrease in revenues for many firms, because production and selling activities conflicted with social distancing practices. For some firms, production halted, because production would have led to workers being highly exposed to COVID-19. For other firms, customer demand flatlined, because the firm’s goods and/or services entailed exposure to COVID-19.
Firms differ in how their financial affairs are organized. Some firms hold large amounts of cash to help them cope with unexpected events. They also keep debt capacity and limit their exposure to debt rollover risk. These firms have financial flexibility, so that they can more easily fund a cash flow shortfall, such as the one created by the COVID-19 shock. In contrast, firms with less financial flexibility might rapidly descend into financial distress and be forced to take actions that healthy firms would consider detrimental to long-term shareholder wealth.
We first analyze whether financial flexibility is valuable and if so, by how much, using firms’ stock performance from February 3 to March 23, 2020, which we call the collapse period. We consider firms to be more financially flexible if they have more cash, less short-term debt, and less long-term debt at the end of 2019. We find evidence supportive of the role of financial flexibility in our sample, which includes all U.S. industrial firms listed on exchanges at the end of 2019. When we compare highly financially flexible firms to firms with low flexibility, we find that the stock price of highly flexible firms fell by 26% less than the stock price of firms with low flexibility during the collapse period.
We expect that more financially flexible firms benefit less from the positive news about the stimulus package announced on March 23, 2020, that affected stock prices on March 24, 2020, a day we call stimulus day. On stimulus day, firms with less debt experience lower stock returns, but the other attributes of financial flexibility are not related to stock returns. We also find that the worse performance of firms with lower financial flexibility compared to their industry persists through the rebound of the stock market.
Since the COVID-19 shock has a greater and more direct impact on the revenues of firms that have greater exposure to COVID-19 because of how they produce or how they sell, we expect firms to benefit more from financial flexibility if they are more exposed to the shock. We find that when we classify industries as highly affected by the shock because of their sensitivity to the need for social distancing, firms in these industries benefitted more from higher cash holdings.
Firms with greater financial flexibility also performed better during the post-Lehman stock market drop in 2008–2009. We find that the coefficients for long-term debt and on cash holdings in our regressions explaining stock returns following the Lehman bankruptcy are remarkably similar to the coefficients for these variables in our regressions explaining stock returns during the COVID-19 shock. This suggests that for the sample as a whole the value of financial flexibility is similar across the two crises. However, we show that the industries that perform worst in 2008–2009 and the ones that perform worst in 2020 differ. The industries that perform worst during the collapse period in 2020 have a much higher exposure to the need for social distancing than the industries that have the worst performance in 2008-2009. Perhaps more importantly, the differential impact of cash holdings we document for firms exposed to the need for social distancing is unique to the COVID-19 shock and is economically large.
It is well-known since Modigliani and Miller (1958) that the equity of a levered firm is riskier than the equity of an otherwise identical firm with less leverage. Hence, it is important to ascertain that the greater stock return drop of firms with lower financial flexibility is not simply the mechanical result of these firms having more leverage. Three different facts that we describe in the paper show that the effect we document can reasonably be attributed to financial flexibility and not to leverage alone.
For given financial flexibility, corporate diversification could help firms cope better with an adverse shock if a conglomerate is active both in industries highly affected by the shock and in industries less affected by the shock. We find some evidence that such conglomerates performed better than stand-alone highly affected firms during the collapse period.
A way for firms to increase financial flexibility is through greater retention of cash flow. The CARES Act limits repurchases by corporations. In the public debate about the act, there was much discussion that corporations would have been more resilient had they received lower payouts in previous years. Surprisingly, there is no statistically significant relation between past payouts and stock returns during the collapse period whether or not we control for our financial flexibility proxies. We provide a straightforward explanation for this surprising result. If firms had not made payouts in 2019 (or 2017-2019) and had instead increased their cash holdings or decreased long-term debt, the impact for the average firm would have been small.
To conclude, we examine the value of financial flexibility in the unique situation of a sudden and unexpected revenue shortfall brought about by demand and supply shocks related to the increase in the need for social distancing associated with the COVID-19 shock. Across all firms, we find that, everything else equal, the revenue shortfall affects a firm’s stock less if the firm is more financially flexible. This benefit of financial flexibility is economically important. The difference between the stock price drop of a firm with high financial flexibility and the stock price drop of a firm with low financial flexibility is equal to 26% of the stock price drop of the average firm.
Though financial economists have argued that financial flexibility might be used to hurt shareholders (Jensen 1986), investor activists have campaigned to force firms to decrease cash holdings and increase leverage, and the private equity industry has made the reduction of financial flexibility intrinsic to its business model, the results of this paper should remind us that financial flexibility is also a key risk management tool. However, this tool does not come for free. Future research should help us understand better how to value the downside of financial flexibility to help shareholders and managers trade off the benefits and costs of financial flexibility more effectively.
The complete paper is available for download here.
