Overcoming Overhang Agency Costs, Investment and t

OvercomingOverhang:AgencyCosts,InvestmentandtheOptiontoRepurchaseDebtBRANDONR.JULIO∗November2006[JobMarketPaper]ABSTRACTThepresenceofriskydebtinafirm’scapitalstructurecanleadtoinefficientinvestmentde-cisionswhenmanagersactintheinterestofshareholders.Basedonthisagencycostperspective,Idescribethemarketfordebtrepurchasesandexaminewhetherdebtrepurchaseactivityiscon-sistentwithafirm’sdesiretomitigatedebtoverhang.Ipresentanagencymodelofdebtwhichdemonstratesthatwhenafirmfacesadebtoverhangproblem,thevalueofareductionindebtcanoutweighthecostoftherepurchaseandincreasethewelfareofbothstockholdersandbondholders.UsingasampleofdebtrepurchasesinitiatedbyU.S.firmsovertheperiod1996to2004,Ifindevidenceconsistentwiththeagencycostmodelofcorporatedebtpolicy.Specifically,Ifindthatfirmsaremorelikelytorepurchaseoutstandingdebteitherbyopenmarkettransactionsortenderofferswhenpotentialtransferstobondholdersarehigh.Employingamatchingmethodologybasedonpropensityscores,Idocumentsignificantincreasesinfirminvestmentlevelsandefficiencyforrepurchasingfirmsrelativetoacontrolsample.Thisimprovementismorepronouncedforfirmswithhigherexpectedtransferstobondholders(overhang).Inaddition,theefficiencyimprovementsareconcentratedininvestmentexpendituresrelatedtonewinvestmentprojects,ratherthaninex-pendituresonmaintainingexistingassets.Thisfindingisrobusttocorrectionsforselectionbiasandendogeneity,aswellasvariousproxiesforgrowthopportunities.Keywords:CapitalStructure;DebtOverhang;InvestmentPolicy;AgencyCosts;CashPolicy;JELClassification:G31;G32∗DepartmentofFinance,UniversityofIllinoisatUrbana-Champaign.Contactinformation:340WohlersHall,1206S.SixthStreet,Champaign,IL61280;e-mail:[e-mail];phone:[phone].IthankSeanBrady,BoBecker,MurilloCampello,DavidIkenberry,WoojinKim,TimOpler,JoshPollet,MichaelWeisbach,JoshWhiteandseminarparticipantsattheUniversityofIllinoisforcomments.I’malsogratefulforhelpfuldiscussionswithmembersoftheLiabilitiesManagementgroupatCreditSuisseFirstBoston.Theusualdisclaimerapplies.I.IntroductionWhyandwhendofirmsrepurchasepubliclytradeddebt?Althoughdebtretirementbyopenmarketrepurchasesandtenderoffersarerathercommon,verylittleisunderstoodaboutthemarketfordebtrepurchasesandthemotivesbehindthesefinancingactivities.Thisissurprising,giventhelargeamountofmoneyinvolvedinthesetransactions.In2004,forexample,totalcashrepurchasesofpubliclytradeddebtby347U.S.firmsexceeded$60Billion1.Debtrepurchasestendtobequitelarge,averaging$120.67millionpertransaction.Therepurchaseretires61%ofthefacevalueofthetargetedbondonaverage,andreducestherepurchasingfirm’sleverageratiobymorethan16%.Itisnotobviouswhyafirmwouldchoosetomakenon-requiredpaymentstobondholdersratherthaninvestorpaythecashdirectlytotheshareholdersintheformofdividendsorsharerepurchases.Ifamanagerisactingintheinterestoftheshareholders,theremustbesomevaluetorepurchasingdebtfromtheperspectiveoftheownersofthefirm.Thispaperexaminesanagency-costbasedexplanationasonepotentialmotiveforwhyfirmschoosetorepurchaseoutstandingpublicdebt.UsingaspecialsampleofopenmarketdebtrepurchasesandtenderoffersbyUSfirmsovertheperiod1996to2004,Iempiricallytestthepredictionsofthemodelandfindevidencethattheagency-costmodelofdebtpredictsboththetimingandinvestmentimpactofdebtrepurchases.Whenafirmaddsriskydebttoitscapitalstructure,itintroducesaseriesoffinancialobligations,legalconstraints,andincentiveswhichcancauseconflictsbetweenmanagers,shareholdersanddebtholders.Myers(1977)showedthatwhenafirmhasriskydebtinitscapitalstructure,managersact-ingintheinterestofshareholdersmayrejectpositivenetpresentvalueinvestmentopportunities.This”underinvestment”or“debtoverhang”problemoccurswhenapositivenetpresentvalueprojectde-creasesthevalueofequitybecausesomeofthevaluecreatedgoestothedebtholders.Inotherwords,debtoverhangincreasestherequiredrateofreturntoequityholdersandmakesitdifficultforafirmtoobtainexternalfinancing.Inefficienciesarisingfrompotentialtransferstobondholdersrepresentawell-knownagencycostofdebt,whichisespeciallytroublesomewhentheoutstandingdebtispubliclytradedandhencedifficultorimpossibletorenegotiate.Ifafirm’sexistingdebtstructurecausesdeviationsfromitsoptimalinvestmentpolicy,therewillbegainsassociatedwithadjustingthelevelorcompositionofdebtonthefirm’sbalancesheet.Whenthesegainsoutweighthecostsofadjustment,weexpecttoobservechangesinthefirm’scapitalstruc-ture.Buildingonthisintuition,thispaperarguesthatwhenpotentialtransfersofinvestmentpayoffs1Thisrepresentsonlycashrepurchasesofpubliclytradedbonds.Thisdoesnotincludedebtretirementsbycalls,puts,sinkingfunds,conversions,refundingsorrefinancings.1tobondholdersarehigh,thegainstoshareholdersfromimprovementsininvestmentefficiencyandimprovedaccesstoexternalcapitalarelargerthanthecostofforegonecashholdingsusedtorepur-chaseoutstandingdebt.Thus,indescribingthemarketforrepurchasingdebt,thispapershedslightonsomeinterestinginteractionsbetweenafirm’sinvestment,cash,andcapitalstructurechoices.Ipresentamodelinwhichthereductionofcashholdingsinexchangeforareductionintheamountofpublicdebtoutstandingismotivatedbythegainsaccruingtoboths