Equity issues when in distress

• Date: 01 June 2019
• Author: Mark D. Walker,Qingqing Wu
• Published date: 01 June 2019
• DOI: http://doi.org/10.1111/eufm.12220

Eur Financ Manag. 2019;25:489–519. wileyonlinelibrary.com/journal/eufm © 2019 John Wiley & Sons Ltd.

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489

DOI: 10.1111/eufm.12220

ORIGINAL ARTICLE

Equity issues when in distress

Mark D. Walker

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Qingqing Wu

North Carolina State University, 2801

Founders Drive, Raleigh, North Carolina

Correspondence

Email: mdwalker@ncsu.edu

Abstract

We investigate the role of financial distress in the seasoned

equity market. We find that distressed firms comprise

about 40% of SEOs and these distressed issuers have worse

abnormal announcement returns than non‐distressed

issuers. Stock return volatility is an important determinant

for announcement returns for non‐distressed SEO issuers

but not for distressed SEO issuers. Signals of firm quality

are associated with better announcement returns, larger

issues, increased investment, improved operating perfor-

mance, and lower likelihood of delisting for distressed SEO

firmsascomparedtonon‐distressed firms. Our findings

suggest equity finance is valuable for financially distressed

firmswithstronggrowthprospects.

KEYWORDS

financial distress, SEO

JEL CLASSIFICATION

G31; G32

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INTRODUCTION

Firms that are in, or near, financial distress face additional costs in obtaining finance. For

distressed firms, raising debt capital may be more costly due to higher interest rates, or in more

extreme circumstances, further credit may simply be unavailable due to prior debt covenants or

unwillingness of lenders to extend further credit. New equity capital has its own additional costs

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FINANCIAL MANAGEMENT

We are grateful to an anonymous referee and John Doukas (the editor) for their insights and guidance. We also thank

Jesse Ellis, Sean Flynn, Michael Hertzel, Rongbing Huang, Jacob Kleinow, Srini Krishnamurthy, Stephen McKeon,

David Offenberg, Yuri Tserlukevich, and Suyan Zheng for helpful comments. This paper also benefitted from

participants’comments at the 2015 Financial Management Association meetings, the 2015 Eastern Finance Association

meetings, the 2017 Midwestern Finance Association meetings, and at seminars in Virginia Commonwealth University

and UNC Charlotte. All errors are our own.

for distressed firms. An equity issuance for a distressed firm should improve the firm’s ability to

repay debt thereby increasing the value of outstanding debt. Assuming that new shares are

purchased in the market at a fair price, the increase in debtholders’wealth necessarily comes

from the pre‐issuance shareholders, as described by Myers (1977). However, stockholders in

distressed firms also receive benefits from equity issues. Additional equity can increase the

continuation value of the firm, particularly if the firm has valuable projects that need finance.

The firm may also avoid equity issuance costs associated with pecking order considerations. If

debt is less attractive, or unavailable, the negative signal associated with the choice to issue

equity rather than debt will be weaker.

In this study, we provide further evidence on the role of equity finance for distressed firms.

We identify firms that have a higher probability of entering financial distress and choose to

issue equity using both Altman (1968) and Campbell, Hilscher, and Szilagyi (2008). Equity

issues by distressed firms are relatively common. Over our sample period of 1994–2015, 3,692

SEOs are conducted by industrial firms that meet our data requirements. Of these, 1,450 (39.3%)

have Altman’sZ‐scores that categorize them as being financially distressed. Compared to

non‐distressed firms, our distressed firms tend to have very poor operating performance, less

working capital, and more debt although not at extreme levels. However, both distressed and

non‐distressed SEO groups have high valuations relative to industry peers. These characteristics

are broadly less attractive to creditors, yet the high valuations indicate growth prospects that

would fit more for equity investors. The average abnormal returns for SEO announcements are

worse for distressed firms as compared to the abnormal returns for non‐distressed firms. This

finding suggests that the aggregate costs of issuing equity are greater for distressed firms than

for non‐distressed issuers.

We next examine these returns in the cross section. The wealth transfer hypothesis implies a

worse (more negative) reaction for those firms that have less ability to meet their debt

obligations. Consistent with this view, we find that the interest coverage ratio has a positive and

significant relation with abnormal returns suggesting that wealth transfers from existing equity

holders to debtholders are important, consistent with prior findings by Elliott, Prevost, and Rao

(2009).

Stock return volatility is often viewed as a proxy for information asymmetry, which has a

predicted negative relation with announcement returns for SEOs due to overvaluation

concerns.

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This negative impact of information asymmetry should generally be present for all

equity issuers; however, for two non‐exclusive reasons, stock return volatility may have

different effects for financially distressed firms. First, a distressed firm’s stock may have option‐

like characteristics since the firm has higher probability of entering a default state and an equity

issue may have a meaningful, positive impact on the firm’s continuation value. As such,

volatility could actually be value enhancing. Second, for distressed firms, although information

asymmetry may affect value negatively in general, there is less new information regarding firm

value associated with the choice to issue equity over debt, since debt is likely less (or not)

available. Therefore, we expect that stock return volatility will be more positive for distressed

firms’announcement returns either through the channel of greater volatility of future outcomes

or through less impact of information asymmetry.

Our multivariate analysis bears this prediction out for SEOs. High prior stock return

volatility is negatively related to abnormal announcement returns for non‐distressed SEO firms,

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For empirical evidence, see, for example, Lee and Masulis (2009).

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WALKER AND WU