Title: Bankruptcy Risk, Costs and Corporate Diversification (Fee or subscription required.)
Authors: Rajeev Singhal and Yun (Ellen) Zhu (both Oakland University)
Publisher: Journal of Banking and Finance
Date Published: December 2011 (online) and forthcoming (print)
What effect does diversification have on the risk that a company will go bankrupt, and on the subsequent costs while it is in bankruptcy? According to this paper, diversification can be beneficial for the firm and its managers, but only to a point. Diversified companies are less likely to file for Chapter 11 and be liquidated than more single-minded firms, the authors find, because the breadth of their activities acts as something of a shield. But when they do go bankrupt, their complexity apparently turns against them, and they spend more time digging themselves out, paying higher costs along the way.
Although the effects of diversification have been studied in many corporate contexts, diversification’s impact on the risk and costs of bankruptcy has drawn little empirical scrutiny. The authors of this paper sought to fill that gap by analyzing all the Chapter 11 filings from 1991 through 2007 recorded by www.bankruptcydata.com, which amasses filings by all companies that have issued any public securities and that have at least $50 million in assets.
After excluding financial and utility firms (because of the different regulatory structures that affect bankruptcy in these industries), the authors were left with a sample of 769 bankruptcy filings. They measured diversification by counting the number of unique business segments in a firm as reported in the Compustat database. They also controlled for industry-wide propensity to diversify, as measured by merger waves in a given year, and ensured that their results were not driven by the varying size of the firms in the study.
Of the companies in the bankruptcy sample, 147 (or 19 percent) operated multiple business units and 622 (81 percent) had only one segment. To perform a regression analysis on the sample, the authors tried to match each of the bankrupt firms with a non-bankrupt company from the same industry that had comparable assets in the year of the Chapter 11 filing. They found matches for 601 of the sample companies.
An analysis of the matched companies revealed that diversified firms had a lower probability of filing for Chapter 11. Controlling for other factors, the authors compared companies that had multiple businesses with companies that had just one, and found that the likelihood of filing was 15 percent lower in the first group.
The authors also found that about 47 percent of the focused firms and 54 percent of the diversified companies reorganized as a result of the bankruptcy process. In terms of other outcomes, diversified firms did better than focused firms. About a third of the focused firms were liquidated, compared with 27 percent of the diversified companies. Diversified firms were also slightly less likely to be acquired by another company after they declared bankruptcy.
But it’s not all good news for diversified firms. On average, these firms stayed in Chapter 11 about three months longer than focused firms, or 15 months in all, before they were restructured, liquidated, or bought by another company, the authors found, which implies that diversified firms experience higher direct and indirect costs than focused firms going through bankruptcy. The authors argue that this could be because diversified firms are more complex and face a more complicated bankruptcy procedure.
Direct bankruptcy costs — including filing, legal, and professional fees — have been estimated in previous studies to equal about 3 percent of the market value of the pre-filing assets for large firms. Indirect costs, generally regarded to be much more substantial, include the lost profits from forfeited sales, losses from assets sold in fire sales, and less-than-optimal changes to a firm’s investment and financing policies while it is under duress.