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.
In examining the investment patterns of the firms, the authors found evidence that diversified companies that reorganize may not be backing the right elements of their business during the bankruptcy process. Focusing on changes in the firms’ business segments from the end of the fiscal year prior to filing for Chapter 11 to the end of the fiscal year after emerging from bankruptcy, the authors found that 24 percent of the diversified firms reduced the number of their business units, 71 percent experienced no change, and 5 percent expanded the number of units.
“If a diversified firm makes efficient investment decisions, it should retain the main segments and divest the less important ones,” the authors write, but “these results show that less than a quarter of the sample reduces the number of segments.... Furthermore, diversified firms tend to divest segments with larger sales and assets during the Chapter 11 process, which may be costly if divestitures take place at fire sale prices.”
Additionally, the authors write, diversified firms may invest less efficiently than focused firms because well-run portions of the business may be forced to subsidize inefficient segments.
Another important takeaway from the study: Diversification benefits managers and increases their job security because their firms are less likely to go belly-up or liquidate once in bankruptcy. Therefore, the authors write, “managers are willing to undertake value-destroying diversification to derive private benefits,” betting that they will avoid the serious personal costs — including harm to their career prospects and loss of status — that typically occur when companies go bankrupt.
Diversified firms are less likely than more focused firms to go bankrupt and be liquidated as a result. However, once they have filed for Chapter 11, diversified firms take longer to restructure, make questionable decisions about how they reorganize, and pay higher costs during the process.