Debtholders:
The second pilar of this course: debtholders
Try to understand the role of debt(holders)
What is the debt-equity conflicts and how to mitigate it?
There are four forms of debtholder-equity holder conflicts. There creates not a bigger pie.
1. Debt overhang
Equity holders may underinvest, they may discard positive NPV project when the firm’s existing
debt captures most of the project’s benefits.
This is sometimes referred to as the underinvestment problem
With risky debt, equity holders have an incentive to pass up internally financed positive NPV
project when the funds can be paid out to equity holders as dividend.
2. Myopic (kortzichtig) investment
Equity holders may look for quick pay-off. They may prefer less profitable short-term projects
over more profitable long-term project.
Firms with large amounts of debt tend to pass up high NPV in favour of lower NPV projects that
pay of sooner
3. Asset substitution
Here equity holder’s gamble. They may take on overly risky projects, even if the NPV is
negative.
The equity holders of a levered firm may prefer a high-risk, low (or even negative) NPV project
to a low-risk, high NPV project
4. Reluctance to liquidate
Keep zombie alive. Equity holders may want to keep a firm operating even if its liquidation
value exceeds it operating value
Risk neutral: indifferent between two options (for example option 1: for sure 100 or option 2:
50% change op 200)
Lessons from the fourth debt-equity holder conflict
. Since debt holders have priority in the event of liquidation, they have a stronger interest in
liquidating the assets of a distressed firm than the firm’s equity holders.
Senior debtholders have more liquidation appetite than the junior debtholder.
. Equity holder profit from gambling (profit from the possible upside benefits that may have
realized if the firm continues to operate)
. As a result, a firm’s financial structure partially determines the conditions under which….
These four cases, try to connect this with examples.
, Evergrande example
Chinese property group Evergrande faces a huge debt crisis.
How is Evergrande’s business model?
- Buying land from local government, developing it and selling residential apartments
before finished
- Use the proceeds of those sales (along with debt) to finance further land purchases
Who is suffering most here?
- Shareholders & bondholders
- Homebuyers (stakeholders) who already paid for their homes yet to be built
- Employees (another stakeholder) who are about to lose their works
- International bond market
You need connections to get big loans
Bad accounting job of PwC, the three red flags in China are:
1. Liability to asset ratio of 70%
2. Net gearing ratio less than 100%
3. Cash to short-term debt ratio more than one
Main takeaways of the Evergrande clip:
1. Business model
2. The three red lines
3. Too much money > too big to fail
4. High(est) risk
5. Political connections
6. Consumer command couldn’t keep up with the demand
7. Keep building new apartments, even when the birth rate in China was slowing down.
This is an absolute growth model
How to minimize debtholder equity holder conflicts?
Simplest way is to get rid of debt. But then there is no leverage > probably suboptimal. No tax
advantage perhaps. Agency cost suboptimal too.
Several ways to mitigate the debtholder – equity holder conflict:
1. Protective covenants
Specify seniority of the debt, who is getting what in case of default
Specify how to distribute dividends and repurchasing.
Satisfy some restrictions (D/E, working capital etc.)
Restrict sale of an asset
Technical default > violating the rules of the contract.
2. Using bank and privately placed debt
Banks want to be part of the board of directors. Because then you have monitoring power
May eliminate ‘debt overhang problem’ and ‘asset substitution problem’
- Bank is better to able monitor
The second pilar of this course: debtholders
Try to understand the role of debt(holders)
What is the debt-equity conflicts and how to mitigate it?
There are four forms of debtholder-equity holder conflicts. There creates not a bigger pie.
1. Debt overhang
Equity holders may underinvest, they may discard positive NPV project when the firm’s existing
debt captures most of the project’s benefits.
This is sometimes referred to as the underinvestment problem
With risky debt, equity holders have an incentive to pass up internally financed positive NPV
project when the funds can be paid out to equity holders as dividend.
2. Myopic (kortzichtig) investment
Equity holders may look for quick pay-off. They may prefer less profitable short-term projects
over more profitable long-term project.
Firms with large amounts of debt tend to pass up high NPV in favour of lower NPV projects that
pay of sooner
3. Asset substitution
Here equity holder’s gamble. They may take on overly risky projects, even if the NPV is
negative.
The equity holders of a levered firm may prefer a high-risk, low (or even negative) NPV project
to a low-risk, high NPV project
4. Reluctance to liquidate
Keep zombie alive. Equity holders may want to keep a firm operating even if its liquidation
value exceeds it operating value
Risk neutral: indifferent between two options (for example option 1: for sure 100 or option 2:
50% change op 200)
Lessons from the fourth debt-equity holder conflict
. Since debt holders have priority in the event of liquidation, they have a stronger interest in
liquidating the assets of a distressed firm than the firm’s equity holders.
Senior debtholders have more liquidation appetite than the junior debtholder.
. Equity holder profit from gambling (profit from the possible upside benefits that may have
realized if the firm continues to operate)
. As a result, a firm’s financial structure partially determines the conditions under which….
These four cases, try to connect this with examples.
, Evergrande example
Chinese property group Evergrande faces a huge debt crisis.
How is Evergrande’s business model?
- Buying land from local government, developing it and selling residential apartments
before finished
- Use the proceeds of those sales (along with debt) to finance further land purchases
Who is suffering most here?
- Shareholders & bondholders
- Homebuyers (stakeholders) who already paid for their homes yet to be built
- Employees (another stakeholder) who are about to lose their works
- International bond market
You need connections to get big loans
Bad accounting job of PwC, the three red flags in China are:
1. Liability to asset ratio of 70%
2. Net gearing ratio less than 100%
3. Cash to short-term debt ratio more than one
Main takeaways of the Evergrande clip:
1. Business model
2. The three red lines
3. Too much money > too big to fail
4. High(est) risk
5. Political connections
6. Consumer command couldn’t keep up with the demand
7. Keep building new apartments, even when the birth rate in China was slowing down.
This is an absolute growth model
How to minimize debtholder equity holder conflicts?
Simplest way is to get rid of debt. But then there is no leverage > probably suboptimal. No tax
advantage perhaps. Agency cost suboptimal too.
Several ways to mitigate the debtholder – equity holder conflict:
1. Protective covenants
Specify seniority of the debt, who is getting what in case of default
Specify how to distribute dividends and repurchasing.
Satisfy some restrictions (D/E, working capital etc.)
Restrict sale of an asset
Technical default > violating the rules of the contract.
2. Using bank and privately placed debt
Banks want to be part of the board of directors. Because then you have monitoring power
May eliminate ‘debt overhang problem’ and ‘asset substitution problem’
- Bank is better to able monitor
