Question

Provide an example of a company that is debt adverse, but could drive additional earnings by increasing their debt load.

Answer 1

This study examines the hot debt market, or the clustering of debt issue volume in certain periods

of time, and the factors behind this phenomenon. In particular, by taking the perspective of the

pecking order theory and following a recent study by Doukas et al. (2011), I investigate whether

the active debt issue market is driven by adverse selection costs of equity. I hypothesize that when the time-varying information asymmetry related to a company is severe and consequently the adverse selection costs of issuing equity high, the firm takes on to issue debt in order the utilize the favorable window of opportunity even when no actual need for additional capital, i.e.real investment opportunities, existed. For the empirical analysis I use debt issue data ofsyndicated loans, public and private debt issues of non-financial companies from 1999-2009 in the U.S. The comprehensive data of the debt market allow me to further examine the behavior of different debt issue types and to contribute to the still limited literature on the drivers of variousdebt markets. Building on the pecking order theory and prior literature (e.g. Krishnaswami et al.,1999), I further test whether the hot market phenomenon is morepronounced for private debt.

For measuring the adverse selection costs I use four proxies, three of them (stock price beta,stock price synchronicity and residual volatility of stock price) directly related to firmperformance and one indirect measure (analysts’ earnings forecast dispersion). All the measuresare widely used in prior literature on adverse selection costs. The choice of multiple proxies is motivated by the ambiguous nature of information asymmetry of equity and the fact that no established benchmark measure of adverse selection costs exists but the measures instead vary from market microstructure-based to balance sheet figures.

I find that the aggregate issue volume strongly clusters in years 2005-2007 and is in particular driven by the increase in the issue volume of syndicated loans. The hot debt months, or the months ranked in the top 30% issue volume, consequently occur in these years for the aggregate sample and the subsample of syndicated loans. Investigation of two other subsamples, namely public and private debt issues, reveals that these markets have behaved in significantly other way in 1999-2009 having their hot debt months in 2001-2002 and 2006-2009 for public debt issues and 2000-2001, 2003-2004 and 2006 for private debt. Concerning all the three debt types, I also find that over the year firms prefer issuing debt close after disclosing financial information from the previous year to further minimize the information asymmetry (Dierkens, 1991) even though in the case of debt this were not as critical as for equity issues.

When examining the determinants behind debt issue clusters, I find that in addition to higher adverse selection costs, firms are driven to the active debt issue market for favorable debt market conditions. Most importantly for the focus of the study, on the basis of stock beta and stock pricesynchronicity, the results allow me to accept the hypothesis of the dependence of debt issue clusters on information asymmetry in aggregate and for the syndicated loan market. In the public and private debt market, contrary to what Doukas et al. (2011) report, adverse selection costs do not seem to have the expected positive impact on the occurrence of hot debt months.The importance of lower interest rates and risk spreads provides supporting evidence for the naïve timing strategy of companies earlier documented by e.g. Barry et al. (2008). While thedeterminants of hot debt months of syndicated loans and public debt issues confirm earlier evidence of counter-cyclicality of debt issuance (Choe et al., 1993), the private debt market appears to peak in expansionary periods in the economy, and also increase in issue volume in times of high equity market returns. Without plunging further in the analysis, these results

suggest that the market of private placements of debt actually behaves more equity-like and thus is not as clear substitute for the public debt as some earlier research (e.g. Denis and Mihov, 2003; Gomes and Phillips, 2007, working paper) suggests.

According to the results, it seems that the debt market timing to time-varying adverse selection costs is more pronounced for private debt issuance as the hypothesis H2 argues. Syndicated loans, that basically are private debt issued to financial institutions, provide the most convincingevidence for this. I find that the adverse selection costs are the highest for both hot and cold syndicated loan issuers of all the subsamples. Moreover, evidencing the timing attempts, document that the hot syndicated loan issuers make significantly larger issues and issue atconsiderably longer maturities than issuers in other times. For the sample of private debt issues, I find that the impact of hot debt market on the issue size is significant, which further supports the hypothesis.The massive volume of syndicated loans and the unexpected behavior in this market of relationship-based lending does, in fact, support the overall theory of this study on the importance of adverse selection costs as a debt issue driver. The surge of private debt and consequently the low levels of corporate bond issue volume suggest that companies have relied more on this type of relationship banking partially due to its information-safety. In other words, adverse selection costs seem to have affected companies’ financing decision between not only equity and debt but also between different debt types in the line of the pecking order theory and earlier studies such as Krishnaswami et al (1999). The fall of the private debt market conflicts with this explanation,but the private placement market has distinct characteristics such as limited issue size and relative complexity of arrangement. Thus, even though private debt might appear as a preferredinstrument to corporate bond due its information-safety, it cannot be considered as a real alternative to public issuance, as earlier noted. The sudden crash of the syndicated loan market also challenges the explanation on the pecking order of debt instruments but it is more probablydue to radically decreased supply that has dried up amid collapses of banks, uncertainty related to financial institutions as a whole and tightened regulation than a dramatic change in adverse lselection costs of equity.

Regarding the hypothesis H3 that hot debt issuers issue more debt than cold debt issuers for utilizing the window of opportunity, I do find that the issue size is larger for hot debt issuers than for cold debt issuers the average difference being 4.1 % points in the aggregate sample. This complements the findings on the hot market effect on issue size in Alti (2006) and Doukas et al.(2011). In line with earlier studies such as Denis and Mihov (2003) and Arena (2011), Idocument larger issue sizes for private (private and syndicated loans) than public debt. However,higher adverse selection costs do not seem to encourage firms to make larger debt issues in hot debt months on average. For public and private debt issues information asymmetry appears tohave some explanatory power on the issue size. Mostly, however, it is other factors, such as profitability, pre-issue leverage ratio and small firm size that increase the issue size. For the hypothesis H4, the proceeds from hot debt issues are not used for investments i.e. issuedecision is not driven by real investment opportunities but mainly determined by market conditions, I investigate the impact of hot debt month and adverse selection costs on the dynamics of leverage and its components. I find that a debt issue in a hot debt market increases the leverage ratio, reduces the net equity issuance, increases retained earnings and decreases cash holdings. The results for the aggregate sample and also for syndicated loans thus suggest rejecting the forth hypothesis. However, in case of public and private debt issues, a hot debt issue accumulates cash reserves providing evidence in favor of the hypothesis. The regression results confirm that the impact of hot debt issuance on the issuer’s balance sheet does not tell about timing attempts, in aggregate, even though in case of public and private debt issues the regressions yield results consistent with the hypothesis. Against the research question, the statistical significance of the impact of adverse selection costs in the use of proceeds appears weak.

In overall, based on this study it appears that timing considerations do play a role in firms’ capital structure decisions and that especially the unusual behavior of syndicated loan market seems to have been partially affected by the asymmetrical information between investors and managers.The relation between adverse selection costs and debt market timing is varying in magnitude and also in direction for different debt types, but perceptible and positive for syndicated loans.Nevertheless, as pointed out in Section 1.3. as one limitation of the study, finding reliable evidence of this relation still suffers from the ambiguous nature of information asymmetry and the lack of valid measures to proxy for adverse selection costs of equity. This clearly challenges the interpretation of the results of also this study as the measures are known to be able to capture the phenomenon far from perfectly and each from a slightly different angle.Similarly, when drawing conclusions about drivers of debt issue clusters it must be kept in mindthat using regressions does allow examining the relative importance of certain factors behind a phenomenon but in the same time suffers from extreme simplification. There may be factors that are difficult to control and include in models but which yet may have significant explanatorypower. As Bayless and Chaplinsky (1996) note in their study on equity market timing, herding and fad-based behavior provide a partial explanation for the increased volume in hot periods and these basically unidentified determinants of issue volume result in hot and cold issue markets being defined with some noise. As earlier discussed, especially the case for syndicated loans with an exceptionally strong rise (and later fall) in volume suggests that in addition to factors addressed in this study there are forces behind this phenomenon that may be related to this kind of herding, either on the demand or supply side.

Regarding the implications for practice, the most important contribution of the study is the broadened understanding of the drivers of the debt issue market. This is not a trivial issue amid the globally increasing importance of debt financing. The finding that companies are prone to opportunistic behavior regarding the timing of the issue and the choice of debt type gives debt investors an improved insight into the market. For example, the results indicate that a relativelylarge supply of debt issues, of syndicated loans in particular, should be expected in a counter99 cyclical (and high information asymmetry) period in the economy, which may pull down debt prices. The results also benefit equity investors. As the adverse selection costs were found to be

high in the hot syndicated loan market, at that time investors should with caution invest in the shares of these issuers potentially subject to mispricing. Whether, in money terms, it actually is profitable for companies to issue in a hot debt market would require analyzing the prices paid for debt or the development of company value of hot debt issuers, an issue which is left for future research to examine.