JOURNAL,OF

Fhanclal
ELSEYIER Journal of Financial Economics 37 (1995) 129-157
ECONOMICS

Causes of financial distress following leveraged

recapitalizations
David J. Denis, Diane K. Denis
Virginia Polytechnic Institute and State University, Blacksburg, VA 24061-0221, USA

(Received June 1993; final version received April 1994)

Abstract

We report that 31% of the firms completingleveragedrecapitalizationsbetween1985

and 1988subsequentlyencounterfinancialdistress.Following their recaps, the distressed
firms exhibit (1) poor operating performancedue largely to industry-wide problems,(2)
surprisingly low proceedsfrom assetsales,and (3) negative stock price reactionsto
economicand regulatory events associatedwith the demiseof the market for highly-
leveragedtransactions.The incidenceof distressis not related to severalcharacteristics
that have previouslybeenlinked with poorly-structured deals.We thusattribute the high
rate of distressprimarily to unexpectedmacroeconomicand regulatory developments.

Key words: Financial distress; Recapitalizations; Leverage

JEL classijication: G32; G33; G34; G35

1. Introduction

Corporate restructuring in the 1980s included a large number of highly-

leveraged transactions in which firms borrowed against future cash flows to
make cash payments to their shareholders. Numerous previous studies provide

We are grateful for helpful comments received from Ben Branch, Leroy Brooks, Dave Brown, Rob
Hansen, Scott Harrington, Michael Jensen, Greg Kadlec, Wayne Mikkelson (the editor), Greg
Niehaus, Tim Opler, Meir Schneller, Vijay Singal, Michael Vetsuypens (the referee), Ralph Walkling,
and Marc Zenner. The paper has also benefited from presentations at the University of Florida, the
NBER, the University of Pittsburgh, the University of South Carolina, the 1993 FMA meetings, and
the 1994 AFA meetings.

0304-405X/95/$07.00 0 1995 Elsevier Science S.A. All rights reserved

SSDI 0304405X9400792 Y
130 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157

evidence that such transactions improve firm value and operating efficiency.’
More recently, however, many highly-levered firms have encountered financial
distress. For example, Kaplan and Stein (1993) report that 36% of firms
completing management buyouts between 1985 and 1989 subsequently de-
faulted on their debt. This high rate of default has led many to question whether
the benefits from highly-leveraged transactions have been overstated.
Two hypotheses can explain the recent surge in failed transactions. First, the
market for these transactions may have become overheated in the latter part of
the decade, resulting in deals that were overpriced and poorly structured and,
thus, should not have been undertaken. Kaplan and Stein (1993) present evi-
dence of changes in the structure of large management buyouts in the 1980s
that is consistent with this hypothesis.
An alternative, but not mutually exclusive, hypothesis is that problems with
highly-leveraged transactions in the late 1980s stemmed from macroeconomic
and regulatory developments such as the recession, the collapse of the junk bond
market, and the credit crunch of 1990. Thus, transactions that were value-
increasing ex ante may have failed for reasons outside the control of those who
designed them. For example, the economic recession of 1990-91 is likely to have
reduced operating cash flows, thereby increasing the likelihood that a
highly-levered firm would be unable to meet its debt obligations. The recession
may also have had a second, less obvious, effect. Shleifer and Vishny (1992)
argue that asset markets are less liquid during an economic downturn. An
unexpected decline in asset liquidity is particularly damaging to firms for which
asset sales are necessary in order to meet their debt obligations, as is the case in
many highly-leveraged transactions. In addition, Jensen (1991) argues that
several developments, including regulatory restrictions on investments in high-
yield instruments, the prosecution of Drexel Burnham Lambert, and a reduction
in net new lending to the corporate sector by commercial banks (Putnam, 1991,
reports that net new lending to the nonfinancial corporate sector by commercial
banks collapsed from $33 billion in 1989 to $2 billion in 1990), not only reduced
funding available for the purchase of corporate assets but also made it more
difficult for distressed firms to recontract with debt claimants.
We provide evidence on the causes of financial distress following highly-
leveraged transactions by examining a sample of 29 leveraged recapitalizations
(recaps) completed between 1985 and 1988. Unlike firms that complete
leveraged buyouts, firms that undergo leveraged recapitalizations remain
publicly traded. This makes them well-suited for studying the long-run conse-
quences of highly-leveraged transactions because more complete post-transac-
tion data is available through published financial statements.

‘See Kaplan (1989), Muscarella and Vetsuypens (1990), Opler (1992), and Smith (1990) for evidence
on improvements in operating efficiency and equity value following leveraged buyouts. See Denis
and Denis (1993) and Palepu and Wruck (1992) for the effects of leveraged recapitalizations.
 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157 131

A large fraction of our sample transactions subsequently encounter financial

distress: nine of the 29 firms either file for Chapter 11 or restructure their debt
claims out-of-court by the end of 1991. On average, the firms that experience
distress structure their recaps such that they are more highly levered and
have tighter interest coverage ratios than the other firms. These findings are
consistent with both the overheating hypothesis and the hypothesis that, ex
ante, the distressed firms expected to engage in a greater amount of post-recap
restructuring but unfavorable events following the recaps limited the extent of
this activity.
We report several findings that support the hypothesis that the recession as
well as legal and regulatory developments adversely affected the sample re-
capitalizations. First, we find that the distressed firms in the sample are charac-
terized by large negative changes in operating performance in the three years
following the recapitalization. However, industry-adjusted performance changes
in these same firms are insignificantly positive over the same period, suggesting
that broader economic factors are largely responsible for the poor performance
of the distressed firms.
Second, we do not find a higher rate of asset sales among the distressed firms,
which is surprising given tighter interest coverage ratios at the time of recapital-
ization and the lack of performance improvement following the recaps. We also
find that announcements of asset sales by the distressed firms are met with
negative stock price reactions and that these negative reactions are concentrated
among those firms operating in poorly-performing industries. In contrast, asset
sales announcements by the firms that are not in distress are met with positive
stock price reactions. We conclude that the distressed firms had difficulty selling
assets and received lower-than-expected prices for the assets they did sell due to
an unanticipated reduction in the liquidity of asset markets. Furthermore, our
estimates suggest that five of the nine distressed firms would have been able to
meet required debt payments in the year of default had asset sales produced the
anticipated proceeds.
Finally, an event-study analysis of seven economic and regulatory events
related to the demise of the market for highly-leveraged transactions indicates
that, while announcements of these events are associated with significant nega-
tive abnormal returns for the full sample of recaps, the firms that eventually
encounter financial distress experience a significantly more negative cumulative
abnormal return over all seven events.
We also examine several characteristics that have previously been linked to
poorly-structured deals, including the use of junk bond financing, the extent of
managerial ‘cashing out’ in the transactions, and the incidence of pre-recap
hostile takeover bids. We find that the distressed and nondistressed firms do not
differ significantly with respect to any of these characteristics, suggesting that
poor deal structure is not the primary explanation for the incidence of financial
distress in our sample.
132 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157

2. Sample description

2.1. Sample selection

Our sample consists of the completed leveraged recapitalizations studied in

Denis and Denis (1993). All firms announcing public leveraged recapitalizations
over the period 1984-1988 are identified by searching the Dow Jones News
Retrieval for all forms of the word ‘recapitalize’.’ We select those cases in which
firms propose leveraged recapitalizations consisting of a payout to common
shareholders that is financed by new borrowings. From an initial sample of 40
proposed recapitalizations, one transaction is excluded because it created a new
class of shares with limited voting rights and ten recapitalizations are excluded
because they are not completed (nine of these ten firms are acquired and one
withdraws its recap proposal). This leaves a sample of 29 completed recapital-
izations.
The sample recapitalizations are structured in a variety of ways. The common
characteristics are a large increase in leverage and a large payout to common
shareholders; the median payout is 96% of the pre-recap market value of the
firm’s equity. The payouts are made via special dividends, share repurchases,
and exchange offers made up of some combination of cash, debt securities,
and/or new common shares for existing shares.
Leveraged recapitalizations differ from leveraged buyouts in that buyouts are
characterized by larger increases in managerial ownership and are often spon-
sored by promoters (such as Kohlberg, Kravis, and Roberts) who represent
a majority of the equity and hold a majority of the seats on the board of
directors. Given these differences in organizational structure between leveraged
buyouts and leveraged recaps, the extent to which our results can be generalized
to leveraged buyouts is an open question.

2.2. Incidence ofJnancia1 distress

We examine the Wall Street Journal and its index for any indications of
financial distress for our sample firms from the time of the completion of the
recap through December 31, 1991. We define distress as either a restructuring of
debt claims for the purposes of avoiding or resolving default or a filing for
Chapter 11 under the U.S. Bankruptcy Code. Debt restructurings are defined as
in Gilson (1989) and include (a) reductions in stated interest or principal,

ZWe are unable to search the Dow Jones News Retrieval prior to 1984. However, to our knowledge,
there were few (if any) leveraged recaps prior to 1984. Indeed, only one of our sample recaps is
announced in 1984. Ending the sampling period in 1988 allows for at least three post-recap years of
data for each transaction.
 D.J. Denis, D.K. DenisjJournal of Financial Economics 37 (1995) 129-157 133

(b) extensions of debt maturity, or (c) grants of equity interests to creditors.3 Of

our 29 sample firms, nine (3 1 “A) subsequently encounter financial distress; four
of these eventually file for bankruptcy under Chapter 11. (The nature of each
firm’s distress and details of the events leading up to and following it are
described in the Appendix.)
Financial distress is concentrated in the most recent years and among the
firms that completed recaps most recently. Seven of the nine firms encountering
financial distress do so in 1990 and 1991. Only one of the ten recaps completed
in 1985 and 1986 becomes financially distressed, while eight of the 19 recaps
completed in 1987 and 1988 encounter some form of distress by the end of 1991.
This time pattern suggests either that the later recaps were more likely to be
poorly structured or that their later completion dates left the firms insufficient
time to accomplish planned restructurings before the onset of macroeconomic
and regulatory problems.
We measure the change in firm value associated with the recap by calculating
cumulative abnormal returns over the period extending from 40 days prior to
the first indication of any corporate control activity or the date of the recap
announcement (whichever is sooner) through completion of the recap. Because
25 of our sample recaps are announced following either a hostile takeover bid or
rumors that the firm is a takeover target, two-day recap-announcement abnor-
mal returns would measure only the marginal value of the recap proposal
relative to the expected value of the control threat. [The rate of corporate
control activity is nearly identical in the samples of distressed (89O/) and
nondistressed (85%) firms. None of these takeover bids are successful.] Abnor-
mal returns are computed using the standard market model technique; pa-
rameters are estimated over the 250-day period beginning 290 days prior to
day zero. Significance of median cumulative abnormal returns is calculated
using the Wilcoxon signed-ranks test.
Use of a pre-recap estimation period to calculate post-recap cumulative
abnormal returns implicitly assumes that beta is stationary over the two periods,
despite the fact that the recaps lead to significant increases in the leverage of the

W is possible that our examination of the Wall Street Journal fails to identify some cases of financial
distress and we therefore misclassify some firms. To examine this possibility, we also defined distress
on the basis of interest coverage ratios. Following Asquith, Gertner, and Scharfstein (1992), a firm is
classified as financially distressed if in any two consecutive years its ratio of operating earnings to
interest expense is less than 1.0 or if in any single year this ratio is less than 0.8. The use of this
definition did not identify any additional distressed firms. In fact, only one other firm (Newmont
Mining) had a coverage ratio of less than 1.5 in any year. Newmont’s ratio was 1.2 in the first year
following its recap, but rose to 2.1 by the following year. On the other hand, one of the firms that we
classify as distressed (Holiday) on the basis of an offer to exchange new debt for old would not be
classified as distressed on the basis of its coverage ratio. Our results are not sensitive to the inclusion
of this firm among the distressed firms.
134 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (199.5) 129-157

sample firms. Similar to Kaplan and Stein (1990) and Palepu and Wruck (1992) we
do not find large increases in beta estimates following our sample transactions.
Moreover, there are no statistically significant differences in beta estimates between
the distressed and nondistressed firms either before or after the sample recapitaliza-
tions. We obtain similar results computing abnormal holding period returns rather
than cumulative abnormal returns and annualizing post-recap abnormal returns to
account for the variation in the length of the post-recap period across firms.
Interestingly, there is no significant difference in the cumulative abnormal
returns of the distressed and nondistressed firms over the recap period. Median
cumulative abnormal returns are 25.8% for the nondistressed firms and 32.9%
for the distressed firms. Not surprisingly, however, there is a large difference in
post-recap abnormal returns. Over the period from completion of the recap
through December 31, 1991, median cumulative abnormal returns are an
insignificant - 0.9% for the nondistressed firms and a significant (at the 10%
level) - 56.3% for the distressed firms. The large positive market response to
the recaps of the distressed firms and their strongly negative cumulative abnor-
mal returns in the post-recap period suggest that the market did not view the
distressed firms’ recaps as being poorly structured, ex ante.

2.3. Debt service requirements

In Table 1 we present evidence on the post-recap debt service requirements of

the sample firms. We report average and median values but focus on medians to
control for the influence of outliers. Panel A reports post-recap coverage and debt
ratios. We measure coverage as the ratio of operating income in the year prior to
the recap to debt payments due in the first year after the recap. The median ratio
of pre-recap operating income to post-recap interest payments is 1.82 for firms
that encounter financial distress and 3.83 for the other firms. Similarly, the ratio of
pre-recap operating income to the sum of post-recap interest and principal
payments is 0.80 for the distressed firms and 2.49 for the nondistressed firms.
These differences are significant at the 0.02 and 0.07 levels, respectively.
The distressed firms are also characterized by somewhat higher debt ratios as
of the end of the fiscal year in which the recap is completed. The median ratio of
long-term debt to total assets is 0.75 for the distressed firms and 0.48 for the
nondistressed firms. Similarly, the ratio of total debt to total assets is 1.14 for the
distressed firms and 0.91 for the nondistressed firms. These differences, however,
are not statistically significant.
Panel B provides further evidence on the 1everage:induced constraints by
computing the additional cash required to avoid default and the percentage
changes in operating income, total assets, and capital expenditures required to
generate this additional cash. We calculate the additional cash requirement as
the difference between the firm’s interest and principal obligations in the first full
year following the recap and its net cash flow (defined as the difference between
 D.J. Denis, D.K. DenisjJournal of Financial Economics 37 (1995) 129-157 135

Table 1
Average and median (in parentheses) debt service requirements for 29 leveraged recapitalizations
completed between 1985 and 1988

Year 0 is defined as the year the recapitalization is completed. Panel A presents coverage and debt
ratios. Panel B presents the additional cash required to meet year + 1 interest and principal
payments, holding year - 1 operating income and capital expenditures constant, and the percent-
age changes in operating income, total assets, or capital expenditures required to meet these
additional cash needs. P-values denote the significance of the diffe:.mce between the distressed and
nondistressed firms, using a t-test for averages and a Wilcoxon signed-ranks test for medians.
***,**, * denote significance at the 0.01, 0.05, 0.10 levels, respectively.

Full sample Nondistressed Distressed

Average Average Average P-value

(Median) (Median) (Median) (difference)

Panel A. Coverage and debt ratios

Interest coveragea 4.16 4.14 2.70 0.04

(3.18) (3.83) (1.82) (0.02)
Interest and principal coverage” 2.69 3.05 1.79 0.14
(2.36) (2.49) (0.80) (0.07)
Long-term debt/Total asset? 0.70 0.66 0.79 0.47
(0.52) (0.48) (0.75) (0.25)
Total debt/Total assetsb 1.16 1.14 1.22 0.66
(0.93) (0.91) (1.14) (0.49)

Panel B. Additional cash required and necessary operating changes

Additional cash required’ $182.5* $60.9* $486.6 0.17

($ millions) ($34.5)* ($14.4) ($125.9)** (0.15)
Percentage change in operating 62.8** 24.6* 158.2 0.19
income requiredd (34.7)*** (18.9)* (41.8)** (0.10)
Percentage change in total assets - 7.9** - 3.1 - 19.8 0.20
requiredd ( - 5.3)*** ( - 3.6) ( - 6.3)** (0.07)
Percentage change in capital - 140.1 - 4.9 - 478.0 0.24
expenditures requiredd ( - 50.4)* (- 26.1) ( - 73.9)** (0.02)

“Coverage ratios are measured as operating income for the year prior to the recap divided by interest
and principal payments due in the first year after the recap.
‘Debt ratios are measured as of the end of the fiscal year in which the recap is completed.
‘We calculate the additional cash requirement as the interest expense and principal payments
required in the first full year after the recap less operating income net of capital expenditures in the
last full prior to the recap.
dComputed as the percentage change necessary to generate the additional cash required if changes
in this variable were the only way to generate additional cash.
136 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157

operating income and capital expenditures) in the last full year prior to the recap.
In other words, holding operating income and capital expenditures constant at
pre-recap levels, we calculate how much additional cash is required to meet
post-recap interest and principal payments, ignoring any additional borrowing.
The sample firms require a median $34.5 million additional cash to meet
post-recap debt payments. The median firm could generate this amount by
either increasing operating income by a median 34.7%, selling a median 5.3% of
the total assets of the firm (if the assets are sold for their book value), or reducing
capital expenditures by a median 50.4% (or, of course, by some combination of
these actions). By way of comparison, Kaplan (1989) reports median changes of
15.6% in operating income and - 21.1% in capital expenditures from the year
before to the year after management buyouts. He does not report changes in
total assets but does indicate that 20 of his 48 sample firms divest assets worth
more than 5% of the total value of the buyout.
The results also indicate that the distressed firms require significantly more
drastic post-recap changes than do the nondistressed firms. The median re-
quired change in operating income is 41.8% for the distressed firms and 18.9%
for the nondistressed firms. Alternatively, the median distressed firm could meet
its cash needs by selling 6.3% of its total assets, whereas the median nondis-
tressed firm would only have to sell 3.6% of its assets. Finally, the median
capital expenditure reduction required by the distressed firms is 73.9%, versus
26.1% for the nondistressed firms.
Overall, the findings in Table 1 suggest that the distressed firms structure their
recaps such that they are financially more vulnerable than the nondistressed
firms, on average. One explanation for this difference is that the distressed firms
took on unreasonably high levels of debt in their recaps, consistent with an
overheated market. Alternatively, the distressed firms may have expected to
engage in a greater amount of post-recap restructuring, such as through asset
sales, but unfavorable post-recap events limited the extent of this activity.

3. Post-recap changes in operating characteristics

If the economic recession adversely influenced the performance of the dis-

tressed firms, we should see reduced operating cash flows for these firms
following their recaps. Moreover, other firms in their industries should be
similarly affected. Table 2 reports median percentage changes in the ratio of
operating income to total assets from one year prior to the recapitalization (year
- 1) through one, two, and three full years following each recap.4

4Denis and Denis (1993) and Palepu and Wruck (1992) also provide evidence on changes in
operating income, total assets, and capital expenditures following leveraged recapitalizations. This
 D.J. Denis, D.K. Denis/Joumal of Financial Economics 37 (1995) 129-157 131

Table 2
Post-recap changes in operating characteristics for the sample of 29 leveraged recapitalizations
completed between 1985 and 1988
Changes are measured from the year prior to through the third full year following each recapitali-
zation (year - 1 to year + 3). Median percentage changes are listed for the 20 firms not experienc-
ing financial distress through the end of 1991 and the nine firms experiencing some form of financial
distress over the same period. P-values denote the significance of the Wilcoxon signed-ranks test
comparing the median values for each of the two subsamples. ***. **, *denote significance at the
0.01, 0.05, 0.10 levels, respectively.

Percentage changes
Year - 1
level c - 1, 11 c- 421 I: - L31

(A) Operating income/Total assets

Distressed 0.13 - 1.0% - 22.1%* - 40.8%
Nondistressed 0.15 30.4%** 31X?&** 27.4%**
P-value 0.43 0.35 0.02 0.06

(B) Operating income/Total assets (industry-adjusted)=

Distressed 0.02 4.6% - 1.3% 3.4%
Nondistressed 0.02* 25.2%*** 22.8%** 24.2%***
P-value 0.45 0.29 0.22 0.15

(C) Total assets

Distressed 2040.20 - 3.4% 3.3% - 8.8%
Nondistressed 2395.20 - 11.6%** - 10.2% - 7.3%
P-value 0.35 0.62 0.56 0.90

(D) Capital expenditures

Distressed 153.6 - 41.6% - 55.4% - 58.7%
Nondistressed 141.3 - 31.6% - 41.40X* - 33.0%
P-value 0.67 0.90 0.52 0.26

(E) Capital expenditures/Total assets

Distressed 0.09 - 32.4% - 63.6% - 61.8%*
Nondistressed 0.08 - 22.6% - 23.0% - 19.7%
P-value 0.82 0.74 0.21 0.07

“Industry-adjusted change equals the percentage change in the ratio for the sample firm minus the
median percentage change for its control firms over the same period. For each sample firm, a control
set of firms is defined as those firms listed on Compustat that have the same two-digit SIC code and
have a book value of total assets within 25% of that of the sample firm. If this results in fewer than
three control firms, we include the industry firms that are next closest in book value of total assets
until we have three control firms.

study differs in that we (i) provide evidence on differences between distressed and nondistressed
firms, (ii) present industry comparisons, and (iii) measure changes through three years following the
recap. Denis and Denis (1993) do not provide evidence on (i) and (iii) while Palepu and Wruck do not
provide evidence on (i) and (ii).
138 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995/ 129-157

The distressed firms do not exhibit the improvements in operating per-

formance typical of highly-leveraged transactions. Table 2 indicates that the
distressed firms experience a median 1% decline in the ratio of operating income
to total assets over the year - 1 to year + 1 period and a median - 40.8%
change from year - 1 through year + 3. This decline is significantly different at
the 0.06 level from the 27.4% improvement in operating performance exhibited
by the nondistressed firms over the [ - 1, + 31 period.
For each sample firm, we identify a control sample consisting of all firms listed
on Compustat that have the same two-digit Standard Industrial Classification
code and a book value of total assets that is within 25% of that of the sample
firm as of the year ending just prior to the recap. If fewer than three control firms
are identified, we include the industry firms that are next closest in book value of
total assets until we have three control firms. The number of control firms
ranges from three to 17, with a median of three. We define an industry-adjusted
change as the percentage change for the sample firm minus the median percent-
age change for its control firms over the same period.
The results in Table 2 indicate that industry-wide factors account for most of
the decline in operating performance observed following the recaps completed
by the distressed firms. Median industry-adjusted changes in the ratio of
operating income to total assets are actually positive, though insignificant, over
the [ - 1, + 31 window and do not differ significantly from the performance
improvements exhibited by the nondistressed firms. Thus, the poor absolute
performance of the distressed firms is due primarily to industry effects.
We also decompose the ratio of operating income to total assets into the ratio
of operating income to sales (operating margin) and sales to total assets (asset
turnover). The results (not presented in a table) indicate that distressed firms
experience large, though insignificant, decreases in unadjusted operating mar-
gins and asset turnover; these changes differ significantly from the insignificant
increases of the nondistressed firms. Industry-adjusted operating margins are
insignificantly positive for both the distressed and nondistressed firms. Indus-
try-adjusted asset turnover ratios are insignificantly negative for the distressed
firms, significantly different from the increases in asset turnover experienced by
the nondistressed firms.
Given their poor operating performance, one might expect the distressed
firms to attempt to generate cash through either asset sales or capital expendi-
ture reductions. John, Lang, and Netter (1992) find that asset sales are a com-
mon response to poor operating performance. Brown, James, and Ryngaert
(1992) and Ofek (1993) find that firms are more likely to sell assets following
poor performance if they are more highly levered or less liquid. Similarly,
evidence in Asquith, Gertner, and Scharfstein (1992) suggests that asset sales are
important in minimizing the costs of financial distress. Moreover, the results in
Table 1 indicate that, lacking any improvement in operating income, reductions
in total assets and/or capital expenditures are required by the distressed firms in
 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157 139

order to avoid default. In spite of this, however, Table 2 indicates that the
financially distressed firms do not sell a greater fraction of their assets than do
the nondistressed firms. The percentage change in total assets over the
[ - 1, + 31 window is - 8.8% for the distressed firms and - 7.3% for the
nondistressed firms. Over the [ - 1, -t 21 window, the distressed firms actually
increase their total assets by 3.3%. We address the issue of asset sales in more
detail in the following section.
Table 2 also presents evidence on the magnitude of capital expenditure
reductions for the distressed and nondistressed firms. We measure percentage
changes in both the level of capital expenditures and the ratio of capital
expenditures to total assets. While the capital expenditure reductions are gener-
ally greater for the distressed firms, they are significant only over the [ - 1, + 31
window for the ratio of capital expenditures to total assets. The percentage
change in this ratio over the [ - 1, + 33 window is - 61.8% for the distressed
firms and - 19.7% for the nondistressed firms (with the difference significant at
the 0.07 level).
It is interesting to note that the distressed firms appear to make cuts in capital
expenditures similar to those of the nondistressed firms in the year immediately
following the recapitalization and then make further cuts in years + 2 and + 3.
In contrast, the nondistressed firms do not make further capital expenditure
reductions following year + 1, suggesting that the distressed firms are forced
into making deeper capital expenditure cuts than they had initially planned,
perhaps due to unexpectedly poor operating performance and/or lower-than-
expected proceeds from asset sales (for an example, see the Appendix entry for
Carter Hawley Hale).

4. The role of asset sales

The recession and several legal and regulatory events may have led to
a reduction in the liquidity of asset markets in the late 1980s and early 1990s. If
there is such a reduction in liquidity, firms attempting to sell assets will suffer
two effects. First, some assets will not be sold because the price obtained for
them would be lower than the expected benefits of retaining the assets, resulting
in actual levels of asset sales that are lower than planned levels. Second, those
assets that are sold may be sold for a lower price than was initially expected. If
the latter is the case, we would expect a negative market reaction to asset sale
announcements even if the sales themselves are value-enhancing.5

51f our distressed firms tend to be smaller, single-division firms, or if they have a greater fraction of
intangible assets, they may have more difficulty selling assets regardless of the liquidity of the asset
sales market (Brown, James, and Mooradian, 1991). However, we find that the distressed and
nondistressed firms do not differ significantly in any of these characteristics.
140 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157

We search the Wall Street Journal for each sample firm for qualitative
evidence that the distressed firms are more likely to experience difficulty com-
pleting planned asset sales. Four of the nine distressed firms are the subject of at
least one article indicating that the firm either was unable to complete a planned
asset sale or received a disappointing price for assets sold (see the Appendix
entries for Carter Hawley Hale, Goodyear, Harcourt Brace Jovanovich, and
Interco). There are no such references for any of the 20 nondistressed firms.
We further examine whether the prices received for sold assets were disap-
pointing by examining stock price reactions to announcements related to
specific asset sales subsequent to each firm’s recapitalization. We search the
Wall Street Journal Index and 8-K reports for each firm for the period extending
from the completion of the firm’s recap through the end of 1991. This process
results in a sample of 177 announcements related to asset sales, 127 by the
nondistressed firms and 50 by the distressed firms.6 Of the 29 sample firms,
25 announce asset sales following completion of their recaps. The median
number of announcements per firm is six, with a range of 0 to 22. However, we
do not have stock return data for two of the firms. (Colt Industries went private
prior to its asset sale announcements and Metromedia could not be found on
the CRSP tapes.) Thus, our analysis focuses on 172 announcements made by 23
firms.
Our sample of asset sale announcements differs from those of previous studies
in two important ways. First, our sample firms have all recently undergone
a highly-leveraged transaction, thus raising the probability that they will at-
tempt to sell assets. In most cases, the firms explicitly state that they will sell
assets in the near future and that the proceeds from these sales will be used to
pay down debt. Thus, most of our asset sales will be at least partially anticipated.
Second, we examine a time period, 1989-1991, in which, for reasons mentioned
previously, there may have been significant shocks to asset liquidity.
Panel A of Table 3 summarizes the abnormal returns associated with our
sample of asset sale announcements. For each announcement we cumulate
market model abnormal returns over a three-day interval centered on the
announcement. For our full sample of 172 announcements, we observe an
average three-day [ - 1, l] abnormal return of 0.07%, insignificantly different
from zero. However, similar to previous studies of asset sales (e.g., Hite, Owers,
and Rogers, 1987), announcements by the nondistressed firms are characterized
by significant positive average abnormal returns averaging 0.69% (Z = 2.52).
In contrast, the announcements of the distressed firms are characterized by

6The number of announcements does not directly correspond to the number of distinct divestitures.
There is occasionally more than one announcement relative to a given divestiture; all of these
announcements are included in our analysis. On the other hand, one announcement occasionally
concerns more than one distinct divestiture.
 D.J. Denis, D.K. Denis/Joumal of Financial Economics 37 (1995) 129-157 141

Table 3
Three-day announcement-period abnormal returns for 172 post-recap announcements related to
asset sales made by the sample of 29 firms completing leveraged recapitalizations between 1985 and
1988

Panel A presents summary measures for the sample of 172 announcements. Panel B presents
summary measures of abnormal returns per firm. Panel C presents summary measures of the
cumulative abnormal return for each firm’s announcements. Abnormal returns are estimated using
the standard market model procedure with parameters estimated over the 250-trading-day period
beginning 290 days prior to each announcement day. Significance of mean abnormal returns is
measured using Z-values. P-values measure the significance of differences in average and median
abnormal returns for the two subsamples using two-sample t-tests for averages and the Wilcoxon
signed-ranks test for medians. ***, **, *denote significance at the 0.01, 0.05, 0.10 levels, respectively.

All Non- P-value

firms distressed Distressed (difference)

(A) All announcements

Average 0.07% 0.69%*** - 1.49% 0.00
Median - 0.39% 0.21% - 1.26%** 0.00
Z-statistic 1.28 2.52 - 1.55
Percent negative 54.1 48.4 68.0
Number of observations 172 122 50

(B) Average abnormal returns per firm

Average 0.19% 0.63%** - 2.07%* 0.00
Median 0.25% 0.57% - 2.73%** 0.03
Z-statistic 0.72 2.11 - 1.87
Percent negative 43.5 31.2 71.4
Number of firms 23 16 7

(C) Cumulative abnormal returns per firm

Average 0.09% 5.33%** - 11.87%* 0.01
Median - 1.17% 3.30%** - 10.90%** 0.04
Z-statistic 0.72 2.11 - 1.87
Percent negative 43.5 31.2 71.4
Number of firms 23 16 7
-

negative abnormal returns averaging - 1.49% (2 = - 1.55). The difference

between the abnormal returns of the distressed and nondistressed firms is
significant at the 0.01 level.
We also calculate abnormal returns for the subsample of announcements with
asset values that are at least 5% of the market value of the firm’s equity
following the recap. We have data on the sale price for 111 of the 172 asset-sales
announcements; 80 of these are related to assets that are at least 5% of
post-recap equity value. Abnormal returns for this subsample of transactions
are slightly stronger than the results for the whole sample. The average an-
nouncement-period abnormal return (not reported in a table) is 1.42%
(2 = 3.00) for the nondistressed firms and - 1.96% (2 = - 2.07) for the
142 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157

distressed firms. Median abnormal returns for the nondistressed and distressed
firms are 0.19% and - 1.60%; the latter is significant at the 0.05 level.
We also compute each sample firm’s average abnormal return as the average
of the three-day abnormal returns associated with each of that firm’s asset sale
announcements. The results in panel B suggest that the negative abnormal
returns surrounding the announcements of the distressed firms are not limited to
just a few firms. The mean average abnormal return for the distressed firms is
- 2.07% (2 = - 1.87) and 71.4% of the observations are negative. In contrast,
the mean average abnormal return is 0.63% (2 = 2.11) for the nondistressed
firms and only 31.2% of the observations are negative.
Finally, for each firm, we cumulate the three-day abnormal returns associated
with the firm’s asset sale announcements. The results in panel C of Table 3
suggest that the cumulative effects of the asset sale announcements for the
distressed firms are economically quite large. The average cumulative abnormal
return for the distressed firms is - 11.87% (2 = - 1.87). In contrast, the
average cumulative abnormal return is 5.33% (2 = 2.11) for the nondistressed
firms.
The share price declines associated with the asset sale announcements of the
distressed firms are consistent with the hypothesis that, on average, the prices
received by the distressed firms are unexpectedly low due to a reduction in the
liquidity of asset markets. Alternatively, however, the distressed firms’ an-
nouncements may simply convey information about the firms’ unexpected need
for funds. Although this seems unlikely given that the large additional cash
requirements estimated in Table 1 are known at the time of the recap and that
most of the sample firms publicly state that they will sell assets following the
completion of their recapitalization, we examine a subsample of five asset sales
by distressed firms for which there is an announcement of the intent to sell an
asset followed by a separate announcement that terms of a sale have been agreed
upon. If the distressed firms’ negative abnormal returns are due to the negative
information implied by the need to raise additional funds, the reaction to the
announcement of intent should be negative. We find, however, that the orig-
inal-intent announcements are met with an insignificant median abnormal
return of 0.2%, while the announcements of the terms of the sales are associated
with a significant (at the 0.07 level) median abnormal return of - 2.39%. These
results suggest that the negative abnormal returns of the full sample of distressed
firms’ announcements are not due to the market inferring negative information
about the need to raise cash.
Another interpretation of the negative abnormal returns associated with
the distressed firms’ asset sales is that the poor financial condition of the
distressed firms weakens their bargaining position and thus reduces the prices
received for the assets sold regardless of the liquidity of asset markets. For
example, creditors may force inefficient liquidations that enhance the value of
their claim but damage equity value. Gilson (1990) notes that creditors in
 D.J. Denis, D.K. Denis/Journal of Financial Economics 37 (1995) 129-157 143

financially-distressed firms often insist on the divestiture of certain assets as

a condition for restructuring.
We address this possibility by partitioning our asset sale announcements into
four mutually exclusive groups on the basis of both industry performance and
the sample firm’s financial condition as of the time of the announcement. We
define a sample firm’s industry as ‘troubled’ if the median control firm exhibits
a negative change in operating earnings over the period extending from one year
prior to two years after the sample firm’s recapitalization and ‘healthy’ other-
wise. The sample firm’s financial condition is measured as the ratio of the firm’s
operating earnings to interest and principal obligations for the year ending prior
to the asset sale announcement. We divide the sample announcements into those
with a coverage ratio greater than one and those with a ratio less than one. If the
distressed firms’ negative abnormal returns are due to their weakened bargain-
ing position, the seller’s financial condition should be the primary determinant
of the market’s reaction to the asset sale announcement. Thus, all firms with
coverage ratios less than one should exhibit negative abnormal returns regard-
less of industry performance. In contrast, if the negative abnormal returns are
due to a reduction in asset liquidity, negative returns should be concentrated
among poorly-performing firms in troubled industries. The reduced number of
potential asset buyers in a troubled industry increases the likelihood of being
offered an unexpectedly low price for an asset. A firm that is performing well can
choose not to sell the asset if the offer price is too low; however, a firm that is
performing poorly is more likely to have to sell the asset in order to avoid
default.
In Table 4 we report announcement-period abnormal returns for each of the
four groups. Within each group, we first average the abnormal returns asso-
ciated with each individual firm’s asset sale announcements (as in panel B of
Table 3) and then compute cross-sectional statistics on these average abnormal
returns. The results indicate that announcements of asset sales have a significant
negative stock price reaction only for firms with coverage ratios less than one in
troubled industries. All of the other subsamples exhibit positive average and
median stock price reactions. The fact that firms with low coverage ratios in
healthy industries do not exhibit negative abnormal returns is consistent with
Shleifer and Vishny’s (1992) model of asset liquidity but is inconsistent with the
hypothesis that the abnormal returns are determined primarily by the bargain-
ing position of the selling firm. These findings are similar to those of Brown,
James, and Mooradian (1993), who find that both industry conditions and the
financial health of the selling firm influence the abnormal returns of asset sales
announced by financially distressed firms.
Shleifer and Vishny (1992) also hypothesize that, to the extent that financial
distress stems partially from industry-wide problems, firms may be more likely
to sell assets to firms outside their industry. However, we do not find evidence of
this in our sample. Of the 101 asset sales for which we could identify the industry
144 D.J. Denis, D.K. DenislJourmal of Financial Economies 37 (1995) 129-157

Table 4
Three-day announcement-period abnormal returns for post-recap announcements of asset sales,
partitioned by the coverage ratio of the sample firm and the performance of the industry

Troubled industries are defined as those in which the median control firm experiences a negative
change in operating earnings in the period from one year prior to two years after the recapitalization
of the sample firm. The sample firm’s coverage ratio is defined as the ratio of operating earnings to
interest and principal obligations for the year ending just prior to the asset sale announcement. In
each cell, we compute an average abnormal return associated with each firm’s announcements so
that there is at most one observation per firm in each cell. We then report the mean average
abnormal return, the median average abnormal return, the Z-statistic in parentheses, the fraction
negative in brackets, and the number of observations. Abnormal returns are estimated using the
standard market model procedure with parameters estimated over the 250-trading-day period
beginning 290 days prior to each announcement day.

Troubled Healthy
industries industries Difference

Coverage ratio < 1 - 1.82% 0.65% - 2.47%

- 1.83% 0.55% ( - 2.00)
( - 1.70) (1.16)
[0.71] co.331
N=7 N=6

Coverage ratio > 1 0.59% 0.88% - 0.29%

0.57% 0.19% ( - 0.63)
(1.05) (1.87)
[0.20] co.331
N= 10 N=9

Difference in means - 2.41% - 0.23%

(1.98) (0.28)

of the buying firm, 88 are in the same industry as the seller. The fraction of
buyers outside the industry does not differ significantly between the distressed
and nondistressed firms, nor are there any significant differences between the
stock price reactions of asset sales to industry and nonindustry buyers.
In Table 5 we address the extent to which the distressed firms could have
avoided distress had they had fewer problems selling assets. We compute
a measure of the total cash shortfall from asset sales for each distressed firm.
Whenever available, we use the difference between the price received for the
asset and the expected price as reported in the Wall Street Journal. Alternatively,
we estimate the cash shortfall as the abnormal return on the announcement of
the asset sale times the market value of the firm’s equity. Where possible, we
include the cash shortfall from asset sales not completed; the total shortfall will
be understated to the extent that we are unable to obtain an expected price for
assets not sold. We compare this total asset sale shortfall to the additional cash
 D.J. Denis, D.K. Denis/Journal of Financial Economics 37 (1995) 129-157 145

Table 5
A comparison of the total cash shortfall from asset sales and the additional cash required to avoid
default in the year of the first indication of financial distress for the nine distressed firms

The total asset sale shortfall is the sum of the shortfall from completed asset sales and the shortfall
from sales not completed. We measure both shortfalls as the difference between the price received for
the asset (zero in the case of an asset sale that was not completed) and the expected price as stated in
press reports. When this quantity is unavailable, we measure the shortfall as the abnormal return
over the three days centered on the announcement of the sale multiplied by the market value of the
firm’s equity. The additional cash required in the first year of distress is the difference between the
firm’s interest and principal obligations and its net cash flow (operating income less capita1
expenditures) for that year.

Total asset sale Additional cash required

shortfall” in year of distress
Firm name (S millions) ($ millions)

Carter Hawley Hale $612.6 $38.6

Goodyear $489.1 $139.5
Harcourt Brace Jovanovich $924.9 $243.6
Holiday $35.2 - $33.7
Interco $288.5 $223.1
Quantum Chemical $140.7 $164.4
Standard Brands Paint $0.0 $164.4
Swank $0.0 $8.3
USG $54.5 $351.0
Median $140.7 $139.5

“Carter Hawley Hale’s total shortfall includes $650 million from asset sales not completed. Similarly,
Goodyear’s total includes $750 million, and Harcourt Brace Jovanovich’s includes $33.9 million
from sales not completed.

required to avoid default in the year in which we have the first indication of
distress. (Of course, our estimates implicitly assume that any additional cash
flow from asset sales could be used to pay the current year’s required interest
and principal. However, bank loan covenants may require the firm to use the
proceeds from asset sales to pay down bank debt rather than to make interest or
principal payments on any other debt claims.)
The results in Table 5 indicate that the shortfalls from asset sales are of
sufficient magnitude to have had a meaningful impact on the probability of
distress. The median shortfall is $140.7 million, nearly identical to the median
$139.5 million required to avoid default. Five of the nine distressed firms exhibit
shortfalls from attempted asset sales that are greater in magnitude than the
additional cash needed to avoid default. For a sixth firm, the shortfall is
approximately 85% of the additional cash needed. These findings suggest that
the majority of the distressed firms could have remained solvent had asset sales
produced the anticipated proceeds.
146 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157

5. Event study of post-recap events

The results in the previous section suggest that an unexpected decrease in

asset liquidity was an important cause of financial distress for our sample firms.
One obvious explanation for this reduction in liquidity is the onset of the
recession in 1990. However, several legal and regulatory initiatives may also
have contributed to a reduction in asset liquidity by reducing funding available
for corporate control transactions. W.T. Grimm reports that divestitures ac-
count for 35-40% of mergers and acquisitions in the 1980s (Weston, 1989); thus,
any reductions in funding for corporate control transactions are also likely to
influence the ability of firms to complete planned divestitures. For example, the
collapse of the junk bond market and subsequent financing difficulties for
potential acquirers have been cited as one reason that Interco received unex-
pectedly low prices for the assets it sold (‘Wall Streeters Helped Interco Defeat
Raiders - But at a Heavy Price’, Wall Street Journal, July 11, 1990). Similarly, in
discussing the reasons for market-wide declining asset values, Steven Waters,
co-head of mergers and acquisitions at Morgan Stanley, said: ‘To make matters
more difficult, would-be buyers of assets are finding it hard to obtain financing
of their own . . with U.S. banks curbing their lending and U.S. leveraged
buy-out firms less active . . .’ (‘Rash of Corporate Sell-Offs Undercutting Asset
Values’, Wall Street Journal, November 7, 1990). Moreover, Jensen (1991)
argues that legal and regulatory initiatives have contributed to the increase in
defaults of highly-leveraged transactions by reducing the ability of distressed
firms to recontract with debt claimants.
Jensen (1991) Waite (1991), and Yago (1991) describe a series of restrictions
on investment in high-yield instruments placed on thrift institutions, insurance
companies, money market mutual funds, and commercial banks. For example,
Waite (1991) shows that high-yield mutual funds experienced a net outflow of
$500 million in the two months following passage of the Financial Institutions
Reform, Recovery, and Enforcement Act (FIRREA), after averaging net inflows
of $300 million per month in the first eight months of 1989. He argues that the
regulation-induced sell-off of high-yield bonds caused junk bond prices to fall
substantially. In addition, the prosecution of the principal market-maker for
junk bonds, Drexel Burnham Lambert, is arguably associated with the demise of
the junk bond market. Of course, if Drexel’s failure is a result of the collapse of
the market for high-yield debt or if other investment banks can provide the same
service as Drexel, we would not expect Drexel’s failure per se to influence the
viability of existing highly-levered firms. Both Benveniste, Singh, and Wilhelm
(1992) and Jensen (1991) argue, however, that Drexel occupied a unique position
in the production and trading of high-yield bonds. Finally, Benveniste, Singh,
and Wilhelm (1992) identify the default of Integrated Resources, and Comment
and Schwert (1993) identify the default of Campeau and the collapse of the UAL
buyout agreement, as important events in the collapse of the junk bond market.
 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157 147

We search the Dow Jones News Retrieval for announcements of the events
discussed above. This process results in a sample of seven event dates related to
reductions in funding available for corporate control transactions. If the above
events have an adverse effect on the ability of our sample firms to sell the assets
necessary to meet debt obligations or to recontract with debt claimants, we
expect to observe negative stock price reactions to the event announcements.
Moreover, we expect more-negative announcement effects for the distressed
firms because they are financially more vulnerable at the time of the announce-
ments. Recall that all but one of the distressed firms’ recaps were completed in
1987 and 1988. The distressed firms thus had little time to pay down debt prior
to these legal and regulatory developments. Consistent with this, the median
ratio of operating income to interest and principal obligations as of year-end
1988 is 0.98 for the distressed firms and 2.57 for the nondistressed firms.
We are unable to include two potentially important events in our analysis
because we could not identify precise announcement dates. First, in 1990, the
National Association of Insurance Commissioners (NAIC) imposed tougher
reserve requirements for insurers’ junk bond holdings. Since insurers historically
account for about 30% of junk bond purchases (see ‘Insurance Firms’ Junk
Bond Holdings Likely to Face Tougher Rules By States’, Wall Street Journal,
April 30, 1990), this action was expected to further damage the market for
high-yield debt. Second, shortly after the collapse of the UAL buyout, bank
regulators imposed new accounting standards for loans made in leveraged
transactions. A loan was now classified as an HLT loan if it more than doubled
the firm’s debt and made debt equal to at least 50% of total assets. Previously,
a bank loan was classified as an HLT only if debt exceeded 75% of total assets.
These new standards were expected to have a ‘substantial effect on the level of
HLTs’ (see ‘Bank Stocks Face Headache From Loan List’, Wall Street Journul,
November 30, 1989).
Table 6 provides a brief description of each event and reports average and
median abnormal returns over the three-day period centered on the announce-
ment of each event. Panel A indicates that average abnormal returns for the full
sample are significantly negative for five of the seven event periods. Panel B
presents the average and median total cumulative abnormal returns over the
seven events for the sample firms. For comparison purposes, panel B also
presents total cumulative abnormal returns for the control firms over these same
seven events. The results indicate that the sample firms’ cumulative abnormal
return over all seven events averages - 10.69% (median = - 9.81%). In
contrast, the control firms’ mean and median cumulative abnormal returns do
not differ significantly from zero. Thus, these events have a negative impact on
the sample firms that is not experienced by similar firms that have not under-
gone highly-leveraged transactions.
Although both the distressed and nondistressed firms exhibit cumulative
abnormal returns that are significantly negative, Table 6 indicates that there is
 \
Table 6 6
Average and median (in parentheses) three-day abnormal returns surrounding announcements related to the decline of the market for highly-leveraged $
transactions %
%
Results are presented for the full sample of 29 firms completing leveraged recapitalizations between 1985 and 1988, the 20 firms not experiencing financial 2
distress through the end of 1991, and the nine firms experiencing some form of financial distress. P-values test for differences in abnormal returns between $
the two subsamples. ***, **, * denote significance at the 0.01, 0.05, 0.10 levels, respectively. k’

Full Non- s
sample distressed Distressed
3.
2
Average Average Average P-value lo
(Median) (Median) (Median) (difference) 2:
2
z
Panel A. Cumulative abnormal returns for individual events L

1. 3/16/89 SEC pressures Drexel to remove Milken from control of junk bond -0.51% -0.69% 0.33% 0.99 2
P
operations (1.25%)* (- 1.44%) ( - 1.23%) (0.96)
5
2. 6/6/89 Integrated Resources defaults on portion of commercial paper - 1.32% 1.13% - 1.68% 0.94
obligation (-1.30)** (- 1.28%)** (- 1.32%) (0.9 1)
3. 7/26/89 Congressional ban on investment in junk bonds by thrift institutions - 1.90%*** -0.77% -4 020/L?*** 0.00
(-1.75%)* (-0.96%) (-4:21%)* (0.16)
4. 9/14/89 Campeaw unable to make $50 million interest payment due next day - 199%*** -154%** (-3:02%)**
-2 90%*** 0.44
(-2:12%)*** (-1:36%)* (0.22)
5. N/16/89 Collapse of UAL buyout due to reluctance of banks to provide -307%*** -2.56%*** - 3.96%*** 0.53
financing (-2:360/o)*** (-2.43%)*** (-2.09%)** 0.98 b
6. 2/1#/90 Drexel Burnham Lambert files for bankruptcy protection - 0.11% 0.09% - 0.54% 0.76 5
( - 0.54%) (- 0.54%) (0.86%) (0.88) if
-6.15%*** 0.00 *G’
7. 10/22/90 Proposal to limit money market fund investment in low-grade -163%** 0.50%
commercial paper (- l:80%) (0.16%)
~. . ( - 6.57%)+
_______~ (0.01) ~~~ :
b
Panel B. Cumulative abnormal returns over all events 3
i;,
Sample firms - 10.69%*** -606%*"* - 19.96%*** 0.00 2
(-9.81%)*** (-8:770/a)** (- l&30%)*** (0.07) 2
3
Control firms -1.20% - 1.55% -0.05% 0.33 k
(-0.68%) (-0.72%) (0.32%) (0.50) q
P-value (difference) 0.00 0.03 0.00
(0.00) (0,06) (0.00)

(.
150 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157

a substantial difference between the market reactions of the two subsamples.

The distressed firms exhibit average abnormal returns that are more negative
than those of the nondistressed firms for six of the seven individual event
periods. Over all seven events, the distressed firms exhibit an average cumulative
abnormal return of - 19.96% (median = - 16.30%) significantly different at
the 0.01 level from those exhibited by the nondistressed firms (average
= - 6.06%, median = - 8.77%). Moreover, all nine of the distressed firms
have negative cumulative abnormal returns when cumulated over all seven
events. (Excluding firms that file for Chapter 11 or restructure their debt claims
prior to the announcement of an event, the average cumulative abnormal return
for the distressed firms is - 15.27%. This is significantly different from those of
both the nondistressed firms and the distressed control firms at the 0.01 level.)
Thus, it appears that the legal and regulatory shocks described earlier are
particularly damaging to those firms that ultimately encounter financial distress.
These results suggest that at least part of the poor ex post performance of those
firms encountering financial distress can be traced to economic and regulatory
developments that were beyond the control of the firms undertaking the recaps.
As a more formal test of our hypotheses, we regress the cumulative abnormal
return (CAR) over all seven events on the firm’s interest and principal coverage
ratio (COVERAGE) as of the end of 1988, just prior to the first event. We expect
that firms with lower coverage ratios will have returns that are more negative
because these firms would be more likely to have to sell assets or recontract with
debt claimants in order to avoid default. We also include a dummy variable
(DISTRESS) equal to one for the distressed firms and zero otherwise. The results
are as follows (t-statistics in parentheses):

CAR = - 13.85 + 2.24COVERAGE - lO.l5DISTRESS, R= = 0.47 .

( - 3.74) (2.94) (- 2.19)

As expected, those firms that are financially more vulnerable at the time of the
announcements experience lower announcement returns. Moreover, the regres-
sion model explains 47% of the cross-sectional variation in cumulative abnor-
mal returns.
It is noteworthy that the losses suffered by the distressed firms’ shareholders
over just these seven event periods (21 trading days) represent a large portion of
the total shareholder losses suffered by these firms in the post-recap period. The
median ratio of the total cumulative abnormal return associated with the seven
events to the total cumulative abnormal return from completion of the recap
through December 31, 1991 is 17.7% for the nine distressed firms. If we add the
total cumulative abnormal returns associated with each distressed firm’s asset
sales announcements to the seven event-period cumulative abnormal returns we
can account for a median 53.2% of the post-recap shareholder losses even though
these event periods account for only a median 3.9% of the post-recap trading days.
 D.J. Denis, D.K. DenislJournal of’Financia1 Economics 37 (1995) 129-157 151

6. Ex ante vulnerability to distress

The evidence to this point supports the hypothesis that post-recap economic
and regulatory developments are an important cause of financial distress in our
sample firms. However, it is possible that poor ex ante deal structure also
contributes to the likelihood of financial distress. Indeed, as noted earlier, one
interpretation of the evidence in Table 1 is that the distressed firms took on
unreasonably high levels of debt in their recaps. We address this issue by
examining characteristics that Kaplan and Stein (1993) and Palepu and Wruck
(1992) have previously linked with poorly-structured highly-leveraged transac-
tions.
Kaplan and Stein (1993) document a positive relation between the use ofjunk
bond financing and the incidence of financial distress in a sample of large
management buyouts completed in the 1980s. They argue that their evidence is
consistent with an overheated buyout market in which excess demand from junk
bond buyers caused some deals to be structured in a way that made them more
vulnerable to financial distress. Panel A of Table 7 indicates, however, that the
use of junk bonds is not related to the incidence of financial distress in our recap
sample; 56% of the distressed firms and 59% of the nondistressed firms issue
junk bonds to finance their recapitalizations.
Kaplan and Stein also suggest that managers who liquidate a large fraction of
their pre-buyout equity holdings may have a greater incentive to participate in
overpriced or poorly-structured transactions. We measure the ratio of the dollar
value of management’s post-recap equity holdings in the sample firms to the
dollar value of their pre-recap equity holdings. Panel A of Table 7 indicates that
this ratio is higher for the nondistressed firms, a median of 0.67 versus 0.30 for
the distressed firms, suggesting that distressed firm managers do cash out to
a greater degree. However, this difference is not statistically significant.
Finally, Palepu and Wruck (1992) suggest that defensive recaps are more
likely to be poorly structured than are voluntary recaps. They find that recaps
preceded by hostile takeover bids are followed by poor stock price performance,
while voluntary recaps are followed by positive cumulative abnormal returns.
However, panel A of Table 7 does not reveal a significant difference in the
fraction of recaps that are defensive in our distressed and nondistressed sub-
samples; 44% of the distressed recaps and 60% of the nondistressed recaps are
defensive.
The fact that the distressed and nondistressed firms do not differ with respect
to any of the characteristics that have previously been linked to poorly-struc-
tured deals leads us to conclude that ex ante vulnerability is not the primary
explanation of financial distress in our sample. Nevertheless, the finding that the
distressed firms are not more likely to have been preceded by hostile bids is
surprising given that Palepu and Wruck (1992) document poor stock returns
following defensive recaps over virtually the same time period. We explore this
152 D.J. Denis, D.K. DenislJournal of Financial Economies 37 (1995) 129-157

Table 7
Characteristics related to the ex ante vulnerability of 29 firms that completed leveraged recapitali-
zations between 1985 and 1988

Panel A presents the fraction of firms using junk bonds, the median ratio of post- to pre-recap
managerial ownership, and the fraction of firms with hostile takeover bids prior to the recap for the
full sample and for the distressed and nondistressed subsamples. Panel B presents median post-recap
cumulative abnormal returns and median absolute and industry-adjusted changes in the ratio of
operating income before depreciation to total assets (OIBDITA) for the defensive and voluntary
subsamples. P-values denote the significance of the difference between subsamples, using a Wilcoxon
signed-ranks test and a difference in proportions test. ** denotes significance at the 0.05 level.

Full Non- P-value

Characteristic sample distressed Distressed (difference)

Panel A. Recapitalization characteristics

Fraction of firms using junk bonds 0.58 0.59 0.56 0.90

Post-recap ownership ($)/Pre-recap
ownership ($) 0.59 0.67 0.30 0.40
Fraction of firms receiving hostile
takeover bids 0.55 0.60 0.44 0.42

P-value
Defensive Voluntary (difference)

Panel B. Post-recap performance changes

Post-recap cumulative abnormal returnsa - 92.5%** 40.0% 0.06

Change in OIBDITA from year - 1 to - 3 7.6% 19.8% 0.86
Industry-adjusted change in OIBD/TA from
year - 1 to + 3b 15.9%** 3.2% 0.19

“The post-recap period extends from the completion of the recap to December 31, 1991. Abnormal
returns are computed using the standard market model technique; parameters are estimated over the
250-day period beginning 290 days prior to day 0.
‘Industry-adjusted change equals the percentage change in the ratio for the sample firm minus the
median percentage change for its control firms over the same period. For each sample firm, a control
set of firms is defined as those firms listed on Compustat that have the same two-digit SIC code and
have a book value of total assets within 25% of that of the sample firm. If this results in fewer than
three control firms, we include the industry firms that are next closest in book value of total assets
until we have three control firms.

issue further by replicating Palepu and Wruck’s measurements of stock returns

using our sample firms. Panel B of Table 7 indicates that we obtain results
similar to those of Palepu and Wruck. The firms that complete recaps following
hostile bids experience large and significant negative cumulative abnormal
 D.J. Denis, D.K. DenisJJournal of Financial Economics 37 (1995) 129-157 153

returns over the period from completion of the recap through December 31,
1991. This result differs significantly from the positive, though insignificant,
cumulative returns following voluntary recaps.
It is puzzling that the defensive firms’ negative abnormal stock returns are
not associated with a higher incidence of financial distress. We conjecture
that the poor stock price performance may reflect unfulfilled expectations
of a subsequent takeover of the firm. Press reports indicate that six of the
11 defensive recaps that do not subsequently incur distress remain takeover
targets following the completion of the recap, but are not taken over by the
end of 1991. A seventh firm (Owens-Corning Fiberglas) loses 25% of its value
when it announces a large charge to earnings to cover the expected costs of
asbestos litigation. Moreover, panel B of Table 7 indicates that, unlike the
distressed firms, firms that undertake defensive recaps do not exhibit median
decreases in post-recap operating profitability. We conclude that the negative
stock returns following defensive recaps are not due to poor post-recap operat-
ing performance.

7. Conclusion

We examine causes of financial distress in a sample of 29 leveraged recapital-

izations. We find that recapitalizations that ultimately become distressed are
characterized by poor post-recap operating performance due largely to indus-
try-wide problems. The distressed firms display surprisingly low levels of asset
sales and experience negative market reactions to the asset sales they do
complete. In addition, they exhibit negative market reactions to events that lead
to reduced funding for corporate control transactions and adversely affect the
ability of firms in distress to recontract with debtholders.
We do find that the distressed firms structure their recaps such that they are
financially more vulnerable than were the nondistressed firms at the time of their
recaps. However, the fact that the distressed and nondistressed firms do not
differ significantly with respect to ex ante characteristics that have previously
been linked to poorly-structured deals suggests that poor deal structure is not
the primary cause of financial distress in our sample.
We conclude that the economic recession of 1990-91 and a number of
post-recap legal and regulatory developments increased the incidence of
default in our sample of leveraged recaps by (i) decreasing the funding available
for the purchase of corporate assets and hence reducing the liquidity of asset
markets, and (ii) making it more difficult for firms in distress to recontract with
debt claimants. While these developments are generally believed to have cur-
tailed the market for new highly-leveraged transactions, our results suggest
that they also adversely affected the viability of already-completed leveraged
recapitalizations.
154 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157

Appendix

This appendix provides brief case histories of the nine sample firms that
experienced financial distress following completion of their leveraged recapital-
izations. The information is obtained from annual reports, proxy statements,
10-K reports, and articles appearing in the Wall Street Journal.

Carter Hawley Hale

Following a hostile takeover offer from Limited, Carter Hawley Hale (CHH) announced plans to
spin off a division to shareholders and make a special payout of $325 million. The payout was
completed in September 1987. The recapitalization increased the firm’s total debt to 114% of the
book value of the firm’s assets. In the three years following the recap, the ratio of operating income
to total assets declined by 66%, the book value of total assets was reduced by 8%, and capital
expenditures were reduced by 67%. Earnings shortfalls prevented CHH from undertaking the level
of store remodelings required to remain competitive. The firm was forced to sell its Thalhimer’s unit;
analysts suggested that the weak retail climate led to a lower price than would have been expected in
past years. Shortly after abandoning plans to sell its credit card operations to a General Electric unit
for $650 million, CHH filed for bankruptcy protection under Chapter 11 in February of 1991.

Goodyear Tire and Rubber

Following the disclosure that Sir James Goldsmith held a large stake in the firm, Goodyear offered to
repurchase Goldsmith’s stake and announced a tender offer to repurchase an additional 36.5% of its
shares. The recap totaled $2.6 billion and increased total debt to 65% of the book value of the firm’s
total assets. Following the recapitalization, the firm announced that stringent cost-cutting measures
would be undertaken and that capital expenditures would be slashed to service debt. Analysts
supported the moves, suggesting that such a restructuring was long overdue for Goodyear. Asset sales
proceeded as planned in the early years, though the firm actually increased the book value of total
assets by 22%. The ratio of operating income to total assets increased by 21% and capital expenditures
were reduced by 53% in the three years following the repurchase. One year following the recap
Goodyear was two years ahead of schedule in repaying its debt. However, a general slump in the world
tire business, combined with a significant increase in foreign competition, led to a significant drop in
earnings the following year. Asset sales became problematic; a $1.4 billion pipeline could not be sold.
In 1991, the firm was actively seeking buyers for its non-tire assets in an effort to reduce its $3.7 billion
debt. However, rather than sell these assets for prices that Goodyear considered too low, the firm
renegotiated its bank credit agreement to reduce the pressure on the firm to sell assets.

Harcourt Brace Jovanovich

Harcourt paid a large debt-financed special dividend comprised of $1.6 billion cash and 40.5 million
shares of 12% preferred stock, increasing total debt to 168% of the book value of total assets. The
recap was designed to defeat a hostile takeover bid by British Printing & Communications. Analysts
and the market responded favorably to the recap, explicitly stating that it was not expected to
endanger the company’s future. Although the firm ‘ran a tight ship’ following the recap, the
publishing industry declined significantly. In the three years following the recap, the ratio of
operating income to total assets declined by 17% and capital expenditures were reduced 61%.
Moreover, the firm received unexpectedly low prices for the assets it sold. Its sales of HBJ
Publications and Harcourt’s theme parks generated only $1.4 billion; they had been expected to
generate nearly $2.2 billion. Approximately 15 months after the recap Harcourt attempted to ease
the terms of the recapitalization by issuing new bonds. The proceeds were used to pay down the
firm’s bank debt. The maturity of the remaining bank debt was extended. The firm was ultimately
acquired by General Cinema in a transaction valued at $1.4 billion.
 D.J. Denis, D.K. DenislJournal of Financial Economics 37 (1995) 129-157 155

Holiday Corp.
Holiday paid a special dividend of $65 per share or $2.6 billion, increasing total debt to 132% of the
book value of total assets. The recap was in response to a rumored hostile takeover attempt by
Donald Trump. Analysts generally considered the move a mistake, believing that it would leave the
firm very vulnerable to economic downturns. Approximately six months after the recap, the firm
sold its hotels outside North America to Bass PLC to relieve the pressures of its debt obligations.
Three months later, Holiday completed an exchange offer for some of the firm’s outstanding notes.
Subsequently, the firm sold its entire Holiday Inn operations to Bass PLC and spun off its remaining
properties into a new company named Promus.

Interco
Interco made a special payout of $2.4 billion in cash and securities, increasing total debt to 157% of
the book value of total assets. The recap was proposed in response to a hostile takeover attempt by
the Rales brothers. The firm intended to sell assets quickly following the recap. In the three years
following the recap, the ratio of operating income to total assets declined by 51% and the book value
of total assets was reduced by 37%. The prices received for the assets sold were generally lower than
the firm and its advisor, Wasserstein Perella, had expected. The firm’s Ethan Allen and Central
Hardware divisions were sold for a total of only $633 million when $850-$950 million had been
expected. Wasserstein Perella blamed the poor price for Ethan Allen on reduced profit expectations
and the inability of potential acquirers to find financing following the collapse of the junk bond
market. Ultimately, after failing to reach an agreement with its bondholders to restructure the firm’s
debt, Interco filed for bankruptcy under Chapter 11 in January 1991. The firm emerged from
bankruptcy in August 1992.

Quantum Chemical
Quantum Chemical paid a special dividend of $50 per share, increasing the firm’s total debt to 114%
of the book value of total assets. The firm had recently divested its wine and spirits business to focus
on its core chemical business and announced a $600 million expansion in that area to take
advantage of excess demand in the industry. In the following year prices for the firm’s products fell
by 20-30%. In addition, a fire shut down a plant responsible for 20% of the firm’s production. In the
three years following the recap, the ratio of the firm’s operating income to total assets declined by
56%. Beginning in ‘1990, Quantum delayed further expansion, closed three plants, and began
looking for nonstrategic assets to sell. Over the three-year period, however, the firm actually
increased the book value ofits assets by 24% and capital expenditures by 4%. In 1991 Quantum was
forced to write off its equity in Petrolane, a joint venture it had entered in 1989. By 1991, the third
year following its recap, Quantum’s operating profits were no longer sufficient to cover its interest
and principal obligations and the firm was forced to restructure its debt.

Standard Brands Paint Co.

Standard Brands repurchased 53% of its common stock, increasing the firm’s total debt to 89% of
the book value of total assets. The plan was designed to defeat a hostile takeover offer from
Entregrowth. In the three years following the recap, the ratio of the firm’s operating income to total
assets declined by 41%, capital expenditures were reduced by 59% and the book value of total assets
declined by 9%. By 1991, the firm was in violation of some of its debt covenants and ultimately filed
for bankruptcy under Chapter 11 in 1992.

Swank
Swank paid a special dividend of $18.10 per share to all nonmanagement and non-ESOP shares,
increasing total debt to 77% of the book value of total assets. In the three years following the recap,
the ratio of operating income to total assets increased 62% and the book value of total assets was
reduced by 51%. Nevertheless, in each of the three years following the recap, the firm’s operating
156 D.J. Denis, D.K. DenisjJournal of Financial Economics 37 (1995) 129-157

income was insufficient to cover its interest and principal obligations and the firm was in violation of
some covenants of its credit agreements. The credit agreements were subsequently amended.

USG Corp.
Following the acquisition of a 9.8% stake in the firm by Desert Partners, USG made a special
payout of cash, debt, and stock totaling $37 per share or $2.15 billion. At the time of Desert’s
acquisition, competition for the firm’s major product was increasing and its price structure was
weakening. The recap increased total debt to 181% of the book value of total assets. USG
announced its intention to sell assets, institute cost cutting measures, and cut capital expenditures by
more than 50%. In the three years following the recap, the ratio of operating income to total assets
declined by 54%, the book value of total assets was reduced by 22%, and capital expenditures were
cut by 73%. The firm defaulted on its junk bond interest obligations in 1991 and declared
bankruptcy under Chapter 11 in 1992. At that time, every one of USGS major competitors were also
operating in Chapter 11.

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