Dynamic Debt Negotiation

Topic 7 Dynamic Debt Renegotiation
Corporate Finance (Part 1)
Pierre Mella-Barral
Edhec Business School
mella@edhec.edu
Ph.D. in Finance Corporate Finance (Part 1)
Page 1
Overview
Default versus Liquidation Timing: Debt Renegotiation
Debt Forgiveness and Strategic Debt Service
Valuing Bargaining Power
Page 2
When a firm enters a debt contract, debt-holders are to

receive a series of payments (coupon).
These promises are credible, to the extend that if

share-holders repudiate the debt contracts, i.e. do not fulfill
their debt service obligations, debt-holders are entitled to
invoke debt collection law to seize the assets of the firms:
They can force liquidation and request the Absolute Priority
Rule to be applied.
Page 3
Debt opens the following sequence of decisions:

1. Share-holders have residual control rights, defined as the right
to decide all usages of the real assets in any way not
inconsistent with the contract.
In particular they decide when to abandon, in a
non-cooperative fashion, i.e only maximizing the value of their
claim (equity).
That is share-holders hold a limited liability call option.
2. In the event of repudiation, debt-holders recover the control of
the firm.
They can decide to force bankruptcy, but will only do so if it is
in their best interest.
Page 4

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Consider more carefully decision 2
Debt-holders can force bankruptcy, but bankruptcy is not

optimal because as residual claimants the debt-holders bear
all the costs of bankruptcy.
prefer to renegotiate with share-holders.
This further decision is also taken non-cooperatively, but this

time by the debt-holders, i.e only maximizing the value of
their claim (debt).
Debt-holders hold a liquidation call option which only

becomes active once shareholders exercise their limited liability
call option. This is an embedded (or compound) option.
This illustrates the fact that corporate decision making most

often involves sequences of decision which are taken by
different players.
Page 5
We have considered decision 1 (the limited liability option)

but ignored decision 2.
That is, we have considered that in the event of repudiation,

debt-holders always respond triggering liquidation. Leland
(1994).
Amounts to assuming that the debt-holders option not to

seize the assets of the firm (and renegotiate) is equal to zero.
Page 6
Debt suffers from the following moral hazard problem:
Default versus Liquidation Timing:

The ex-ante (cooperative) optimal time of liquidation
differs from
Debtors ex-post optimal time of default.
Renegotiating the contract is pareto-optimal.
Debt-holders optimal decision 2 does not consist of

immediately forcing bankruptcy.
Page 7
Debt contract concessions can be

temporary, or
permanent
Notice:
Does not assume asymmetric information.
Trading occurs continuously in perfect and frictionless markets.
Management acts in debtors interest.
Page 8
Empirical Evidence on Debt Renegotiation
Deviations from the priority of creditors claim on the

pre-liquidation cash-flows of the firm:
Firms emerge from debt restructuring with lower debt-equity
ratios.
Leverage &
Firms re-enter restructuring within a few years after
completing restructuring.
Sequences of debt reorganizations.
Deviations from the priority of creditors claim on the

post-liquidation (residual) value of the firm:
Departures from the Absolute Priority Rule in liquidation
(Debtors get a share of the proceeds of a liquidation sale, even
though creditors are not completely paid-off).
Page 9
Model
Framework: Mella-Barral (1999)

I
Firm status described by a summary state variable, reflecting

economic fundamentals, xt , which follows a diffusion process
dxt
= (xt ) dt + (xt ) dBt .
where B is a standard Brownian motion.

I
Assume risk-neutrality, and a constant borrowing and lending

safe rate, .
Page 10
Model
I
The incumbent can operate the physical assets:

yields a period income flow (which maybe negative in
some range),
(xt )
Alternatively, the incumbent can liquidate the physical assets:

In the hands of competitors, the physical assets could
yield an income flow,
(xt )
Assumption
1. At entry, (x0 ) > (x0 ) (otherwise already in liquidation).
2. The functions (x) and (x) have a single crossing point,
3. the corresponding state, x , is smaller than x0 .
Page 11
Model
A representation of the set-up is as follows:
Page 12
Valuation, under the First Best Policy

I
Denote (x) and (x) the unlimited liability value of a

perpetual claim on the income flows (x) and (x)

Z
s
(xs ) e
ds | x = x .
(x) E
(x)
Z

(xs ) e s ds | x = x .
Then the value of the firm:

U(xt )
(xt ) + [ (x) (x)] P(xt x) ,
where P(xt x) is the Laplace transform of ft (Tx ), the

density of Tx , the first time at which xt hits the level x.
The ex-ante optimal liquidation trigger level, x, solves the first
order condition
U(xt )
= 0.
x
Page 13
Valuation, under the First Best Policy

A representation of the set-up in terms of values is as follows:
Page 14
Benchmark Model of Debt

I
Creditors are a cohesive group: abstracting from the

hold-out problem, in the presence of multiple creditors.
Tax advantage of debt is set to zero.
The status is observable to both parties, but not verifiable to

outsiders, thus cannot be part of an enforcable contract, as in
Hart Moore (1989).
Debtors select their time of default in an unconstrained
fashion.
Liquidity problems do not influence debtors decision to default.

No debt protective covenants imposes liquidation to the
debtors.
I
Infinite maturity debt contract.
Contracts can be perfectly and costlessly renegotiated.
Page 15
Debt: Standard Debt Contract

Debtors, D, promise to their creditors, C,
1. : Coupon payment every unit of time. Infinite maturity.
Debtors can at any time decide to repudiate the contract and
default on their contractual obligations.
If the contract is not serviced, creditors can take legal action,
going to court, and force a liquidation sale.
2. C (x): Claim on the residual value of the firm in liquidation.

If the Absolute Priority Rule is applied, creditors are paid first,
out of the proceeds of a liquidation sale, up to a par value, P.
Then, C (x) = min{ (x); P}).
Debt contract:
C ( ; C (x) )
Pre-liquidation
cash flows
Post-liquidation
cash flows
Page 16
Valuation under the Second Best Policy

No Reorganization, as in Leland (1994):
I Debtors claim (Equity):

D(xt | ) = (xt )
+ (x D ) C (x D ) (x D ) +
Creditors claim (Bonds):

C (xt | )
C (x D )

P(xt x D )
where
Z
P(xt x D ) =
t
I
e (Tx D t) ft (Tx D )d Tx D .
Debtors non-cooperative (unconstrained) optimal default

trigger level, x D , solves
D(xt | )
= 0.
x D
Page 17
Ex-Post versus Ex-Ante Optimal Timing
The ex-ante optimal (first-best) liquidation trigger level, x,

consists of balancing
a pre-liquidation rent, (x), against
an alternative rent, (x).
whereas
Debtors ex-post optimal (second-best) default trigger level,
x D , consists of balancing
a pre-default rent, (x) , against
an alternative post-default rent, (x) C (x).
Page 18

I
The second best choice can therefore lead to either

inefficiently early liquidations,
Page 19

I
or inefficiently late liquidations.
Page 20
Consequently,
such that
There exists a unique level of debt service obligations, ,
x equals x D .
This, for any given liquidation sharing rule, C (x), such as the
APR. Hence with the APR, there exists a unique level of
borrowings for which debtors optimal decision is not ill-timed.
Page 21
I
I
Renegotiation is pareto-optimal.
There are two dimensions to it:
1. Leverage (as we have just see);
2. Bargaining power (who internalizes the surplus to be gained in
reorganizations).
Page 22
First Dimension: Leverage

I
Case (a): For higher levels of leverage ( > ),

x D > x, Early default.
It will becomes in creditors interest to make deferring
concessions, prior to forcing liquidation. With respect to the
debt contract C(; C (x)):
Reducing the coupon (self-imposed debt write-off).
Rationale for Debt Forgiveness.
Case (b): For lower levels of leverage ( > ),

x D < x, Late default.
It will becomes in creditors interest to make an inducive
concession, in order to have liquidation earlier. With respect
to the debt contract C(; C (x)):
Concession on C (x), the residual claim.
Rationale for Departures from the APR, in liquidation.
Page 23
Second Dimension: Bargaining Power
We have developed the intuition when creditors make

self-imposed concession.
However, instead of passively accepting or rejecting such

concessions, debtors can actually obtain more.
Debtors may behave opportunistically, given creditors

willingness to avoid bearing the costs of an ill-timed
liquidation (strategic debt service).
So it is important to consider the relative bargaining power

between debtors and creditors in reorganizations (after
default), denoted BD
C.
Page 24
Second Dimension: Bargaining Power

I
Consider the two limiting cases (Stackelberg equilibria).

Case (i): the creditors make take-it-or-leave-it offers to the
debtors:
Self-imposed concessions, BD=0
C=1 .
Case (ii): vice-versa:

Forced concessions, BD=1
C=0 .
I
The surplus to be gained in reorganizations is

U(x)
[ D(xt | ) + C (xt | ) ]
First Best
Second Best
(with x )
(with x D )
Page 25
Debt Renegotiation
Out of the four possible cases, we now only examine

Case (a) (i): Creditors deferring, self-imposed concessions
To highlight the importance of bargaining power, we then

briefly contrast it with
Case (a) (iI): Creditors deferring, forced concessions
Page 26
Creditors deferring, self-imposed concessions
Case (a): Higher levels of outstanding debt, leading to an

early default:
Reorganizing the debt contract, C(; C (x)), consists of
deferring concessions
Debt Forgiveness: decreasing the coupon obligation, .
Case (i): Creditors make take-it-or-leave-it offers to the

debtors.
Page 27

1. The first reorganization occurs when the state variable first
reaches xCf .
2. Dynamic reorganization: = Further debt forgiveness
options will be exercised by creditors, each time xt reaches a
new historical minimum.
xt
inf {x }.
0t
At each reorganization time, the creditors optimal reductions

leaves their debtors marginally preferring continuation to
default.
3. Creditors are only interested in making such concessions as
long as they gain from avoiding early liquidations.
Therefore this process of successive concessions stops when
when liquidation is optimal. This
the coupon is reduced to ,
occurs when xt reaches x.
Page 28

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This sequence can be represented just on the previous graph:
Page 29

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Separating planes, yields corporate debt relief Laffer curves:
Page 30
Creditors deferring, forced concessions
Consider now Case (a) (ii): Creditors deferring, forced

concessions:
I
Shareholders essentially blackmail their creditors. Strategic

debt service
Concessions can be permanent (as discussed here), but they

could be temporary, as with debt holidays.
Page 31
Case (a) (ii): Creditors deferring, forced concessions

I
The sequence of renegotiations represented on one graph is:
Page 32
Contrasting Reorganization Timing

I
Strategically forced concessions occur well before creditor

self-imposed ones:
Page 33
Value of Bargaining Power
Such real option models permit to measure the importance of

renegotiation bargaining power (here in debt pricing).
The bonds default risk premium with self imposed

concessions is
pC (xt , xt )
C (xt , xt ) ,
(xt ) C
and similarly, with forced concessions it is

pD (xt , xt )
D (xt , xt ) .
(xt ) C
Page 34
Value of Bargaining Power

I
Relative difference between the bonds risk premium with

self-imposed concessions versus forced concessions is
pD (xt , xt ) pC (xt , xt )
,
pC (xt , xt )
at any time before the first reorganization.
Numerical examples yield that the balance in bargaining power can

modify
the debt risk premium at entry, by around 17%;
the ex-post departure from the APR by around 21%.
Page 35
Readings
Mella-Barral, P., and W.R.M. Perraudin, 1997, Strategic Debt
Service, Journal of Finance 52, 531-556.
Mella-Barral, P., (1999) The Dynamics of Default and Debt
Reorganization, Review of Financial Studies, Vol. 12, No. 3,
pp 535-578.
Page 36

Dynamic Debt Negotiation

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Topic 7 Dynamic Debt Renegotiation

Corporate Finance (Part 1)

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Default versus Liquidation Timing: Debt Renegotiation

Debt Forgiveness and Strategic Debt Service

Valuing Bargaining Power

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Default versus Liquidation Timing: Debt Renegotiation

When a firm enters a debt contract, debt-holders are to

These promises are credible, to the extend that if

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Default versus Liquidation Timing: Debt Renegotiation

Debt opens the following sequence of decisions:

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Default versus Liquidation Timing: Debt Renegotiation

Consider more carefully decision 2

Debt-holders can force bankruptcy, but bankruptcy is not

This further decision is also taken non-cooperatively, but this

Debt-holders hold a liquidation call option which only

This illustrates the fact that corporate decision making most

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Default versus Liquidation Timing: Debt Renegotiation

We have considered decision 1 (the limited liability option)

That is, we have considered that in the event of repudiation,

Amounts to assuming that the debt-holders option not to

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Default versus Liquidation Timing: Debt Renegotiation

Debt suffers from the following moral hazard problem:

Default versus Liquidation Timing:

Renegotiating the contract is pareto-optimal.

Debt-holders optimal decision 2 does not consist of

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Default versus Liquidation Timing: Debt Renegotiation

Debt contract concessions can be

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Empirical Evidence on Debt Renegotiation

Deviations from the priority of creditors claim on the

Deviations from the priority of creditors claim on the

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Framework: Mella-Barral (1999)

Firm status described by a summary state variable, reflecting

= (xt ) dt + (xt ) dBt .

where B is a standard Brownian motion.

Assume risk-neutrality, and a constant borrowing and lending

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

The incumbent can operate the physical assets:

Alternatively, the incumbent can liquidate the physical assets:

Topic 7 Dynamic Debt Renegotiation

Ph.D. in Finance Corporate Finance (Part 1)

Topic 7 Dynamic Debt Renegotiation

Valuation, under the First Best Policy

Denote (x) and (x) the unlimited liability value of a

Then the value of the firm:

(xt ) + [ (x) (x)] P(xt x) ,