Why Distressed Companies Can't Raise Equity

Earlier today, Hostess Brands (maker of the twinkie) filed for bankruptcy protection.  Such a sad headline got me thinking of bankruptcy in general, and why companies that may be worthwhile enterprises can't raise equity when confronted with financial distress.

First, I want to clarify that bankruptcy is not necessarily a doomed result to be avoided.  Its entirely possible the company seeks bankruptcy protection to free itself of overly burdensome contracts that inhibit its success.  Nevertheless, bankruptcy can be costly.  Many distressed companies would seek to avoid bankruptcy but cannot--even if they show an optimistic future.

Why is this?  I've learned that the reason many companies can't raise equity capital when experiencing difficulty is a product of:

1) distinctions between debt and equity capital

2) uncertainty in future firm value 

An example can illustrate how both of these  factors interact to leave some companies shut out of equity markets.

Consider a firm with $90 million in par value of debt capital.  We'll assume that the future of this firm will take one of two distinct outcomes, each with 50% chance of occurring.  In outcome U (U = "up"), the firm is worth $130.  Firm value is equal to debt value plus equity value.  In outcome D (D = "down") the firm is worth $70.  For our purposes, we'll ignore any time value of money.  What is the current equity worth?

Firm value = (50% * firm value in outcome U) * (50% * firm value in outcome D) = $100

So the firm value is $100.  Does this mean that equity value equals firm value - debt capital?  Well, yes, as long as the debt capital is measured at market value.

In this case, debt capital is worth less than its par value.  I know this by applying the same approach to determining current value of the firm.  Specifically, debt capital in outcome U is worth its full par value of $90. In outcome D, debt is worth only $70.  At 50% probability for each scenario, debt capital is currently worth $80.  Thus, equity capital is worth $20.

Such a company is quite leveraged, having a debt/equity ratio of 4.  Lets say that the company is losing customers and suppliers due to its high leverage.  It wants to raise an extra $10 in equity capital to reduce their debt/equity ratio from 4 to less than 3 (using the assumption that equity value will obviously go from $20 to $30 with $10 of equity contribution).  What actually happens?

Adding $10 to our firm value in both outcome U and D will provide our answers.  Firm value, debt value, and equity value in outcome U will now be $140, $90, and $50, respectively.  In outcome D, firm value, debt value, and equity value will now be $80, $80, and 0.  So, at 50% probability, we see that total firm value increases by $10 to $110.  Debt capital is now worth $85, and equity value is now worth $25.  Of the $10 equity contribution, $5 increased equity value, while $5 increased debt value.  Said differently, 50% of the equity contribution value was simply transferred from equity capital to debt capital.

If you were a potential equity investor, would you want to invest where 50% of your investment went to helping a different set of investors?  Neither would I.

This situation occurs when equity capital gets a large percentage of its value from its option-like features.  Equity possesses option like features because it gets the opportunity participate in the upside, but has a floor of zero on the downside.  Options become valuable when volatility (or uncertainty) is high.  Volatility becomes more valuable when firm value and debt capital are similar.  This means that volatility is valuable for equity holders as the debt burden grows.  Although volatility is valuable to these equity holders, it becomes a double edge sword as described above.  The equity holders trade the "option value" inherent in their share price for the risk that the company will likely not be able to raise further equity even if desperately needed.

When reflecting on the financial crisis, banks and other financial institutions were subject to much of what has been discussed above.  These firms were leveraged so highly, debt capital was approximately equal to firm capital.  Many banks and financial institutions escaped, and their common stock investors saw huge returns.  Those companies that needed equity to restore confidence, however, were left empty handed, even if they represented a potentially valuable, long term business franchises.