When companies in financial difficulty are forced to sell assets – especially real assets such as factories, business units, real estate, or the entire company – the news is often seen as negative all around. In these situations, often referred to as “fire sales,” companies are forced to sell assets below fair value (see Pulvino, 1998[1]), and the spillover effects can be costly as well. These spillover costs, or externalities, include plant closings and job losses that hurt employees, suppliers, customers, and competitors (see Goolsbee and Krueger, 2015[2]). Fire sales may also depress the values of the assets of healthy companies in the same industry (see Benmelech and Bergman, 2011[3]).
The costs of fire sales have been analyzed in many academic studies, and they influence public policy debates, often resulting in pressure for governmental entities to bail out the firms in difficulty to avoid the associated costs – in particular, the spillover costs. In fact, in many countries, the government response to the COVID-19 pandemic has been to provide bailout funds either through cash grants or through loans and loan guarantees, partly to avoid corporate bankruptcies and liquidations and their associated fire sales (for a discussion of the COVID-19 bailouts, see Meier and Smith, 2020[4]).
What is often underappreciated, however, is the magnitude of the gains that occur in sales of distressed assets. There has been little research quantifying the gains for fire sales of real assets. In theory, it’s not clear whether buyers gain. While there can be a redistribution of wealth from the seller to the buyer, the seller’s loss can also reflect an inefficient reallocation to a buyer that cannot use the assets as effectively as the seller, while buyers that can use the assets more productively are sidelined because they do not have the resources to fund the acquisition.
In our research paper “The Bright Side of Fire Sales,” we analyze 30 years of data on fire sales of real assets and find that buyers experience large gains at the expense of sellers. Since the gains of buyers in fire sales are underappreciated, ignoring them can overstate the overall costs, which in turn can exaggerate the need for bailouts as a tool to prevent fire sales. Our result therefore has implications for the debate about whether bailouts should be used as a tool to prevent fire sales, particularly since bailouts also impose costs on society.
To measure the gains that buyers of distressed assets experience, we analyze more than 21,000 completed acquisitions announced between 1982 and 2012 – including acquisitions of entire companies or individual assets. We limit the data set to publicly traded companies in the United States for which data were available on Compustat and CRSP and use several other data screens that are standard in mergers and acquisitions (M&A) research. To define fire sales, we identify transactions where the seller is bankrupt, where the transaction is part of a liquidation plan, or where the seller is in a debt restructuring that imposes a loss on the creditors. In all these cases, the seller has lost some – or all – control of management decision-making to a bankruptcy court or to creditors, who are unlikely to get as high a price for the distressed assets as the seller’s management might have. Based on these criteria, we find 428 fire-sale acquisitions.
We measure the differences between the stock performance of companies making acquisitions over the three-day period surrounding the announcement of the transaction compared with the performance of the stock market as a whole, adjusting for risk (referred to as “abnormal returns”). We then compare the abnormal returns of buyers in fire sales with the abnormal returns of buyers in regular acquisitions, and the results are striking: The returns for fire-sale acquisitions are about 2 percentage points higher than for other acquisitions. These results hold in a variety of robustness tests and subsamples. For example, the results hold both for acquisitions of assets and acquisitions of entire companies.
Not surprisingly, sellers lose substantially in fire sales relative to regular acquisitions. But when we value-weight the gains to buyers and the losses to sellers using the respective sizes of buyers and sellers as weights, the returns of such a hypothetical combined firm in a fire sale are similar to the returns in regular transactions. This suggests that the loss to the seller in a fire sale is to a large degree a wealth transfer to the buyer.
We further study the reasons why abnormal returns are higher in fire sale acquisitions. The returns to buyers in fire sales are higher when there is less competition for the seller’s assets. In addition, buyers in fire sales gain more when the seller’s industry (or the M&A market in the industry) has low liquidity, is financially constrained, or the entire economy is in recession. We also find that returns are higher for buyers in fire sales when the seller’s assets are generic or easily deployable and lower when they are industry-specific. The underlying idea behind these tests is that they vary the amount of bargaining power between the buyer and seller. The more bargaining power on the buyer’s side in a fire sale, the larger the buyer’s gains in these transactions, suggesting that the underlying mechanism behind our results is the weak bargaining position of the seller in fire sales.
We also contribute to a recent literature on the changing nature of chapter 11 bankruptcy. In this part of the paper, we only use a sub-sample of transactions that all involve asset purchases out of bankruptcy. To measure creditor control (which reduces the seller’s bargaining power), we use the presence of debtor-in-possession (DIP) financing and key employee retention plans (KERPs) (see, e.g., Skeel, 2003[5], and Baird and Rasmussen, 2003[6], 2010[7]). We find that bankruptcy asset purchases with creditor control yield higher abnormal returns for buyers than bankruptcy purchases without creditor control.
Next, we study the real effects associated with fire sales. We do not find that fire sales yield better accounting performance for the buyers after the acquisitions or that fire sales are more or less successful based on news reports in the years after the transaction. This indicates that buyer returns are not due to a higher-quality match between buyers and sellers or the revelation of good news about buyers. Instead, these results support our argument that buyers purchase assets at a low price.
Importantly, we also study the externalities of fire sales. We find no difference between fire sales and regular transactions in the stock price response of the seller’s peers, its customers, or its suppliers. We do find a decline in employment relative to regular acquisitions but not relative to bankruptcy restructurings not accompanied by asset sales. Therefore, we conclude that the externalities of fire sales for other stakeholders are limited.
Last, we address many potential alternative explanations for the results. The most important is the hypothesis that higher returns for buyers are a compensation for risk taking. When we control directly for the riskiness of the assets, however, we find no differences in the magnitude or the significance of the abnormal returns.
Conclusion
Overall, our analysis considers a large number of stakeholders that could be negatively affected by a fire sale but finds little evidence for such negative effects. The main effect of fire sales is a wealth transfer from the seller to the buyer. This implies that, from a welfare perspective, the costs associated with fire sales of corporate assets are much lower than previously thought based on an analysis of seller costs only. From a policy perspective, these findings indicate that the merits of bailouts as a response to the potential losses associated with fire sales are limited, especially given the moral hazard and the other distortions caused by these bailouts.
ENDNOTES
[1] Todd C. Pulvino. C. 1998. Do asset fire sales exist? An empirical investigation of commercial aircraft transactions. Journal of Finance 53:939–78.
[2] Austan D. Goolsbee and Alan B. Krueger. 2015. A retrospective look at rescuing and restructuring General Motors and Chrysler. Journal of Economic Perspectives 29:3–24.
[3] Efraim Benmelech and Nittai K. Bergman. 2011. Bankruptcy and the collateral channel. Journal of Finance 66:337–78.
[4] Jean-Marie Meier and Jake Smith. 2020. The COVID-19 Bailouts. Working Paper. University of Texas at Dallas. Available here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3585515
[5] David A. Skeel. 2003. Creditors’ ball: The new new corporate governance in Chapter 11. University of Pennsylvania Law Review 152:917–51.
[6] Douglas G. Baird and Robert K. Rasmussen. 2003. Reply: Chapter 11 at twilight. Stanford Law Review 56:673–99.
[7] Douglas G. Baird and Robert K. Rasmussen. 2010, Antibankruptcy. Yale Law Journal 119:648–99.
This post comes to us from Jean-Marie Meier, assistant professor of finance at the University of Texas at Dallas, and Henri Servaes, the Richard Brealey Professor of Corporate Governance at London Business School. It is based on their paper, “The Bright Side of Fire Sales,” available here and, as published in the Review of Financial Studies, here.