Aurora Borealis
1 August 2015 CFA Institute Journal Review

Redefining Financial Constraints: A Text-Based Analysis (Digest Summary)

  1. Marc L. Ross, CFA

Text-based analysis informs the authors’ process of identifying firms’ limits on access to capital, be it public or private equity or debt. The goal of their approach is to address current deficiencies in the measurement of financial constraints.

What’s Inside?

The authors develop and test a robust methodology to determine firms’ capital raising constraints by reviewing the required disclosures in 10-K statements. Constraints are distinct between equity and fixed-income markets, both in origin and in response to negative financial shocks.

How Is This Research Useful to Practitioners?

The degree to which a firm may be susceptible to limits on its ability to tap the capital markets affects its growth opportunities and can be bad in the wake of unexpected negative financial shocks, such as those that occurred in the wake of the internet bubble and the Great Recession. Asymmetrical firm information may drive these constraints as well.

A sample of about 52,000 management discussion and analysis (MD&A) portions of firms’ 10-Ks is the basis for the authors’ research, which considers the degree of capital raising limitations for equity, debt, and private placements. SEC Regulation S-K requires firms to disclose challenges to their liquidity, their proposed investments, and any sources of liquidity. Firms that struggle to fund growth opportunities (constrained firms) often face limitations on raising capital in the equity markets and experience a more serious reaction to unexpected macroeconomic events. Additionally, information asymmetries contribute to these limitations at points when certain firm-specific or proprietary issues prove to be challenging. Firms’ breaches of bond covenants, in contrast, contribute to their struggle to borrow funds. Size and age play a role in firms’ limitations. Younger, smaller companies, in particular, need to fund growth opportunities.

Those involved with raising capital should understand potential sources of their clients’ limitations on access to capital.

How Did the Authors Conduct This Research?

A body of existing literature on this subject provides perspective for the authors’ data gathering and research process.

Departing from what they view as limitations of both the sample used and the methodology to assess it, the authors review and parse 12 years of Compustat firm 10-K MD&A information found in the SEC EDGAR database. Winnowed down, the final sample contains more than 48,000 entries. The process entails careful and precise use of meta Heuristica software to conduct text searches that identify the degree to which firms may curtail or limit investment decisions for any number of reasons. Rather than being a binary process that categorizes a firm as constrained or not, the exercise considers financial constraint along a continuum. The constraint query encompasses limitations on equity, debt, and private equity forms of raising capital.

The authors determine firms’ financial constraints through the lens of several policy variables: investment (R&D/sales and capital expenditures/sales) and financing (public seasoned equity offering issuance/assets, private seasoned equity offering issuance/assets, and long-term debt issuance/assets). The tests control for outliers and firms’ age and size.

Using extensive regression analysis, they consider the association between firm and industry characteristics and the constraint variables. They evaluate the results alongside measures used in the literature presented in terms of correlation coefficients. From the analysis, the authors draw several high-level conclusions:

  • Firms with a high delay investment score have good investment opportunities and high Tobin’s q (high growth).
  • A firm’s delay investment score correlates negatively with profitability.
  • A firm’s delay investment variable correlates positively with capital expenditures and R&D.
  • Constraints differ among equity, private placement, and debt markets. The first two tend to be high growth with little profitability, whereas the third one tends to exhibit lower growth and greater leverage.

The authors also consider whether firms with greater levels of financial constraint react differently to negative shocks than those without such constraints. The events in question are the market declines of 2001–2002 in the wake of the technology boom, the 2008–09 financial crisis, and the exogenous mutual fund selling shocks. They confirm that constrained firms will limit their R&D and capital expenditures as well as equity and debt financing more so in times of distress than those firms that are not constrained. This finding appears to be consistent for all three negative shocks, although results may vary by firm size and external financing type.

Asymmetrical information for constrained firms contributes to their challenge with issuing equity rather than debt. Such information relates to proprietary issues and trade secrets. These results are robust to controls for firm size, firm age, and R&D. Firms that have debt issuance constraints often experience covenant violations.

Abstractor’s Viewpoint

A rigorous analysis of stories told in mandated firm disclosures confirms what the relevant literature has long concluded: Constrained firms limit R&D and capital expenditures and curtail equity and debt issuance more so than firms with fewer constraints. This finding holds both in general and during periods of unforeseen financial distress. Informational asymmetry drives, in part, firms’ equity but not their debt market issuance constraints. The authors’ methodology expands on and is superior to other common measures in the research on the topic for prediction of policy curtailments. There would appear to be scope for further research on what measures could better delineate between equity and debt market constraints that are very different.

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