Aurora Borealis
22 August 2019 CFA Institute Journal Review

Asset Allocation in Bankruptcy (Digest summary)

  1. Clifford S. Ang, CFA

The authors investigate the effect of liquidation and reorganization on the allocation and utilization of assets in bankruptcy. They find that asset utilization is lower in liquidations relative to reorganizations and that these effects are concentrated in thin markets and in areas with low access to finance. These findings suggest that when search costs are large, liquidation can lead to inefficient allocation of assets in bankruptcy.

What Is the Investment Issue?

In theory, when there are no market frictions, a bankrupt firm’s assets will be allocated to their best use, regardless of whether the firm chooses to liquidate or reorganize. Markets are not frictionless in practice, however, so the authors investigate how assets are allocated and used when firms liquidate or reorganize, and they identify what market frictions could cause differences in outcomes between the two approaches.

How Did the Authors Conduct This Research?

The authors use Chapter 11 bankruptcy filings data from LexisNexis Law, which include the date the case was filed, the court in which the case was filed, and the judge assigned to the case. The data also contain a status update, which the authors use to identify which cases convert to Chapter 7 liquidation. The authors use data for firms that filed for bankruptcy from 1992 to 2005, which allows them to track the bankrupt firms for a five-year period after the bankruptcy filing. They then combine this information with data from the US Census Bureau’s Longitudinal Business Database. The resulting dataset covers 129,000 establishments belonging to 28,000 bankrupt firms that employed close to 4.7 million workers at the time of bankruptcy.

Focusing on the real estate assets of bankrupt firms in the United States, they construct a novel dataset that tracks the allocation and use of these assets over time. Doing so allows them to capture the allocation and use of assets when plants shut down and the real estate is vacant or when the asset is subsequently repurposed.

The authors test the impact of converting to liquidation on post-bankruptcy plant outcome and real estate use while accounting for the propensity of a particular judge to convert a case to Chapter 7 liquidation. If liquidation has a similar effect on asset utilization as reorganization does, then the coefficient of liquidation should not be statistically different from zero. Otherwise, the coefficient of liquidation measures the causal effect of Chapter 7 liquidation on plant outcomes and asset allocation.

What Are the Findings and Implications for Investors and Investment Professionals?

The findings could be important to investors who have claims to the bankrupt entity.

The authors observe the following:

  1. Both liquidation and reorganization lead to substantial reallocation.
  2. When an asset is redeployed to a different user, that new user is typically a local firm in the same industry.
  3. Industry conditions, especially local economic activity, are important determinants of asset reallocation and utilization.
  4. In thin markets, liquidated assets are more than 30% less likely to be occupied and employment is lower relative to assets in reorganization.
  5. In markets with low access to capital, liquidated assets are less likely to be occupied and employment is significantly lower relative to assets in reorganization. The authors find that these effects are strongest in areas with high search costs, so liquidation may lead to more inefficient allocation of assets in such areas.

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