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The Leverage Ratchet Effect

Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer ()
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Paul Pfleiderer: Graduate School of Business, Stanford University

No 2013_13, Discussion Paper Series of the Max Planck Institute for Research on Collective Goods from Max Planck Institute for Research on Collective Goods

Abstract: This paper explores the dynamics of corporate leverage when funding decisions are made in the interests of shareholders. In the absence of prior commitments or regulations, shareholder-creditor conflicts give rise to a leverage ratchet effect, which induces shareholders to resist reductions while favoring increases in leverage even when total-value maximization calls for the opposite. Unlike inefficiencies based on asymmetric information, the leverage ratchet effect applies to all forms of leverage reduction, including earnings retentions and rights offerings. The leverage ratchet effect is present even in the absence of frictions other than the inability to write complete contracts. The effect creates an agency cost of debt that lowers the value of the leveraged firm. Standard frictions magnify the impact of the effect. In a dynamic context, since leverage becomes effectively irreversible, firms may limit leverage initially but then ratchet it up in response to shocks. The resulting leverage dynamics can produce outcomes that cannot be explained by simple tradeoff considerations. Leverage can be adjusted in many ways. For example, leverage reductions can be achieved by issuing equity to either buy back debt or purchase new assets, or by selling assets to buy back debt. We study shareholders’ preferences over different ways to adjust leverage. A benchmark result gives conditions for shareholder indifference, but generally, shareholders have clear rankings over the alternatives. For example, shareholders often prefer reducing leverage by selling assets even at distressed prices.

New Economics Papers: this item is included in nep-ban, nep-mic and nep-reg
Date: 2013-08, Revised 2017-09
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Related works:
Journal Article: The Leverage Ratchet Effect (2018) Downloads
Working Paper: The Leverage Ratchet Effect (2017) Downloads
Working Paper: The Leverage Ratchet Effect (2015) Downloads
Working Paper: The Leverage Ratchet Effect (2013) Downloads
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