Introduction

This paper analyzes whether firms in financial distress impose indirect costs to their direct competitors and to the real economy by affecting the investment decisions of other firms in the industry. The analysis builds on previous findings that show that when some firms in the industry have financial difficulties, the costs of external financing to rivals increase (Lang and Stulz, 1992; Jorion and Zhang, 2007; Benmelech and Bergman, 2011; Hertzel and Officer, 2012). In principle, the higher financing costs that follow a distress in the industry could reduce investment by affecting the competitors’ ability to obtain sufficient funds. 1 However, a competitor facing financial difficulties could facilitate predation by other firms in the industry, who could exploit their rivals’ weaknesses and increase investment to obtain a higher market share (Fudenberg and Tirole, 1986; Bolton and Scharfstein, 1990; Opler and Titman, 1994). 2 The main objective of this paper is to examine whether competitors of the distressed firms are able to exploit the opportunity to increase their market share, in spite of the potentially higher costs of obtaining finance, or whether the increase in financing costs more than offsets the potential benefits of increasing investment in market share. In addition, the paper seeks to identify the characteristics of the firms that benefit most from their rivals’ financial weaknesses. The main analysis in this paper explores whether the higher financing costs associated with the financial distress of a competitor affect the real investment decisions of other non-distressed firms in the industry. 3 The identification challenge of this analysis is that common economic factors, such as negative demand shocks, could simultaneously lead the weakest firms to miss their debt payment obligations or even file for bankruptcy, and the rest of the firms to reduce their capital investments to adjust to the new economic situation. To overcome this fundamental endogeneity problem, the main identification strategy exploits the cross-sectional heterogeneity of firms’ long-term debt maturity structures within a given industry and year. Specifically, estimations examine whether firms with large fractions of their long-term debt maturing right after a rivals’ bankruptcy filing or debt default (treated firms) had to cut their investment expenditures more than otherwise similar firms that did not have to refinance their long-term debt at that time (control firms). Specifications include industry*year fixed effects, which control for common shocks to the cash flows of all industry participants in a given year. Additionally, the dependent variable is measured in differences to account for unobservable, idiosyncratic firm effects that are fixed around the distress period. Further, the models account for observable firm characteristics that could simultaneously determine investment and debt maturity structures – i.e. size, profitability, investment opportunities, cash flows, and leverage ratios (Barclay and Smith, 1995; Guedes and Opler, 1996; Choi, Hackbarth, and Zechner, 2013) – both as controls in the regressions and through a matching approach. Results from this analysis show that, on average, treated firms cut their yearly investment ratios by significantly larger amounts than controls. Economically, the coefficients imply that the difference in the change in investment to capital ratios is approximately 4 percentage points higher for control firms relative to treated firms. This represents a level of investment that is around 10% lower than predistress levels. Overall, these findings suggest that the potential benefits of increasing investment are more than offset, on average, by the high costs of finance triggered by the distress.