By Professor Gunjan Seth (Marshall School of Business, University of Southern California)
One of the primary challenges faced by the courts after a firm files for bankruptcy is estimating the continuation value of the reorganized firm. Often there are large absolute errors in the court-determined valuations of the reorganized firm. These large valuation errors raise significant concerns regarding the efficiency of the Chapter 11 process. Further, valuation disputes between competing creditor classes are largely responsible for prolonging the length and costs of the bankruptcy process.
In a recent paper, Seth (2022) documents how rights offerings have evolved as a market-based response to resolve the creditor bargaining frictions that are pervasive in bankruptcy. Rights offerings allow the bankrupt firm to raise new capital by offering a class of creditors (or equity holders) the right to purchase equity in the post-emergence company. The money raised in the rights offerings is used to pay off the secured claimants, thereby simplifying the bargaining process. Moreover, rights offerings allow unsecured claimants to objectively signal their beliefs about a particular valuation of the reorganized firm.
We are witnessing an increasing trend of firms using rights offerings to finance their emergence from Chapter 11 bankruptcies. The paper documents three facts using novel hand-collected data on the universe of large publicly listed firms’ Chapter 11 bankruptcy filings from 2003–2021. First, rights offerings were used in 35% of Chapter 11 bankruptcies (asset size weighted), to inject roughly $46 billion of fresh capital into these bankrupt firms. Some recent notable bankruptcies of Hertz Corporation, PG&E Corporation, and SunEdison were all financed by rights offerings. Second, larger bankruptcy cases, with higher numbers of creditors and more fragmented creditor classes, are more likely to use rights offerings to finance their exits from bankruptcy. Third, rights offerings are generally proposed and backstopped by hedge funds that own unsecured debt. On average, the hedge fund charges backstop fees equivalent to 6% of the amount raised in the rights offering. Further, the rights offering participants realize 50% average returns on their investments, within 3 months of the firms’ emergence from bankruptcy.
Using an instrumental variable approach that exploits exogenous stock market fluctuations, the paper documents a significant link between bankruptcy outcomes and the decision to raise financing via rights offerings. Rights offerings increase total creditor recoveries by roughly 40%. Using a rights offering in bankruptcy also reduces the likelihood of the firm refiling for bankruptcy. Post-emergence, the new equity securities of the firms financed by rights offerings significantly outperform those of other firms emerging from bankruptcy by about 30%. This outperformance appears to be driven by positive earnings surprises in firms using rights offerings. Taken together, these findings suggest that rights offerings lead to an overall increase in the value of the reorganized firm.
The paper studies three channels through which rights offerings create value. First, the decision to use a rights offering decreases bankruptcy duration by about seven months, suggesting that these offerings effectively achieve consensus and resolve conflicts of interest between different creditor classes. Their use improves the transparency of the valuation process, as is evident from the finding that rights offerings lower the incidence of unintended wealth transfers (or absolute priority deviations) between different claimants by 40%. Second, by purchasing a slice of equity in the reorganized firm through the rights offering, hedge funds specializing in distressed situations establish significant control rights in the new firm. This equity stake provides high-powered incentives for the hedge funds to improve the overall performance of the reorganized firm. On average, hedge funds purchase 43% of the reorganized firm’s equity and appoint 40% of the board members in the reorganized firm. Third, financing via rights offering replaces costly asset liquidations in firms emerging as going concerns. Bankrupt firms financed by rights offerings do not sell any of their assets in Section 363 sales. Rights offerings have evolved as a market-based solution to resolve the creditor bargaining frictions in bankruptcy. They offer an alternative way of financing bankruptcies and are particularly valuable when traditional sources of financing (like asset liquidations or super-priority financing) are limited and/or excessively costly. It is therefore not surprising rights offerings are on the rise in Chapter 11 bankruptcies, with their use extend
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