Yves here. One thing to keep in mind when reading this post on fire sales in times of industry or overall economic distress: in normal times, most acquisitions fail (as in delivered a poor return on capital for the buyer) due to overpaying for the company. And that in turn is the result of how efficient the process of selling public and decent-sized private companies has become. Lots of bidders results in higher prices.
One of the results of overpayment is squeezing hard, perhaps harder than initially planned, to wring out costs. While the authors point out that job losses are greater in fire sales than in conventional acquisitions, they look to be on a par with headcount cuts in troubled businesses.
By Jean-Marie Meier, Assistant Professor of Finance, University of Texas at Dallas and Henri Servaes, Richard Brealey Professor of Corporate Governance and Professor of Finance, London Business School; CEPR Research Fellow. Originally published at VoxEU
Governments and central banks worldwide have reacted to COVID-19 with unparalleled emergency measures, including bailouts. One key objective of these emergency measures was to prevent fire sales and the externalities associated with them. Based on 31 years of data on fire sales of real assets, this column documents that there is an underappreciated ‘bright side to fire sales’ in the form of gains to buyers. Furthermore, the negative externalities of fire sales for customers or suppliers, for instance, appear limited. These findings indicate that the welfare losses associated with fire sales are smaller than previously thought, thereby raising doubts about the merits of bailouts to prevent them.
The COVID-19 pandemic has put enormous pressure on economies around the world (Baldwin and Weder di Mauro 2020). Many governments and central banks responded with similarly unprecedented emergency measures. For instance, in the US, the federal government legislated $1.8 trillion in bailout funds for the private sector, while the Federal Reserve reacted with around a dozen emergency initiatives (Meier and Smith 2020). One of the policy objectives behind these bailouts and other emergency measures was to avoid fire sales, and the externalities associated with them. Despite these emergency programmes, there has been an increase in bankruptcy filings by large publicly listed US firms according to the UCLA-LoPucki Bankruptcy Research Database. Therefore, it seems reasonable to project that these bankruptcies will lead to an increase in fire sales over the next several months and years.
Starting with Pulvino (1998), a body of academic work on fire sales has emerged. Besides the losses for the seller in fire sales, other articles have documented the externalities of fire sales. For example, these externalities can affect the employees of the fire sale firm, or the suppliers and customers of the distressed firm (Goolsbee and Krueger 2015).
The Bright Side of Fire Sales
What is often underappreciated, however, is the magnitude of the gains that occur in sales of distressed assets. From a theoretical perspective, it is not clear whether buyers gain. While there can be a redistribution of wealth from the seller to the buyer, the seller’s loss can also reflect an inefficient reallocation to a buyer that cannot use the assets as effectively as the seller, while buyers that can use the assets more productively are sidelined because they do not have the resources to fund the acquisition.
We examine 31 years of data on fire sales of real assets and find that buyers experience large gains at the expense of sellers (Meier and Servaes 2019, 2020). Since the gains of buyers in fire sales are often underappreciated, ignoring them can overstate the overall costs of fire sales. As a result, the need for bailouts as a tool to prevent fire sales can be exaggerated. Our findings have important implications for the debate about whether bailouts should be used as a tool to prevent fire sales, especially since bailouts also impose costs on society. For example, bailouts could induce moral hazard and the bailout process could be distorted because of political connections.
We measure the gains for buyers of distressed assets by analysing almost 22,000 completed takeovers from 1982 to 2012 – including acquisitions of entire companies as well as corporate sales of assets or divisions. We limit the data set to acquisitions by US-publicly traded companies. We define fire sales as transactions where the seller is bankrupt, where the transaction is part of a liquidation plan, or where the seller is in a debt restructuring that imposes a loss on the creditors. The common theme of these three criteria is that the seller has lost some – or all – control of management decision-making to a bankruptcy court or to creditors, who are unlikely to get as high a price for the distressed assets as the seller’s management might have. Based on these criteria, we find 428 fire-sale acquisitions.
To value the effect of the M&A announcement on the buyer we use ‘abnormal returns’–the difference between the stock performance of a company making an acquisition over the three-day period surrounding the announcement of the transaction compared with the performance of the stock market as a whole. We then compare the abnormal returns of buyers in fire sales with the abnormal returns of buyers in regular acquisitions, and the results are remarkable: the returns for fire-sale acquisitions are about two percentage points higher than for other acquisitions.
As one might expect, sellers lose substantially in fire sales relative to regular acquisitions. But once one value-weights the gains to buyers and the losses to sellers using the corresponding sizes of acquirers and sellers as weights, the returns of the combined firm in a fire sale are similar to the returns in regular acquisitions. Thus, the loss to the seller in a fire sale is a wealth transfer to the buyer.
The Mechanisms Behind the Buyer Returns in Fire Sales
Next, we ask why abnormal returns are higher in fire sale acquisitions than in regular transactions. We find that the returns to buyers in fire sales are higher when there is less competition for the seller’s assets. In addition, buyers in fire sales gain more when the seller’s industry (or the M&A market in the industry) experiences low liquidity, is financially constrained, or the entire economy is in recession. Moreover, returns are higher for buyers in fire sales when the seller’s assets are easily deployable across industries.
The common theme behind these findings is that they affect the relative bargaining power of the buyer and seller. The more bargaining power on the buyer’s side in a fire sale, the larger the buyer’s gains in these transactions, suggesting that the underlying mechanism behind our results is the weak bargaining position of the seller in fire sales. Many of these elements will also be particularly relevant during the recession caused by the COVID-19 pandemic.
We also contribute to a recent literature on the changing nature of Chapter 11 bankruptcy. For this analysis, we only use a sub-sample of transactions that all involve acquisitions and asset purchases out of bankruptcy. To measure creditor control, which reduces the seller’s bargaining power, we use the presence of debtor-in-possession financing and key employee retention plans. Bankruptcy asset purchases with creditor control yield higher abnormal returns for buyers than bankruptcy purchases without creditor control. This is evidence that the weak bargaining position of the seller in fire sales drives buyers’ gains.
Real Effects and Externalities of Fire Sales
Finally, we study the real effects associated with fire sales. Fire sales do not yield better accounting performance for the buyers after the takeovers. We also do not find that fire sales are more or less successful based on news reports in the years after the transaction. This indicates that buyer returns are not due to a higher-quality match between buyers and sellers or the revelation of good news about buyers. Instead, these results support our argument that buyers purchase assets at a low price.
Importantly, we also investigate the externalities of fire sales. We find no difference between fire sales and regular transactions in the stock price response of the distressed seller’s competitors, its customers, or its suppliers. While we find a decline in employment relative to regular acquisitions, the employment losses in fire sales are similar to the employment losses in bankruptcy restructurings that are not accompanied by asset sales. Therefore, we conclude that the externalities of fire sales for other stakeholders are limited.
Conclusion
We investigate a large number of stakeholders that could be negatively affected by a fire sale but find little evidence for negative externalities. The main effect of fire sales is a wealth transfer from the seller to the buyer. Thus, from a welfare perspective, the costs associated with fire sales of corporate assets are much lower than previously thought based on an analysis of seller costs only. From a policy perspective, these findings indicate that the merits of bailouts as a response to the potential losses associated with fire sales are limited, especially given the moral hazard and the other distortions caused by these bailouts.
We recognise that the economic shock caused by the COVID-19 pandemic is unparalleled since the WWII and the Great Depression, and hence, some emergency measures and bailouts were likely necessary to prevent a meltdown of economic activity. However, one difference between the current crisis and the Global Crisis is the apparent lack of fire sales of struggling companies or investments into such companies at fire-sale prices. Warren Buffett’s Berkshire Hathaway, for instance, invested $5 billion in Goldman Sachs in September 2008 and $3 billion in General Electric in October 2008, while Warren Buffett’s firm has not undertaken any major investments during the COVID-19 crisis (Financial Times 2020). Our results therefore suggest that, at least at the margin, fire sales would have been an effective alternative to bailouts, especially for large bailouts such as for the airlines in the US.
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One element missing from this otherwise very interesting article is the source of funding for fire-sale purchases. Often, the financial institutions that are providing the funding are the same banks that are owned money by the distressed asset owner. In Ireland, there were rumours I heard frequently from property developers that the banks were refusing loans for new residential/commercial developments precisely because they were trying to maintain the value of distressed properties on their books (this is hard to prove of course). Following the collapse of the Celtic Tiger, it was very much in the interest of the holders of assets (which included not just the banks, but also the government), to constrain supply to push up property values again. I suspect that this was one of the reasons why the supply side lagged so much, resulting in rents in particular going sky high.
On an anecdotal basis, I should say that firesales had a positive impact on the Irish property market. Prior to 2008, nearly all residential units were built for sale to individual owners and small landlords. This resulted in major problems, particularly with apartment blocks, as residents found themselves surrounded by units owned by small landlords, many of whom were only interested in squeezing out as much rent as possible and avoiding paying management fees. Many partly built developments over the past 10 years or so were bought up by institutional investors to manage as single units for rent. Most new apartment developments are now sold to those institutional investors, not to individual buyers. The result is far more professional management of the developments, and in general has created a more diverse range of units available for rent, and usually tenants much prefer dealing with a professional corporate landlord rather than an amateur.
I think there is a question as to who the purchasers are. If value transfers are to those who are capital rich then it may promote greater wealth concentration. Some private equity houses did very well out of the last downturn (I’m thinking those property purchases, but I’m sure there’s others). Referring back to the preamble, they can be pretty heavy on cutting costs regardless.
A bit odd to not mention monopoly power at all… We’ve had plenty of examples shown that tech in particular doesn’t even try to profit directly from purchases – the whole point is to shore up the moat. Most industries don’t have quite the same view, but fire sales in particular seem ripe for poor regulatory oversight.
The poor performance of acquisition is defended here as being a sign of an efficient market. That is possible. That’s well documented, and honestly makes the entire ongoing existence of them a bit confusing (there’ll always be dumb money I guess?). But other benefits like market power at least give a suggestion of the purchasers not always being idiots.
Did Mitch McConnel ghost this piece? Kinda sounds like him. A tad too complacent. All things being equal or close to equal when it comes to the purchase of productive assets (or the defeat of your competition), the one thing that will skew the whole analysis is a population explosion that is primarily regarded as “consumers”. When productive assets are bought and sold merely for their revenue capacity, or profits from the wealth they produce, their sales, then after a while, say since 1930, a much larger portion of society is dispossessed. It’s such a no brainer, to me. In the 1930s the massive unemployment disaster was around one-third of the workforce. Many of them limped along in cities and industrial centers but many of them also went back home to the farm where they could wait it out. We now have three times the population. And no family farms. So it’s harder to mitigate the “externalities” without an adequate social safety net – and of course we all know that doesn’t exist here in the US. But the karma of the whole thing is that now, caught with our pants down, we have suddenly realized that Oh god, no jobs means no consumers. So to my thinking this ‘let them eat bankruptcy resolutions’ is virtually irrelevant. And bailouts are certainly not the long term answer. The only answer is a more equitable society. It’s going to be very expensive getting this mess turned around. But interesting. It might go down in history as The Great Capitalist Awakening.