In the US, financially distressed firms use Chapter 11 of the Bankruptcy Code to restructure their liabilities and business operations under the supervision of the bankruptcy court. Many of the Chapter 11 firms successfully reorganize and emerge from bankruptcy. Upon emergence, they often cancel old equity interest and issue new stock (i.e., post-reorg equity) to creditors and new investors.
Earlier studies, including Eberhart, Altman, and Aggarwal (1999), document superb performance of post-reorg public equity. Despite continued interest from both academics and practitioners in the performance of this asset class, the empirical evidence is, by now, quite dated. As the US economy recovers from the COVID-19 pandemic and many firms start to emerge from bankruptcy and issue new stock, it is timely to examine how post-reorg equity has performed in recent decades.
In our recent study, we assemble a comprehensive data set containing all US public firms with $50 million in assets that filed for Chapter 11 from 1981 to 2016 and emerged as public companies. We determine the restructuring outcomes and collect financial information on these cases using a multitude of data sources and follow the performance of their post-reorg equity and operating performance until the end of 2019.
Our study provided novel or incremental information relative to prior studies in three ways. First, we collect pricing information of emerged Chapter 11 firms from over-the-counter (OTC) markets, in addition to public exchanges; and trace their performance over three decades. Second, we adopt a calendar time portfolio approach to examining individual stock returns—in addition to the traditional event studies—so that risk factors are better controlled for. The portfolio approach is also more practical for portfolio managers and investors to measure returns on investing in post-reorg equity. Finally, we examine both institutional ownership of post-reorg equity and market reactions to post-emergence earnings announcements over time to trace out economic mechanisms underlying the performance of post-reorg equity.
To start with, we follow the method developed by Eberhart, et al. to construct characteristics-adjusted abnormal buy-and-hold returns (BHRs). We adjust BHRs of post-reorg equity using S&P 500 index-, firm size- and industry-matched firms, firm size-, industry-, and book-to-market matched firms, and IPO-matched firms, in the same time window as the benchmarks. We find that post-reorg equity, on average, outperforms all benchmarks in the 200-day window after emergence, generating abnormal returns between 40% and 50%. However, the median abnormal return is zero suggesting that gains concentrate in the right tail. We compare returns of stocks that trade in the OTC markets and those traded on public exchanges and find that the outperformance of post-reorg is driven entirely by firms that trade in the OTC market. We also construct matched firms using the proportion of non-trading days of OTC stocks to account for illiquidity premium and find similar performance.
The outperformance of post-reorg equity can be attributed to a few explanations. First, there is a lack of analyst coverage and information on post-reorg equity. Investors largely rely on management projects to form expectations for future earnings. But these projections can be overly conservative. Second, senior creditors have incentives to strategically undervalue the reorganized firm to capture a larger share of the enterprise value in a loan-to-own transaction. Third, investors may place low valuation on these stocks due to the bankruptcy “stigma” and the market’s lack of confidence in emerged firms’ ability to survive. Finally, it is possible that Chapter 11 firms emerge from bankruptcy as leaner and more viable entities than their peers as they shed assets, reject undesirable contracts, and improve corporate focus through restructuring and thus, achieve better-than-expected operating performance over time. All these reasons suggest that post-reorg equity can be underpriced initially but the valuation discount should dissipate as more information about emerged companies is released.
We then adopt cross-sectional regression models to explain individual performance of post-reorg equity. We find that firms which make significant changes to their business operations such as changing their primary industry code or business names do not experience higher returns. In contrast, firms that grant stock options to management as part of the reorganization plan and firms that obtain debtor-in-possession financing from hedge funds and private equity funds experience larger equity returns. Although our sample firms experience a significant improvement in operating performance as well as reduction in leverage throughout bankruptcy, emerged firms do not outperform their industry median, and their leverage ratios remain relatively high in three years after emergence.
To better assess return performance, we form a monthly rebalancing portfolio that buys an equal-weighted amount of all post-reorg firm equity, starting in January 1992, when there were 20 actively traded post-reorg stocks in the market. We assess the portfolio return performance using returns of benchmarks based on (1) four factors including the Fama-French three factors and the momentum factor, or (2) based on five factors including the said four factors and the illiquidity factor, or (3) based on the Fama-French five factors. We find that the equal-weighted portfolio outperforms the risk-adjusted benchmark portfolio by 7.2% annually. When separately forming a monthly rebalancing portfolio including only stocks that trade in OTC markets in a given month and a portfolio including only stocks that trade on public exchanges, we find that the outperformance of post-reorg equity over risk-adjusted benchmarks concentrates in the OTC stock portfolio.
Examining the performance of post-reorg portfolio over time, we next find that the equal-weighted post-reorg equity portfolio outperforms risk-adjusted benchmarks only from the late 1990s to the late 2000s, and its outperformance dissipates in the most recent decade (i.e., 2010–2019). Specifically, we find that post-reorg equity outperforms the five-factor adjusted benchmark returns by 0.8–1.2% per month between 2000 and 2010, before declining to zero after. Even more, stocks traded on public exchanges generated negative alpha in the most recent decade.
In the last part of the study, we examine market reactions to post-emergence earnings announcements and institutional ownership of post-reorg equity over time to provide some explanations on the disappearing outperformance. We find that firms that emerged in the 2000s experience large positive market reactions around their quarterly earnings announcements made in the first 200 days after emergence. However, the positive market reactions disappear in the most recent decade. Second, we find that the post-emergence quarterly institutional ownership of post-reorg equity increased from 40% in the 1990s to 80% in the 2000s. Firms that emerged in the 2000s experience the largest increase in institutional ownership post emergence.
The evidence from our paper shows that the performance of post-reorg equity is highly skewed, and outperformance concentrates in stocks that traded in the OTC markets. The outperformance in earlier periods is attributed to market expectation errors for post-emergence earnings. Institutional investors have exploited the return anomaly over time, which explains the disappeared outperformance of post-reorg equity in the recent periods.
Wei Jiang is an Arthur F. Burns Professor of Free and Competitive Enterprise, Columbia Business School
Wei Wang is a Professor of Finance at Smith School of Business, Queen’s University
Yan Yang is a doctoral student at Smith School of Business, Queen’s University
This post is adapted from their paper, “The Disappearing Outperformance of Post-reorg Equity” available on SSRN.