How to Reduce Your Debt Overhang
A company that is heavily indebted may suffer from a condition called debt overhang. This condition occurs when the organization is unable to easily borrow new money. It may be a good idea to take on new debt, but the debt overhang must be addressed first. Here are some ways to reduce your debt overhang:
Ex-post growth opportunities
A firm that has debt in both the market and the bank can opt for an ex-post corporate policy in case of a problem with debt overhang. The optimal debt structure for a firm depends on the characteristics of the firm, including the amount of market debt and the level of bank debt. High debt levels may increase risky debt and lower future growth opportunities. Therefore, the optimal debt structure depends on the firm’s characteristics and the expected future growth opportunities.
Ex-post growth opportunities for debt overhang are very rare and can be difficult to spot, particularly if a company is unable to raise the capital required to make the investment. Debt overhang can discourage a company from pursuing new opportunities, especially those with a positive net present value. It may also turn off potential investors, as a ballooning debt position discourages new investment. However, a firm can avoid such a risk by carefully selecting the debt composition.
Covenant restrictions in debt contracts
A lender and borrower have an agreement to sign on the terms of a debt contract, called a debt covenant. These agreements impose financial covenants on the borrower and lender, and are legally binding. If the borrower does not comply with these covenants, they may be subject to legal action. Covenants can apply to many sectors, and are most commonly represented as financial ratios. Examples include maximum debt-to-asset ratios, minimum dividend payments, and working capital. The covenants can also include clauses relating to key employee retention.
In debt contracts, covenants are often negative, but can be circumvented with the lender’s approval. For example, a merger restriction is often set in a debt contract, but a lender can nonetheless require immediate repayment of the principal and accrued interest in cases where the borrower has breached the covenant. Another example of a negative covenant is a restriction that prevents the borrower from paying all of its earnings to shareholders or liquidating its assets. Such restrictions can apply to real estate, capital investments, or the disposal of assets. Negative covenants often tie the borrower to specific activities, such as not paying a dividend to its shareholders or to related parties.
Sinking funds
Many investors are unsure if sinking funds are an option for them. The primary advantage of these funds is that they offer investors a sense of security. Because the issuers are generally considered creditworthy, their bonds typically carry lower interest rates. Moreover, the lower debt-servicing costs of sinking funds make them a more attractive option for investors. Sinking funds are often a better option than traditional bonds, because they can be sold at a discount when investors think that the company is unable to repay the debt.
A sinking fund is an account created for the sole purpose of paying off a debt or bond. These funds may be used to pay off a debt upon maturity or buy back bonds in the open market. These funds can also be used to call back callable bonds early. By paying off the debt before the maturity date, companies save on interest expense and prevent financial troubles in the future. But before you consider sinking funds, you should read the prospectus carefully.
Leverage reduction
There are several reasons to consider a leverage reduction for debt overhang. One major reason is that a high level of debt prevents companies from generating new investments or reducing existing debt over time. This situation discourages current investment because the profits generated from new projects would be repaid by the holders of existing debt. Moreover, it makes defaults more likely. Fortunately, it’s possible to overcome this problem.
The main drivers of a recession are rising borrowing costs and excessive leverage. Investment expenditure in the euro area and US fell significantly after the 2008 Global Crisis. As a result, leverage levels have skyrocketed. Leverage was also a key driver of GDP growth and investment spending in the periphery economies of the euro area and US. Leverage is an important factor in this scenario, but it does not always explain the causes and consequences of economic weakness.
