Bargaining Power, Business Cycle and Levered Equity Risk

Bargaining Power, Business Cycle and Levered Equity Risk

By Zhiyao Chen, Ilya A. Strebulaev
June 29,2016

Bargaining power allows equity holders to recover a fraction of residual assets in bankruptcy, therefore reducing their exposure to default risk. We develop an agency-based model and provide the first evidence via structural estimation that equity holders could extract about 50\% of the liquidation surplus from the residual assets. Using a counterfactual experiment, we further demonstrate that bargaining power significantly reduces equity risk, as proxied by stock-cash flow sensitivity. The percentage reduction is 15% during expansions and 36% during recessions for highly leveraged firms, and is 10% during expansions and 26% during recessions for firms with a high book-to-market ratio.