Asset liquidity, debt covenants, and managerial discretion in financial distress:: the collapse of L.A. Gear

A hot growth stock in the 1980s, L.A. Gear's equity fell from $1 billion in market value in 1989 to zero in 1998. For over six years as revenues declined precipitously, management tried a series of radical strategy shifts while subsidizing the firm's large losses through working-capital li...

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Bibliographic Details
Published in:Journal of financial economics 2002-04, Vol.64 (1), p.3-34
Main Authors: DeAngelo, Harry, DeAngelo, Linda, Wruck, Karen H.
Format: Article
Language:English
Subjects:
Asset liquidity
Asset management
Assets
Bank lending
Capital structure
Case studies
Debt
Debt covenants
Economics
Finance
Financial distress
Financial economics
Financial performance
Footwear industry
Growth stocks
Liquidity
Stock prices
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Summary:A hot growth stock in the 1980s, L.A. Gear's equity fell from $1 billion in market value in 1989 to zero in 1998. For over six years as revenues declined precipitously, management tried a series of radical strategy shifts while subsidizing the firm's large losses through working-capital liquidations. The L.A. Gear case illustrates that asset liquidity (broadly construed, not limited to excess cash) can give managers substantial operating discretion during financial distress. It also shows (1) that debt covenants can be stronger disciplinary mechanisms than requirements to meet cash interest payments, (2) why debt contracts typically constrain earnings instead of cash flow, (3) why cash balances are not equivalent to negative debt, and (4) why debt maturity matters. We find that many firms have highly liquid asset structures, thus their managers have the potential to subsidize losing operations should the need arise.
ISSN:0304-405X
1879-2774
DOI:10.1016/S0304-405X(02)00069-7