Debt overhang

Debt overhang is the condition of an organization (for example, a business, government, or family) that has existing debt so great that it cannot easily borrow more money, even when that new borrowing is actually a good investment that would more than pay for itself.

This problem emerges, for example, if a company has a new investment project with positive net present value (NPV), but cannot capture the investment opportunity due to an existing debt position, i.e., the face value of the existing debt is bigger than the expected payoff. Hence, the equity holders will be reluctant to invest in such a project because most of the benefits will be reaped by the debt holders. In addition, debt holders will not finance the firm if the company cannot convince the debt holders that the project will not fail.

The situation emerges if existing debtholders of a company can be expected to lay claim to (part of) the profits of the new project, and this renders the NPV of the project (when undertaken by this company) negative.

The result of having excessive debt is that any earnings generated by new investment projects are partially appropriated by existing debt holders. A firm facing debt overhang cannot issue new junior debt because default is likely. Moreover, more debt will make the problems of debt overhang worse not better. In addition, the firm's shareholders do not want to issue new stock because this forces shareholders to bear some of the losses that would have been borne by junior creditors. Thus, the firm refuses to fund projects with a positive NPV. This problem was first discussed by Myers (1977).

Debt overhang can affect firms or banks that have excessive amounts of debt, but are solvent, in the sense that the value of their assets exceeds the value of their liabilities. Debt overhang also prevents firms that are insolvent, with assets worth less than their liabilities from recovering from their troubles. Bankruptcy which takes the form of Chapter 11 reorganization or receivership, for banks, can cure the problems of debt overhang for insolvent institutions. Successful bankruptcy reorganizations allow organizations to reduce their debt levels and allow new private shareholders to bear enough of the gains from new investments that they will pursue new projects that have positive expected net present value.

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