Product Market Competition and Financial Decisions During a Financial Crisis

• Author: Zhaoxia Xu,Soku Byoun
• Date: 01 May 2016
• Published date: 01 May 2016
• DOI: http://doi.org/10.1111/fima.12096

Product Market Competition

and Financial Decisions During

a Financial Crisis

Soku Byoun and Zhaoxia Xu∗

Wef ind that in the presenceof the “flight to quality” during the 2007-2008 f inancial crisis, firms

that depended less on external financing (or internal finance dependent (IFD) firms) prior to the

crisis were able to secureadditional f inancing and increasedinvestments, while external finance

dependent (EFD) firms significantly contracted their external financing and investments. IFD

firms’ increased investments during the crisis were associated with higher market share growth,

while EFD competitors lost their market share.The results indicate that firms’ financial decisions

during the financial crisis are interrelated with their product marketdimensions.

The 2007 financial crisis began with the liquidity shortfall in the US banking system that was

exogenous to firms’ business fundamentals or to the competitive environment (Kuppuswamy and

Villalonga, 2010). In addition to the reduced supply of capital, the financial crisis heightened

risk aversion among capital providers due to increased information asymmetry, moral hazards,

and uncertainty.1Growinguncer tainty and risk aversion, coupled with scarce liquidity during the

financial crisis, created an abrupt reallocation of capital toward safe borrowers, often referred to

as a “flight to quality” (Caballero and Krishnamurthy, 2008). Our study explores the effect of

such a reallocation of capital during the 2007 financial crisis on product market competition.

According to the long purse theory of predation suggested by Telser (1966) and Bolton and

Scharfstein (1990), firms with more f inancial resources strategically drive out their weaker

competitors. Indeed, a New York Times article reported such firm behavior as follows: “Toys

“R” Us is using the economic downturn to take market share. This year, Toys “R” Us bought

eToys.com, babyuniverse.com, ePregnancy.com, and F.A.O. Schwarz.”2Toys “R” Us reduced its

debt with internal funds prior to the financial crisis allowing it to raise long-term debt during the

crisis. Through those acquisitions, Toys “R” Us was reported to have gained market share.3We

investigate whether firms with superior access to capital during a financial crisis take advantage

of their competitors who do not have such access.

Soku Byoun greatly appreciates the support for this project that was provided by the Hankamer School of Business at

Baylor University. We are grateful for the valuablecomments from an anonymous referee, Sudipto Dasgupta, Wei Jiang,

and Raghavendra Rau (Editor).

∗Soku Byoun is an Associate Professor in the Hankamer School of Business at Baylor University in Waco, TX. Zhaoxia

Xu is an Assistant Professor in the Department of Financeand Risk Engineeringat the TandonSchool of Engineering at

New YorkUniversity in New York, NY.

1Gonzalez-Hermosillo (2008), Coudert and Gex (2007), and Frank and Hesse (2009) find that investors’ risk appetites

change rapidly during financial crises.

2“Toys“R” Us Makes Deal for F.A.O. Schwarz,” byStephanie Rosenbloom, The New York Times, May 27, 2009.

3“Toys“R” Us Trims Losses by Making a Hamster Hot,” by Stephanie Rosenbloom, The New YorkTimes, December 18,

2009.

Financial Management •Summer 2016 •pages 267 – 290

268 Financial Management rSummer 2016

We classify firms into internal (IFD) and external finance dependent (EFD) f irms prior to the

crisis. Reduced capital supplies and increased risk aversion among capital providers during a

financial crisis make raising capital more difficult and more expensive and their effects are likely

to be greater for EFD firms than for IFD f irms. Furthermore, lenders require more collateral

for each loaned dollar during a crisis (Holmstrom and Tirole, 1997). Consequently, it becomes

increasingly difficult for EFD firms to renegotiate f inancial contracts or to secure additional

loans.4In contrast, IFD firms have access to internal capital. Moreover, they are likely to be

preferred borrowers, as their borrowings are secured by stable cash flows.5This provides the

necessary condition for predation. EFD firms become vulnerable as the f inancial system cannot

provide the necessary capital for them, while IFD firms have better access to capital. Thus, in

light of the long purse theory of predation, we hypothesize that IFD firms increase investments

during a financial crisis in order to gain greater market share.

Our analyses indicate that EFD firms experienced significant drops in both debt and equity

financing. They were especially affected by a lack of external equity financing. In contrast, IFD

firms signif icantly increased debt financing during the crisis. The regression results indicate

that changes in external financing from the pre-crisis period to the crisis period were positively

associated with the degree of pre-crisis internal finance dependence. Our results suggest that

with the accessibility of capital during the crisis, IFD firms expanded investments, such as capital

expenditures and acquisitions, while EFD firms reduced these investments and sold some of their

assets. In particular, capital expenditures and acquisitions increased by 23% from the pre-crisis

to the crisis period for IFD firms, while these investments decreased by 16% for EFD firms.

Next, we examine the relative growth in market share during and subsequent to the crisis. IFD

firms’ industry-adjusted market share growth rate was 0.58% higher, while that of EFD firms was

1.25% lower, than the corresponding pre-crisis growth rate. The difference is both statistically

and economically significant. We further observe that the changes in market share growth during

and particularly after the crisis are significantly and positively associated with firms’ pre-crisis

internal finance dependence and crisis period investments, suggesting that IFD firms’ increased

investments during the crisis were associated with increased market share.

If the increase in market share for IFD firms is simply mechanical, it should be explained by

differential investment opportunities that can be exploited only by IFD firms during the crisis.

Thus, we investigate whether IFD firms in high growth industries invest more than those in low

growth industries. We find no significant differences in investment and market share growth

between high growth and low growth industries.

Investments induced by capital scarcity during the crisis reflect predatory motivations in that

they exploit the liquidity needs of other firms (Brunnermeier and Pedersen, 2005). If increased

investments and the resultant market share gains of IFD firms are the consequences of a predatory

strategy induced by the crisis, this behaviorof IFD f irms is likely to be pronounced in competitive

industries and among firms with similar products. Accordingly, we examine the changes in firms’

investments and market share growthduring the crisis conditional on the extent of product market

interactions. We use the Hoberg-Phillipsindustr y concentration measure and the Lerner index to

measure industry competitiveness. We also employ the product similarity measure developed by

Hoberg and Phillips (2010, 2014) to capture the similarity of firms in the product market both

within and across industries. Our findings suggest that the investment activities of firms with

relatively high internal financial dependence and their market share gains during and after the

4The January 2009 Senior Officer Opinion Survey on Bank Lending Practices reports that about 65% of US banks tighten

lending standards on commercial and industrial (C&I) loans.

5Weverify that cash flow volatility was significantly higher for EFD fir ms than for IFD firms during the crisis.