Debt overhang is when an organization (or government/family) incurs debt at such a high rate that they incur too much debt and are unable to fund future projects. In other words, a company accumulates so much debt that banks do not want to give them more money.
Even if a company is presented with a project with a positive net present value, equity investors are unlikely to fund the project because the debt overhang will restrict the profitability.
Consequences of Debt Overhang
1. Lender risk
When a company is experiencing debt overhang, lenders do not want to give them more money. Banks will see a large amount of debt and may be scared that the company will not pay its outstanding balance. They may take the risk anyway but will most likely charge a higher interest rate.
2. Decrease in spending/investing power
A large amount of debt decreases spending power, restricting the improvement of business functions, such as production, marketing, or employment. Conversely, debt overhang decreases investing power and does not allow the business to invest their money into other options, such as ETFs and mutual funds.
3. Major pressure on business decisions
Companies want to be more cautious with business decisions to avoid even more debt. They may also make riskier investments due to higher payouts. Riskier investments may lead to more debt (overhang becomes bigger).
4. Reluctant shareholders
Shareholders are reluctant for the company to issue more stock to stimulate business because it would mean the current shareholders would be liable for the losses from the new shareholders.
How to Correct Debt Overhang?
1. Debt forgiveness
When a company is at the point of closure, a lender may forgive a portion of the debt because the debt value will drop if the company closes. The debt forgiven will attract more investors due to less debt owed.
2. Attentive cash flow control
Cash flow is essentially all of the money that comes in and out of the business. It is important because a company can avoid large sums of debt by being more cautious and paying attention to where their money goes.
Although bankruptcy only cures insolvent companies (cannot pay the money owed), successful bankruptcy reduces the overall debt level.
How Debt Overhang Affects the Economy
Apart from the business side, debt overhang affects economies worldwide. A prime example would be Greece. Listed below are some of the ways tried by Greece to reduce its debt overhang crisis.
As of today, Greece is still faced with a debt overhang crisis (approx. 250 billion euros). Based on their debt overhang, it is likely that countries within the European Union will think twice before they lend money to Greece. It directly correlates with the fact that investors and banks are unlikely to lend money to a company with a large amount of debt.
Debt overhang puts a major strain on businesses and generally results in long-term recovery. The accumulation of debt creates a financial burden due to the fact that lenders will not continue giving the company money.
As shown above, investors are not motivated to invest in a business with more liabilities than assets because it leads to a loss of investment. Although there are ways to get out of debt overhang, it is a long-term process that should always be avoided.
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