Businesses around the world are reeling from the economic fallout of the coronavirus pandemic. Supply-chain disruptions and deep drops in aggregate demand are putting severe pressure on firms (Baldwin and Weder di Mauro 2020). Owing to lockdowns in response to the COVID-19 health crisis, firm cash-flows have dissipated in many industries, pushing businesses into distress (Bosio and Djankov 2020).
The lockdowns implemented to ‘flatten the curve’ have caused de facto shutdowns of economies. Moreover, business revenues are likely to remain low even after economic activity resumes. This is worrying because prior to the coronavirus crisis, firms had taken on extraordinary amounts of debt. Despite policies implemented in many countries to help preserve viable businesses, the current crisis is therefore expected to lead to a much greater surge in business bankruptcy filings than the Great Recession of 2008-09 (Skeel 2020). The consequences of financial distress and corporate bankruptcy for workers can be severe, as many employees suffer large increases in unemployment risk and protracted drops in wages (Graham et al. 2016). These ‘human costs of bankruptcy’ are likely to further exacerbate an economic downturn through the aggregate demand channel.
Loss of talent in crises
Firms’ ability to continue operating during tough economic times like these depends on many factors, such as their cash buffers and access to additional financing, as well as their ability to retain highly skilled labour (‘talent’) in the organisation. The loss of talent may be critical to many organisations, as such workers are crucial for firm productivity and value creation (e.g. Abowd et al. 2005). In fact, the best workers may be particularly indispensable in critical times, such as financial distress, when firms face unique challenges. Firms may have to implement new and unconventional approaches compared to their usual ‘modus operandi’, that talent may find easiest to adapt to and master.
In a large sample of Swedish corporate bankruptcies spanning 2003 – 2011, we find that firms that become financially distressed experience a significant loss of talent (Baghai et al. 2020). We define and measure talent as the set of cognitive and noncognitive abilities that are generally applicable in different tasks and jobs.1 Such talented workers are 50% more likely to abandon the firm as it approaches distress, relative to the average worker. Further, we find that the intake of talented employees in distressed firms does not increase commensurably (Brown and Matsa 2016). Given the importance of talent for firm productivity and value, the fact that the most talented workers abandon a firm as it approaches bankruptcy can be seen as a significant cost of financial distress.
Separating the supply and demand factors
In such an analysis, it is important to separate demand-side and supply-side factors that lead to a change in the labour composition of distressed firms: a lower reliance on talent may be the optimal strategy of a profit-maximising firm that is experiencing financial distress. Direct information on which departures are voluntary and which are forced (firing) is rarely coded in any dataset, and neither is it in ours.
We use two independent approaches to identify voluntary departures. First, we examine whether an employee who leaves a firm is subsequently unemployed (forced departures are likely to be associated with unemployment). We find no evidence of firms firing talent at an increased rate during financial distress. Our second strategy exploits a unique institutional feature of labour laws in Sweden to separate voluntary from involuntary turnover. Many Swedish firms are required by law to follow a last-in-first-out (LIFO) rule when laying off workers. Because we know the joining date of employees, we can determine whether job separations adhere to the LIFO rule or not. Deviations from this rule provide us with a proxy for voluntary departures. We find that talented employees are more likely to leave voluntarily as they ‘jump the queue’ and leave earlier than the LIFO order would imply. Taken as a whole, our results point to talented workers voluntarily ‘abandoning the sinking ship’ in times of financial distress.
What causes the talent loss?
A question that is of interest to financial economists is whether the talent loss is due to the firm ceasing to be economically viable, or whether it is specifically because the firm took on excessive debt and is financially distressed. To answer this question, we consider a sample of Swedish firms exporting to different countries. The idea underlying the test is that a large, exogenous decrease in the value of exports due to unfavourable exchange rate movements is likely to be detrimental to all exporting firms, but the likelihood of financial distress will increase more for highly levered exporters, allowing us to distinguish between financial and economic distress. We find that following a large negative export shock, talented workers in highly leveraged firms (compared to such workers in low-leverage firms experiencing the shock) are significantly more likely to leave the firm. This suggests that talent indeed leaves due to financial distress, rather than simply due to a transient negative shock to firm fundamentals.
How does the risk of losing employee talent affect firm leverage choices ex ante? A useful framework to address this question is the trade-off theory of capital structure, which contrasts the advantages of debt, such as the interest tax shield, with the disadvantages of high leverage—the costs of financial distress. In theory, such costs are understood to include both direct (e.g., legal and advisory fees typically incurred during bankruptcy) and indirect costs (e.g., loss of customers, suppliers, employees). Using our sample of Swedish firms, we find that the dependence of firms on a highly skilled and highly mobile labour force is associated with lower leverage in the cross-section, consistent with the trade-off theory. Taken as a whole, the results support the view that the most talented employees are more likely to desert a firm that is in financial distress, thus providing evidence of an indirect cost of financial distress associated with the loss of talent.
Modern corporations rely heavily on talent. In the new enterprise, human capital surpasses physical capital in its importance for value creation and as a source of competitive advantage (Rajan and Zingales 2000, Abowd et al. 2005). However, the reliance on human capital and the high mobility of skilled labour—stemming from better outside options in the labour market—also expose firms to an added degree of fragility: the possibility of losing key employees during critical and particularly testing times.
Abowd, J M, J Haltiwanger, R Jarmin, J Lane, P Lengermann, K McCue, K McKinney and K Sandusky (2005), “The Relation among Human Capital, Productivity, and Market Value: Building Up from Micro Evidence”, in C Corrado, J Haltiwanger, and D Sichel (eds), Measuring Capital in the New Economy, University of Chicago Press.
Baghai, R, R Silva, V Thell and V Vig (2020), “Talent in Distressed Firms: Investigating the Labor Costs of Financial Distress”, working paper.
Bosio, E and S Djankov (2020), “Southern European and emerging market firms are under severe distress”, VoxEU.org, 6 May.
Brown, J and D A Matsa (2016), “Boarding a sinking ship? An investigation of job applications to distressed firms”, Journal of Finance 71: 507-550.
Graham, J R, H Kim, S Li and J Qiu (2016), “Employee Costs of Corporate Bankruptcy”, working paper.
Heckman, J J, J Stixrud and S Urzua (2006), “The effects of cognitive and noncognitive abilities on labor market outcomes and social behavior”, Journal of Labor Economics 24(3): 411-482.
Lindqvist, E and R Vestman (2011), “The Labor Market Returns to Cognitive and Noncognitive Ability: Evidence from the Swedish Enlistment”, American Economic Journal: Applied Economics, 3: 101-128.
Rajan, R G and L Zingales (2000), “The governance of the new enterprise”, National Bureau of Economic Research.
Skeel, D (2020), “Bankruptcy and the coronavirus”, Brookings Institution working paper.
1 While human capital is multifaceted, cognitive and noncognitive skills are closest to the innate concept of talent that we are trying to capture. Prior studies have shown that cognitive and noncognitive skills are important determinants of education and labour market outcomes (e.g. Heckman et al. 2006, Lindqvist and Vestman 2011); such skills are also closely associated with firm productivity and value creation (e.g. Abowd et al. 2005).