Redefining Financial Constraints: A Text-Based Analysis

Research Objective
The main objective of this paper is to construct separate measures of financial
constraints for firms focussing on equity and debt and reporting financial issues. The
paper also aims to identify the origin of these constraints and how equity and debt
focussed constrained firms react to unexpected financial shocks and the measures they
take.

Research Question
The question here arises why we need separate measures of financial constraints for
equity and debt and in what sense are they different from each other. Can we define
measures that reveal more information about constrained firms than the measures that
have been used in literature. We want to analyze the performance of the KZ index, WW
index and HP’s measure of financial constraints (firm age and firm size) and can our
measures do better than them. We also aim to answer how a financially constrained
firm is different from a financially distressed firm.

Data Used
The financial variables that we create are textually extracted from the 10-K filings of a
firm. Our sample begins with the Compustat firm-years with data available ​between
1997 and 2009​. Financial firms and regulated utilities are then excluded. The sample is
then limited to firm-years with sales of at least $1 million and positive assets. We are left
with 56,496 firm-years.

We web-crawl the Management Discussion and Analysis (MD&A) section from each
10-K filed from 1997 to 2009 in Edgar database. We require machine-readable text
data. After this, we are left with 52,438 firm-years. We then extract the Liquidity and
Capital Resources subsection. But only 44,441 firm-year observations have
machine-readable CAP+LIQ. Our data is finally ready for text analysis (identification of
financial constraints and policy variables). All the above mentioned text extraction steps
are done using a text processing software (Heuristica LLC). It has pre built modules for
fast and flexible querying and produces output that is easy to interpret.

Methodology
Now that we have processed our Compustat data, we​ identify constraints in different
markets​. We first identify firms that discuss the possibility of delaying investment in
CAP+LIQ. By using the two sided sentence view features in the meta Heuristica
software, we identify synonyms to the word curtail and a long list of words identifying
types of investment. Two delay lists are constructed to identify firms that report potential
delays in investment. List 1 has synonyms of the word curtail and List 2 identifies the
types of investment. We go through the CAP+LIQ subsection looking for instances
where one word from each of the two lists appear side by side or separated by no more
than one stop word. The firms that fall into this query are in the “precise training set”.
We also consider a generalized query that requires the words to appear within a
twelve-word window. These firms are referred to as the “twelve-word-enhanced training
set”. More firms fall into the latter training set (5.5% vs 1.7% for precise training set).

Similar technique is used to identify firms that are focussed on issuing equity or debt.
We consider both the precise queries and expanded queries which allow commonly
used phrases to be present in a twelve-word window. Similarly, firms which are
focussed on issuing private placements of equity are also identified.

This approach is a bit naive. It just classifies the firms that explicitly state that they face
constraints as constrained firms while firms that don’t state it directly in their 10-K filings
are classified as fully unconstrained. It’s either constrained or unconstrained. This
approach doesn’t recognise that there is something in between that. We need
continuous measures of financial constraints not binary ones. We use ​cosine similarity
method to build these constraints. Cosine similarities are computed as the inner product
of two vectors - one characterizing the word usage in the firms’ CAP+LIQ section and
the other the word usage of firms in the “precise training set”. By computing cosine
similarities, we compute four constraint variables for each firm (Delay Investment Score,
Debt Focus Delay Investment Score, Equity Focus Delay Investment Score, Private
Placement Focus Delay Investment Score). This approach provides a measure of the
degree to which a firm is constrained.

We examine two investment variables: R&D, CAPX scaled by sales and three financial
policy variables: public SEO issuance, private SEO issuance, long term debt issuance
all scaled by assets. The R&D, CAPX and debt issuance are constructed directly from
Compustat data. Public and private SEO issuances are constructed from SDC Platinum
database. Outlier removal is performed on all five policy variables. We also include two
control variables: log age, log assets.

Major Results
We first examine the properties of our four text based constraint variables in time series
and cross section and then compare them to measures (KZ and WW index) used in
 literature. From Table 1 in paper we deduce that 85.1% of firms have machine-readable
MD&As, what percentage of firms are in the precise and twelve-worded training sets,
what percentage of firm’s sales is used for R&D and CAPX and percentage of assets
used for debt issuance. It also reports the text constrained scores which measure the
degree to which a firm's CAP+LIQ section is similar to that of firms in each respective
training set.

Table 2 shows the Pearson correlation coefficient between various measures of

financial constraints. In addition to our four text based constraints, we also include
covenant violation score, log age, log assets, KZ and WW index. Some conclusions
from this table are :-
1. Delay investment score is highly correlated to equity focus delay score. This means that
constraints are more binding for firms that focus on equity markets than those focussed
on debt markets.
2. WW index is more correlated with equity focus constrained variables and KZ index is
more correlated with debt focus constrained variables. This shows that both indexes are
different.
3. Delay investment score is negatively correlated to both size and age. This shows our
constraint variables are consistent with the findings of HP that constrained firms tend to
be smaller and younger.
4. Debt focus constraint variable is positively correlated with Covenant violation score.
Other variables are negatively correlated with covenant violation. This means that debt
constraint firms are not able to meet contractual obligations.

We map the time series average for delay investment constraint. Figure 3 shows a jump
in constraints in 2008. These constraints fall when the economy improves following a
negative shock. These constraints are highly dynamic. We have a conjecture that
unconstrained firms generally don’t have a separate CAP+LIQ subsection in their
MD&As. This is tested by logistic regression where the dependent variable is whether
the firm has a separate section or not. THe results show that the firms which disclose
CAP+LIQ are more likely to be constrained.

Next, we explore the relation between various firm and industry level characteristics,
and our four constraint variables, controls for firm size, firm age and size of CAP+LIQ
section. Panel Data Regression is used for analysis. The firm and industry level
characteristics are the dependent variables. We have to run separate regressions for
each constraint variable in order to characterize them independently. Some major
results are:-
1. Firms with high delay investment scores operate in industries with high Tobin’s q (a firm
must have a promising investment before it can delay it. This shows that financial
constraint and distress are different things as financially distressed firms have a low q
ratio.
2. Delay investment variable is positively related to both CAPX and R&D at industry level
(supports the idea of having good investment opportunities for financial constraints to be
binding) but negatively related to CAPX and R&D at firm level.
3. From the coefficient pattern, we can see that equity markets are extreme variants of
delay investment constrained firms. Many coefficients have opposite signs for equity
and debt market constraints, showing that both are different. Results for private
placement focused constrained firms are similar to equity focused constrained firms.
4. Equity focused constrained firms have high q, are growth oriented. They reside in
markets with high cash holdings. Debt focused constrained firms have low q, hold less
cash, have high leverage. These firms have resemblance to distressed firms

Next up, we examine whether highly constrained firms react to negative shocks
differently than do unconstrained firms. We consider two types of investment
expenditures - CAPX, R&D and two types of external financing - equity and debt
financing. Three shock variables are considered - 2008-09 financial crisis, 2001-02
technology collapse and the forced mutual fund selling shock. Our hypothesis says that
constrained firms should aggressively curtail issuance and investment activities
following unexpected shocks. Table 4 displays the degree of curtailments experienced
by firms. After the financial crisis, CAPX and R&D scaled by sales is curtailed by huge
amounts Same thing happens after the tech bust. In addition to this public SEO
issuance curtailment was more severe for constrained firms this time. For forced mutual
fund selling shock, results are consistent with the other two shocks but magnitude of
curtailment is smaller.

Shock Response Regressions- ​We now examine the link between constraints and
firm investment and issuance policies using a shock response approach. We consider
firm responses to three shocks: Financial crisis, tech bust and firms in the highest decile
of forced mutual fund selling shocks. We see how the following five policies are
changed during shocks: R&D/sales, CAPX/sales, public SEO issuance/assets, private
SEO issuance/assets and debt issuance/assets. Our prediction is same as our previous
hypothesis. We also want to see whether our constraints offer more information beyond
the findings of HP. For HP, age and size are the best measures of financial constraints.

For each of the policies we consider, we take the change in given policy before and
after the shock as the dependent variable. Our key independent variable is the given
constraint variable being tested (four text based variables, WW and KZ index). We also
have controls for age, size, Tobin’s q, sales growth.

Response to Financial crisis​ - The results are displayed in Table 5. Constraint

variables and other controls are lagged. Independent variable coefficients are calculated
using ​panel data regression​. It is noted that constrained firms (measured using delay
investment variable) significantly curtail R&D, CAPX, private SEO issuance.These are
significant at 1% & 5% level. Similar results are found for equity and private placement
focused constrained firms. Debt focused firms curtail their debt issuance policies. We
also find weak results for the KZ and WW index. Their policy changes are that
consistent. Regarding HP, we find that younger firms significantly curtail all their policies
except R&D more than older firms do. Small firms curtail R&D and private SEO
issuance more than large firms, but increase CAPX, public SEO and debt issuance.

Response to tech bust shock​ - Our sample is restricted to technology firms only.
Delay investment constrained technology firms curtail R&D and CAPX spending and
public SEOs after the bust. Results are similar for equity constrained firms. Private
placements focused constrained firms have similar results except that they increase
issuance of private SEO during the tech bust (significant at 5% level). Debt focus
constrained firms increase investments and SEO issuances. We conclude that
constraints were more binding for equity focus constrained firms. Constraints were less
binding for debt constrained firms. Equity prices also fell during this period. We also find
weak or contrary results for WW and KZ index. Regarding HP variables, we find
consistent results for firm age but mixed ones for firm size.

Response to mutual fund selling shock​ - We only take firms for each year which are
in the highest decile of forced mutual fund selling shock. Results are similar to those for
the financial crisis and tech bust. Delay investment constrained firms significantly curtail
R&D, CAPX, public and private SEO issuances more than unconstrained firms when
they are treated with a large forced selling shock. Debt issuance is not curtailed
significantly. This shows that equity constrained firms face the most binding constraints
and this shock is a shock to the equity market and not debt market. All policies except
debt issuance are curtailed significantly for both equity and private placement focus
constrained firms (at 1% level). Again the results are weak for KZ index and modest for
WW index. We find consistent results related to firm age but mixed ones for firm size.

Overall, we can say that the text based variables that we define provide unique and
consistent information regarding financial constraints and firm age is more informative
than firm size. Binding constraints are more binding in the equity market than in the debt
market.

Another test done tells us that constrained firms are more sensitive to market conditions
in the market where their constraints are binding. This means that equity constrained
firms increase their SEO issuance when aggregate SEO market conditions are
favourable and curtail their SEO issuance when aggregate SEO market conditions are
poor. Similarly debt constrained firms ramp up their lending when aggregate lending to
corporations is high. We perform OLS regressions for this where the dependent variable
is each firm’s public SEO issuance proceeds scaled by assets. Our key independent
variable (cross term) is the product of given constrained variable and aggregate level of
SEO activity or lending activity in the given year. The aggregate SEO variable or the
aggregate lending variable is not lagged while the control and constrained variables are
lagged.

The results of the panel data regression are in Table 8. When equity issuance is the
dependent variable, the key independent variable is based on the change in aggregate
SEO issuance activity. The cross term is highly positive for equity, debt and private
placement constraints. Through this we conclude that constrained firms issue public
SEOs in a way that is more procyclical as compared to unconstrained firms. When debt
issuance is the dependent variable and cross term is based on change in lending
activity of banks, the cross term is only positive and significant for debt focus
constraints. This concludes that these constrained firms issue debt in a way that is more
procyclical than unconstrained variables

Origin of constraints
In this paper out of the many potential origins of financial constraints we explore the role
played by asymmetric information. We first scan the text of all 10-Ks for mention of
proprietary information or trade secrets. When searched within a five worded window,
28.5% of the firms are found to have such text thus indicating high levels of asymmetric
information. We consider regressions in which we examine if constraints in a year t are
related to whether or not the firm has high levels of asymmetric information in year t-1.

The results show that the delay investment constraint is indeed related to higher levels
of asymmetric information with equity and private placement focused constrained firms
linked to even higher levels of asymmetric information. We find a negative link to
asymmetric information for debt focused constrained firms. These results suggest that
equity and debt constraints have different origins.
In another test, we consider ​covenant violations​. We look for words “covenant” and
“violation” in a twelve word window in the CAP+LIQ section of the firm's 10-K. The
dummy variable created for this is our dependent variable. The results of our regression
show that debt focused constrained firms are more likely to experience covenant
violations (significant at 1% level).

Conclusion
We defined four text based financial constraints by analysing that MD&A section of each
firm’s 10-K filing. These 10-K filings are available on COMPUSTAT. We used text
extraction techniques to identify firms which show the intent of delaying investment,
issuing equity, debt and private placements of equity. We then use cosine similarities to
build continuous measures. We use this to construct a broad index of financial
constraints and specific financial constraint measures regarding debt, equity or private
placement focus.

Generally, firms which are financially constrained curtail their R&D expenditures, Capital
expenditures, public and private SEO issuance and debt issuance more than less
constrained firms when they receive negative shocks. We find that equity focused
constrained firms and private placement focused firms curtail more than debt focused
constraint firms.

We then examine the potential origin of constraints and find that asymmetric information
plays a major role. We find links between firms delaying investment, equity, private
placement market constraints and asymmetric information in firm’s 10-K. These firms
report risks related to proprietary information in their 10-K. However, we find negative to
asymmetric information for debt focused constrained firms. On analysing further, we find
debt focused constrained firms report covenant violations in their 10-Ks, they have
investment opportunities they wish to fund but are challenged by high existing debts.
Results show that equity and debt focused firms face different types of constraints
having different origins.

Our constraint measures outperform other measures used in literature regarding their
ability to predict policy curtailments, capturing unique information when firms face
negative shocks and are also able to identify origins of constraints showing that equity
and debt constraints are not only different but equity constraints are more severe.