Financing Constraints, Product Market Competition, and Business Cycle Sensitivity

Abstract

We analyze the interactions between financing constraints and product market competition. Financially constrained firms face restricted access to external finance during economic downturns, precisely when their internal funds decrease. This leads to vicious circle dynamics. We argue that in competitive industries cash flows are particularly sensitive to aggregate shocks, and the adverse dynamics are amplified. We find significant support for this hypothesis in firms' operating profitability and fixed investment. The adverse effects of financing constraints are increasing in the level of product market competition. Market valuations do not take into account these differences in fundamental risk. Unconstrained firms in competitive industries earn positive abnormal returns (on average 24-40 bp per month), especially following periods of macroeconomic distress. Furthermore, financing constraints affect competitive mechanisms within industries. The industry-average level of financing constraints tends to reduce the intra-industry mean-reversion of firm profitability. Again, this regularity is not priced: highly profitable firms earn alphas of 20-29 bp per month if they operate in industries with many constrained firms, but virtually no alphas if their industries have few constrained firms.