In the Path of the Storm: Does Distress Risk Cause Industrial Firms to Risk-Shift?

Abstract

We study whether industrial firms risk-shift in response to distress risk increases induced through hurricane strikes. Using new proxies capturing deliberate managerial decisions about the risk of a firm's operating segment portfolio, differences tests suggest that hurricane strikes prompt moderately, but not highly, distressed firms to skew their asset mixes towards riskier segments by shutting down low-risk, high-average-Q segments. In turn, the moderately distressed firms observe abnormally high failure rates after a hurricane strike. Employing covenant violation data, we offer further evidence that creditor control prevents highly distressed firms from raising their risk. Our conclusions extend those of other studies by suggesting that moderate distress risk levels can lead the managers of industrial firms to not only engage in risk-taking, but, in fact, in risk-shifting.

Keywords: Agency conflicts, risk-shifting, distress risk, segment data, hurricane strikes

JEL Classification: G32, G33