Debt Overhang: Definition, Effects, Solutions

Debt Overhang

Investopedia / Madelyn Goodnight

What Is Debt Overhang?

Debt overhang refers to a debt burden so large that an entity cannot take on additional debt to finance future projects. This includes entities that are profitable enough to be able to reduce indebtedness over time. A debt overhang serves to dissuade current investment, since all earnings from new projects would only go to existing debt holders, leaving little incentive and ability for the entity to attempt to dig itself out of the hole.

Key Takeaways

  • Debt overhang refers to a debt burden so large that an entity cannot take on additional debt to finance future projects.
  • The burden is so large that all earnings pay off existing debt rather than fund new investment projects, making the potential for defaulting higher.
  • Debt overhangs can lead to underinvestment, which stunts growth, making recovery even more difficult.

Understanding Debt Overhang

When an entity has an excessive amount of debt and cannot borrow more capital, that entity is said to be in a debt overhang. The burden is so large that any and all earnings go directly to pay off existing debt rather than fund new investment projects, making the potential for default higher. In most cases, shareholders may be reluctant to approve new stock issuances because shareholders may be on the hook for losses.

Debt overhangs also apply to sovereign governments. In these cases, the term refers to a situation in which the debt of a nation exceeds its future capacity to repay it. This can occur from an output gap or economic underemployment, repeatedly plugged by the creation of additional credit. A debt overhang can lead to stagnant growth and a degradation of living standards from reduced funds to spending in critical areas such as healthcare, education, and infrastructure.

Because of the way they affect balance sheets and bottom lines, debt overhangs can distress entities in different ways. They can cause companies and countries to put a pause on further spending and/or investment. In fact, they can lead to underinvestment. Because they can stunt growth, debt overhangs can make recovery even more difficult.

There are several ways to get out of a debt overhang. Debtors can enroll in debt cancellation programs to get a portion of or the entirety of their debts forgiven by creditors, nations can default on their debt, companies may go insolvent or bankrupt, or existing debt may be repurchased and converted into equity.

The risk of defaulting on debt is greater when a company or country experiences a debt overhang.

Special Considerations

A debt overhang can trap companies as a greater proportion of revenues or cash flow simply goes toward servicing its existing debt. This widening deficit can only be filled through incremental debt, which only increases a company's burden.

A debt overhang is particularly difficult as it straps companies aiming to take advantage of new opportunities with positive net present value (NPV). Although under more normal conditions, these potential projects would repay themselves over time, a ballooning existing debt position in a company could likely turn off would-be investors in the project. Given that the company’s debt holders can be reasonably expected to lay claim to a portion or all of the new project’s profits, the NPV would, in effect, be negative.

To solve the debt overhang in many developing nations, debt cancellation programs are occasionally implemented by intergovernmental organizations such as the World Bank and international organizations such as the International Monetary Fund (IMF). Programs have covered Côte d’Ivoire, the Democratic Republic of the Congo, Gabon, Namibia, Nigeria, Rwanda, Senegal, and Zambia. Another program, the Jubilee 2000 campaign, was an international movement by 40 countries, which called for the cancellation of debt of developing nations by the year 2000. Although the campaign didn't meet all of its goals, it was well received and was generally considered to be successful.

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