Walt Garner: Nina, I want to start with something uncomfortable — I read about a Chapter 11 filing last week, and the line that stopped me was that the company's operations were described as 'stable and ongoing' at the time of the filing. Stable and ongoing.
Nina Park: Hold on — stable and ongoing and still bankrupt?
Walt Garner: That is precisely the point. The business itself had not failed. The debt structure had. And this is not an isolated case — private equity firms hit historic bankruptcy levels in 2024, and a meaningful portion of those filings share that same profile. The underlying assets performing, the financing structure collapsing around them.
Nina Park: Yeah, and I think that's the thing that's actually hard to communicate about financial leverage, because when it's working, it just looks like genius. You borrow cheap, returns get amplified, everyone's happy. But the payments — I mean this is the whole thing — the fixed servicing costs don't care whether you're in an expansion or a contraction. They show up exactly the same. Every month. Same number.
Walt Garner: The obligation doesn't breathe with the business. That's the right way to put it.
Nina Park: And so what we're really trying to work out today is — when does borrowing to grow become a structural trap? Because decades of private equity returns said 'lever up,' and then 2024 said 'actually wait.' That swing is what I want to understand.
Walt Garner: And I'd add: whether anything about that trap was visible in advance, or whether the mechanism is designed to look safe until it suddenly isn't — which is, you see, a rather old problem in the history of credit.
Nina Park: And that's the part that keeps nagging at me — because it wasn't random that those PE firms piled into debt. The math genuinely told them to. Debt is actually cheaper. Like, structurally, mechanically cheaper.
Walt Garner: Now, this is the foundational thing, and I want to be precise about it. The reason debt is cheaper — and this is where Modigliani and Miller eventually land after their original perfect-markets argument — is legal, not mathematical. The lender holds what you'd call a fixed senior claim. Specific interest payments, specific principal, on a set schedule. That promise exists regardless of whether the firm is thriving or struggling.
Nina Park: So the lender's return is just... locked in.
Walt Garner: Locked in, and senior. They get paid before the equity holders see a single dollar. And if that promise breaks — well, creditors don't just wait patiently. They can seize collateral, force a restructuring, or initiate bankruptcy proceedings. That's not a negotiating posture; it's an enforceable legal remedy. Equity holders have none of that. They hold the residual claim — whatever remains after every obligation is satisfied, which in a bad year can mean nothing at all.
Nina Park: Okay and that asymmetry is — I mean, one side actually sleeps fine. The other side is holding a lottery ticket that might be worth zero.
Walt Garner: Which is precisely why the required return on equity is structurally higher. You're bearing the full variability of firm performance. So to get investors to take that residual position, you have to offer them more expected return — which means equity costs the firm more.
Nina Park: So the whole system is basically set up to make borrowing look like the rational move.
Walt Garner: And then — and this is where it compounds — interest payments on debt are tax-deductible. The tax shield. The government is effectively subsidizing every dollar of leverage a firm takes on, because interest reduces taxable income in a way that dividend payments to equity holders simply do not. Trade-off theory, which builds on Modigliani and Miller's later work, names this explicitly: you're weighing that tax shield benefit against the cost of potential financial distress.
Nina Park: Wait — so not only is debt cheaper because lenders accept less return, but the government is also cutting the bill further?
Walt Garner: For decades, yes. And in a low-rate environment, those two advantages — the legal priority discount and the tax shield — stack. Which is, you see, exactly the weather conditions under which private equity's leveraged-buyout model appeared nearly frictionless.
Nina Park: Right — but the part that doesn't fit is that those same features, the hard fixed schedule, the legal remedies, the fact that creditors can pull the trigger — that's also exactly what detonates when rates move and cash flows soften even slightly.
Walt Garner: What we have here is the cost advantage and the danger are the same mechanism. The legal enforceability that makes lenders accept a lower return is identical to the mechanism that lets them force a bankruptcy filing on a company whose operations are, as I said, stable and ongoing.
Nina Park: So they weren't being reckless. They were following the logic perfectly — and the logic had a trap door built in.
Walt Garner: And that trap door is precisely what Modigliani and Miller were, in a sense, trying to argue didn't exist — at least not in the way we imagine it. Their late-1950s proposition, the foundational one, says: in a perfect market, no taxes, no transaction costs, the mix of debt and equity is simply irrelevant to firm value. Completely irrelevant.
Nina Park: Wait — irrelevant? Like it genuinely doesn't matter?
Walt Garner: Mathematically, in their perfect world, yes. Investors can replicate any capital structure themselves, so the firm's choice adds no value. But then they extended the model. Add taxes back in, and suddenly the debt tax shield is real. Add bankruptcy risk, and distress costs are real. And those two forces pull in opposite directions.
Nina Park: Which is trade-off theory — you're balancing the tax shield against the cost of potentially blowing up.
Walt Garner: Precisely. And the implication is that there's some optimal ratio — lever up enough to capture the tax benefit, but not so far you're pricing in distress. Firms should converge on that point.
Nina Park: Except — pecking-order theory goes completely the other direction, and I find it more interesting than trade-off theory. It says firms don't target a ratio at all. They just... use whatever's cheapest and least revealing. Internal cash first. Then debt. Equity only when they're basically out of options.
Walt Garner: Because equity issuance signals something.
Nina Park: It signals that management thinks the stock is overvalued — I mean, why would you sell shares if you thought they were cheap? So outside investors read a new equity offering as bad news. The information asymmetry makes it a costly move even when the fundamentals are fine. And that's not rational optimization, that's — it's closer to what my friend who opened the coffee shop was doing. She avoided the bank loan not because the math was wrong but because the fixed obligation terrified her. Pecking order is basically formalizing that instinct.
Walt Garner: Now, what I find telling — and this is where I'd want to push on the theory — is that we have two competing frameworks, both with genuine empirical support, pointing in almost opposite directions about what firms actually do. That persistence is itself evidence of something.
Nina Park: The 750-firm study.
Walt Garner: Yes — the empirical work on 750 NYSE-listed non-financial firms, seventeen sectors, 2003 to 2020. They tested three specific configurations — 70/30, 61.8/38.2, and 50/50 debt-to-equity splits — using GMM estimation. And the result was that no single configuration dominated. Performance effects varied by sector, by firm size, by market conditions.
Nina Park: Seventeen sectors, eighteen years, and the answer is basically: depends. Which honestly — I mean, that's either deeply unsatisfying or it's actually the point. Capital structure optimization isn't a formula, it's a negotiation with your own firm's specific reality. And the part we haven't even gotten to yet — two firms, same industry, completely opposite structures, completely different outcomes — that's going to make this messier in the best possible way.
Walt Garner: What we have here is the theory doing exactly what good theory should do — it names the forces at work without pretending those forces resolve to one answer. Trade-off theory, pecking-order theory, the Modigliani-Miller extensions — each captures something real. None of them resolves the tradeoff. And that's not a failure of the models. That's the structure of the problem itself.
Nina Park: Okay but that 'depends' answer gets so much more interesting when you actually put two firms next to each other — like, same sector, same Indonesian consumer market, completely different choices. PT Mayora Indah Tbk keeps its debt-to-equity ratio below 100% and runs higher profitability. PT Indofood CBP Sukses Makmur Tbk carries heavier debt but posts stronger liquidity. Same industry. Same macro conditions. Opposite structures.
Walt Garner: And neither is wrong. That's what stops me.
Nina Park: Right — but the part that doesn't fit the clean theoretical picture is that we want to say one of them miscalculated. And you can't. Because the variable isn't the structure. It's the firm itself.
Walt Garner: Which is precisely what the empirical work on high-growth versus stable firms keeps surfacing. Across 150 corporate profiles — and this connects directly to the study's broader findings — high-growth firms consistently lean toward equity because their cash flows are volatile. A fixed debt obligation against unpredictable revenue is genuinely dangerous to service. Whereas the stable, mature firm can absorb that fixed schedule and capture the tax shield benefit, because the probability of distress is low enough that the math actually works in their favor.
Nina Park: So Mayora's structure — the lower debt — isn't conservative. It's matched to what Mayora actually is.
Walt Garner: Precisely. And Indofood's heavier debt load isn't reckless — it reflects a firm whose cash flows can bear the obligation and whose liquidity position confirms it.
Nina Park: Which is — I mean, that should feel obvious in retrospect, but it completely demolishes the idea that there's a formula you apply. Like, even within one sector, firm type is the actual variable.
Walt Garner: Now, where it gets genuinely complicated — and I think this is where rational models start to fray — is when the emotional pull enters.
Nina Park: Yeah, and I have a version of this I think about a lot. Picture a founder — she's profitable, her lender is offering her cheap debt, the spreadsheet says borrow. And she gives up equity instead. Takes a partner. Dilutes her ownership. Because she cannot psychologically handle a fixed monthly payment hanging over the business.
Walt Garner: The spreadsheet says debt. Her nervous system says equity.
Nina Park: And here's the uncomfortable part — she's not irrational. Because that fixed obligation is real. The terror of it is doing actual financial work that the cost-of-capital calculation doesn't price in.
Walt Garner: And this is where agency costs enter, you see. The rational models don't ignore human behavior entirely — they formalize it, actually. Equity financing can dilute managerial effort incentives — moral hazard, in the technical sense. But debt cuts the other direction: it disciplines managers because the fixed obligation is unforgiving. The problem is that near distress, that same discipline can push managers toward excessive risk-taking, because at that point the equity holders have almost nothing to lose.
Nina Park: So debt either disciplines you or turns you into a gambler — depending on how close to the edge you are.
Walt Garner: Which is, indeed, why the non-financial considerations — the founder's fear, the manager's incentive structure, the specific cash flow profile of the firm — aren't noise around the rational model. They are, in a very real sense, the model. Mayora and Indofood didn't land at different structures despite being in the same sector. They landed there because of what each firm actually is.
Nina Park: And that's what connects back to that 2024 conference room — the one from the very beginning. The business running fine. The debt structure the one that filed. Because it's not that leverage was wrong in the abstract. It's that the spread that made it rational — the cost advantage, the gap between what debt costs and what equity costs — that spread compresses when rates rise. Like, mechanically. The required return on debt rises with the rate environment, and at some point the whole arbitrage that private equity was running for twenty years just... closes.
Walt Garner: And then you're left holding the obligation.
Nina Park: With no cheap exit. Because rebalancing — I mean, if you want to shift toward equity at that point, you're issuing shares into a market that reads that as distress. Pecking order in reverse. Or you're selling assets, which has its own execution risk, its own cost. The rebalancing itself is expensive. So you're — okay, actually the trap is even tighter than I initially framed it. It's not just that rates moved. It's that the move to correct for rates is also punishing.
Walt Garner: Which is, you see, the question that perhaps should have been asked at the beginning of every leveraged cycle — not 'is debt cheaper right now,' but whether that cost advantage in this rate regime is worth the fragility it creates in the next one. The calculation has to be run across regimes, not solved once.
Nina Park: Yeah. And nobody in that conference room in 2024 ran it wrong, exactly. They ran it correctly for the conditions that existed. The conditions just changed.
Walt Garner: Stable and ongoing.
Nina Park: Stable and ongoing. Good conversation today.
