SME recovery following a financial crisis: Does debt overhang matter?

• We test whether debt overhang impacts SMEs recovery from the Irish financial crisis.
• Higher debt burdens negatively affect negative investment and employment.
• Debt burdens also increase financial distress.
• The effects are greatest for sectors and enterprises most reliant on domestic demand.
• The impacts are strong for SMEs in the gearing phase before the crisis.

The years before the financial crisis saw a dramatic build-up in private debt levels in several countries and this increase was particularly marked in Ireland. In this paper, we look at whether outstanding debt taken out by small and medium sized enterprises in Ireland constrains current performance following the financial crisis. We find that higher debt burdens (measured as the ratio of debt-to-turnover) have significant negative effects on all measures of firm performance, in particular investment, employment and indicators of financial distress. We find the effects are greatest for sectors and enterprises most reliant on domestic demand which collapsed following the crisis. The effects are also strongest for enterprises that were in the mid-lifecycle, gearing phase, prior to the crisis.