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There are 2 types of defaults: liquidity defaults, in which a firm does not have the cash to make debt payments and strategic defaults, in which a firm defaults because managers want to divert cash to themselves. Debt contracts reduce the incentive for strategic defaults by giving creditors the right to liquidate the company’s assets following a default.
Debt structure affects the trade-off (between the benefits of deterring strategic defaults against the costs of realizing a low liquidation value in a liquidity default) because it affects the price at which creditors can sell the firm’s assets following a default. Suppose that the firm’s assets are worth more combined than separated: the whole is worth more than the sum of the parts. Then if there are many creditors, each of whom is secured by a different asset, a buyer would have to get a large number of them to agree to a sale to maximize the combined value of the assets. But once the buyer has struck a deal with one creditor, his marginal valuation of the other assets rises. So he’ll end up paying more for the remaining assets than if those assets were sold on a stand-alone basis.
By influencing the price at which creditors sell the firm’s assets, debt structure affects both the manager’s incentive to default strategically and the expected liquidation value of the firm. Following a strategic default, the manager will have to pay more to stop the creditors from liquidating the assets when there are many creditors than when there is only one creditor. Therefore, borrowing from many creditors disciplines managers by lowering their payoffs from a strategic default: they have less incentive to divert cash flow to themselves.