Previous work suggests that, when the debtor has private information on the future profitability of the firm, financial distress is costly even if debt can be renegotiated. This paper shows that adverse selection problems can be completely avoided by offering creditors a mix of cash and equity in the renegotiation. Empirical evidence indicates that this is common practice in corporate debt workouts. However, asymmetric information leads to inefficiencies if equity is not treated as the residual claim in bankruptcy. In this case, equilibria exist in which distressed firms go to court too often.