Why Do Firms Go Public Through Debt Instead of Equity?

Private firms can gain access to capital markets in several ways. The most well-known approach is through an initial public offering (IPO) of equity, and high-profile firms typically attract a large amount of attention from the popular press when they go public. However, a less publicized approach is going public through an initial public debt offering (IPDO), an alternative option for tapping public markets. One example of an IPDO firm that issued public debt (through a private subsidiary) before issuing public equity is United Parcel Service Inc. The company was founded in 1907, filed its IPO S-1 registration statement on July 21, 1999, and began trading its equity publicly on November 30, 1999. However, the company carried out an IPDO in December 1989, when it issued 8.375 percent 30-year debentures maturing in 2020 for $700 million through its private subsidiary, United Parcel Service of America Inc. The size of this debt offering was in the top 2 percent of all public debt issues that year.

The choice of going public through the debt markets has been neglected in the academic literature. Yet, as an option, it could also affect the equity IPO choice. Selection biases in the type of firms choosing an equity IPO could influence the results in the IPO market literature.

Debt differs from equity in that many post-issuance contractual rights of lenders are specified in terms of financial statement variables. Reported financial statements can affect various financial covenants and dividend and stock repurchase restrictions. In contrast, shareholders are less interested in whether gain and loss information is reflected in the financial statements or received via non-financial disclosure, so long as they receive it. Firms that can more easily disclose their important performance data through financial statements have a comparative advantage in the debt market. Hence, firms choosing to go public through IPDOs are likely to be systematically different from firms choosing the traditional IPO path.

In our paper “Why do firms go public through debt instead of equity?,” we study firms that go public through IPDOs rather than IPOs, and we explore the significant determinants of that choice. Literature suggests that there are three: (1) the costs of information production, (2) the value of private benefits of control, and (3) the value of a liquid currency.

First, debt markets usually prefer hard, easily verifiable financial information like ratios (e.g. leverage and earning-based interest coverage ratios) and dividend and stock repurchase restrictions that are covered in covenants, the compliance with which can be confirmed with information from in statements. Therefore, firms that are larger, more mature, and have more tangible assets can probably more easily provide the financial statement information that debt markets value most. In contrast, smaller or less mature firms find it relatively difficult to tap debt markets when going public, because their valuations tend to be based on growth potential. Second, private firms that issue equity risk losing control and its benefits. For example, venture capital sponsors who may not be willing to give up control after firms have gone public through equity, might choose to issue public debt instead. Finally, going public through equity rather than debt allows managers to create a liquid currency to carry out other transactions.

To test these theories, we collect a comprehensive sample of IPDO firms covering a total of 635 IPDO issuers from 1987-2016. We collect financial statement data (as well as issuance, pricing, and credit rating data) on the private firms before the IPDO. This data is available because Section 15(d) of the Securities Exchange Act of 1934 mandates that firms that issue public securities of any type file an annual report during the fiscal year within which the public security registration statement became effective, if at the beginning of that year, they had more than 300 security holders on record, and regardless of whether they have publicly traded equity. We then compare this unique sample of IPDO firms with two control samples based on year, industry, and size. The two control samples contain, respectively, (1) firms that issue public equity via an IPO without having any public debt outstanding, and (2) publicly listed firms that tap the public debt market for the first time (public firm debt offerings, or PFDO, firms).

Controlling for industry, year, and size, we find that there are significant differences between IPDO and IPO firms. IPDO firms typically exhibit superior operating performance, spend less on research and development, have higher ratios of operating cash flows to capital expenditure, and have more private debt than IPO firms. In other words, IPDO firms appear to be more established and have assets more amenable to financial statement analysis. They are also more likely to be backed by a financial sponsor such as a venture capital or private equity firm, suggesting that ownership structure also matters. However, an industry liquidity index that measures the level of corporate transaction activity indicates that the creation of a liquid currency is not a factor in choosing between an IPDO or IPO. There are also significant differences between IPDO and PFDO firms issuing in the same industry and year. IPDO firms are older and more likely to be sponsor-backed than PFDO firms are and have better operating performance, similar growth opportunities, and lower liquidity. They also face a significantly higher cost of debt (offer yield), more restrictive covenants, and lower credit ratings.

Finally, IPDO firms appear to get better terms at a subsequent public debt or equity offering. For firms that issue public debt again following the IPDO, the subsequent offering is larger and has a lower offer yield. This result continues to hold in a multivariate framework: When we control for differences across years of issue, leverage, and the terms of the debt, the offer yield is lower for the subsequent issue of public debt by the IPDO firms relative to their first issue of public debt. After adding controls for firm and covenant characteristics, however, the difference in offer yield is no longer significant. After a firm has filed formal financial statements while going public, there appear to be fewer benefits for subsequent issues.

Some 27 percent of the firms in our IPDO sample subsequently choose to raise public equity, and the initial higher cost of debt for them at the IPDO appears to be offset by less underpricing at the time of their eventual IPO. The median IPO underpricing (for which the first day return is a proxy) for our sample of IPDO firms that chose to eventually issue public equity is less than a third of that for matching IPO firms with no prior public debt in place; the amount raised through the offering is double; and the fees charged by equity underwriters are lower. In a multivariate framework, when controlling for firm size, age, operating performance, industry, and time, we find that an IPDO indicator variable is significantly and negatively related to the level of underpricing in the issue.

Our paper shows that ownership structure and the relative cost of information production are significant in explaining how a firm chooses to go public. When debt-first firms eventually go public by issuing equity, they face lower underpricing than contemporaneous firms without public debt that undertake an initial public offering in the same industry. Future IPO research should consider that firms can choose not only to go public and stay private, but also to issue public debt and stay private.

This post comes to us from Denys Glushkov, at Acadian Asset Management; Ajay Khorana, at Citigroup; P. Raghavendra Rau, the Sir Evelyn de Rothschild Professor of Finance at the University of Cambridge; and Jingxuan Zhang, a PhD candidate in finance at Boston College. It is based on their recent article, “Why Do Firms Go Public Through Debt Instead of Equity?,” available here.