Private Equity Firms’ Reputational Concerns and the Costs of Debt Financing (Digest Summary)

Many believe that private equity (PE) firms tend to expropriate other stakeholders of their portfolio companies. The authors’ study of bonds offered during 1992–2011 after IPOs shows that the yield spreads on bonds offered by PE-backed companies are, on average, 70 bps lower, holding other things constant. Another popular notion is that PE firms, as powerful shareholders, could induce portfolio companies to take on more and riskier projects or pay higher dividends, but the authors find that PE-backed IPO companies invest less and are less likely to pay dividends than other IPO companies.

The significant increase in PE-sponsored IPOs has drawn attention to the influence of PE firms on their portfolio companies’ post-IPO stock and operating performance. The authors examine bond offerings of PE-sponsored companies after the IPO and provide useful insights on three issues: (a) the interactions between PE firms and bond investors and the effects of such interactions on external financing, (b) the effects of ownership and corporate governance on the cost of debt, and (c) PE firms’ reputational concerns and external financing costs.

The authors test two competing hypotheses. The wealth expropriation hypothesis suggests that PE firms use their powerful blockholder status in their portfolio companies to transfer wealth from bondholders to themselves. This hypothesis implies that bond investors will require higher yields ex ante on bonds issued by PE-sponsored companies. The reputation acquisition hypothesis suggests that, as blockholders, PE firms have reputational concerns and do not adopt opportunistic corporate policies for their portfolio companies. This, in turn, suggests that PE-backed companies are able to offer lower yields on their debt offerings. The authors present evidence that PE firms help to reduce the cost of public debt for their portfolio companies.

They then examine two additional hypotheses. The overinvestment hypothesis posits that PE-backed IPO companies invest more aggressively around bond offerings, and the excessive dividend hypothesis states that PE-backed IPO companies are more likely to pay dividends. The authors find that PE-backed companies do not pursue investment and dividend policies that hurt bondholders after bond offerings. These results are consistent with the reputation acquisition hypothesis.

The authors use bonds offered during 1992–2011 by IPO companies to study the role of PE firms. They take a sample of 329 bonds issued by 204 companies during the four-year period (at least one year but no more than five years) after their IPOs using the Thomson Reuters SDC Global New Issues database. They first estimate ordered logit models to determine the credit ratings of these bonds at the time of issuance. These findings provide weak support for the reputation acquisition hypothesis.

Next, the authors estimate ordinary least-squares regressions to determine the offering yield spreads of these bonds. Yield spreads on bonds issued by PE-backed companies within five years after the IPO are, on average, 70 bps lower than those on bonds issued by other IPO companies. Economically, for an average bond offering of $410 million by the sample IPO companies and an average maturity of 10 years, the yield spread translates into a $28.7 million savings. It is lower when PE firms maintain higher equity ownership in the issuer in the year before the bond offering. These findings provide strong support for the reputation acquisition hypothesis.

Regarding the overinvestment hypothesis and the excessive dividend hypothesis, the authors’ findings show that PE-backed IPO companies invest less and are less likely to pay dividends than other IPO companies during the bond offering year and the following two years. The vast majority of PE-backed companies pay no dividend at all, and those that do pay dividends do not increase dividend payouts after a bond offering. These findings, taken together with the effects of PE sponsorship on yield spreads, suggest that PE firms do not expropriate investors who purchase bonds offered by PE-backed companies after the IPO.

The authors perform robustness tests, which support their findings.

With PE firms becoming ubiquitous, this research addresses very relevant issues. Some of the authors’ findings in this research seem pleasantly counterintuitive and provide a better understanding of the interaction between PE firms and other stakeholders.