Behind the Debt IPO Decision

What Did the Study Look At?

Firms, like people, follow a familiar life cycle. During the early years, rapid growth allows firms to reinvest profits and raise capital — perhaps with an equity initial public offering (IPO) — to keep the engines running. As they mature and generate healthy cash flows, firms can take on additional debt, though they may find the amount of debt available to them restricted by private lenders. At some point during the middle-to-later stages of maturity, firms often access public debt markets through a debt IPO. Debt IPOs carry less stringent restrictions than capital offered by private creditors, and they can also be a way for boards to rein in senior executives who may be tempted to over-invest by drawing too heavily on a firm’s cash flow.

Many studies have looked at equity-based IPOs, which are high-profile events on the business calendar. Much less attention has been paid to debt IPOs. This study aims to fill in that gap by exploring the roles that company life cycle and market forces play in the timing of debt IPOs.

How Was the Study Designed?

This research is based on an analysis of firms that obtained their first Moody’s ratings between 1980 and 2010. To identify firms in a later stage of the life cycle, the researchers proxy for firm age by using company size and the proportion of equity represented by retained earnings. The influence of internal firm factors was measured by looking at asset structure, profitability, age, risk, and the market’s view of the firm (market-to-book ratio, past and future stock returns).

What Did the Study Find?

• Firms obtained their initial bond ratings on average 9.5 years after their equity IPO and 11.8 years after initiating dividend payments. 
• Growth rates, capital expenditures, and cash flow volatility all declined as the firm accessed public debt markets; these are all markers for mature firms.
• At the firm level, debt IPO occurred following periods of strong operating performance and high excess stock returns. At the market level, entry coincided with favourable interest rates and default spreads. 
• The benefits of careful timing resulted in firms receiving initial bond ratings that were stronger than what would have been predicted. There was no evidence of abnormal numbers of downgrades for these firms in subsequent years.
• The debt IPO decision appeared to be well-timed. For example, researchers found that stock prices for debt IPO firms rose in the period prior to their initial debt ratings and fell subsequently. There was also strong evidence that earnings tended to drop afterwards. Debt-rating initiations were also negatively related to various interest rate measures, suggesting good timing of market factors. 
• While the debt IPO decision seemed to be well timed, the researchers did not find any evidence that firms obtain “inflated” ratings, at least not as reflected in subsequent downgrades.

What Do I Need to Know?

A firm’s decision to begin issuing debt in public bond markets “is a function of both life cycle influence and opportunistic timing,” the researchers note. Firms tend to be in their mature phase and are well placed to secure public debt at favourable rates. Once they are in the “right time of life,” company leaders carefully time the decision to get the best possible market access and cheapest financing, much as they do for equity IPOs. “The evidence shows that opportunistic timing occurs at several levels with firms evaluating their operating performance, excess stock returns, and general interest rate levels when determining the year of rating initiation.” 

Title: Debt-Rating Initiations: Natural Evolution or Opportunistic Behavior?

Authors: Laurence Booth (University of Toronto), Sean Cleary (Queen’s School of Business), Lynnette Purda (Queen’s School of Business)

Published: Journal of Modern Accounting and Auditing (9 (12) 1574-1595)

— Alan Morantz