Bonds - Bond Offerings and Reputation

Transcription

1 Buyout Groups Reputational Concerns and Costs of Debt Financing: Evidence from Bond Offerings by IPO Firms Rongbing Huang, Jay R. Ritter, and Donghang Zhang * May 31, 2012 Abstract A popular view is that buyout groups are focused on short-term improvements in operations and wealth redistribution at the expense of long-term value creation. Using bonds offered during by firms after their initial public offerings (IPOs), we examine the effects of buyout groups (private equity firms) on bond yield spreads, credit ratings, and bond issuers dividend and investment decisions. We find that yield spreads on bonds offered after the IPO by buyout-backed IPO firms are on average 67 basis points lower than those on bonds by other IPO firms, after controlling for other issuer and issue risk attributes, in spite of the fact that bond ratings by both Standard & Poor s and Moody s are unrelated to whether the issuer s IPO was buyout-backed. We also provide evidence that buyout-backed IPO firms are less likely to pay dividends and that they invest less than other IPO firms in the fiscal years of bond offerings. Our findings suggest that the reputational concerns of buyout groups help their portfolio firms reduce the agency costs of debt. Key Words: IPOs, Buyout Groups, Private Equity, Reputation, Agency Costs, Bond Offering * Huang is from the Coles College of Business, Kennesaw State University, Kennesaw, GA 30144, Ritter is from the Warrington College of Business Administration, University of Florida, Gainesville, FL 32611, and Zhang is from the Moore School of Business, University of South Carolina, Columbia, SC Huang can be reached at (678) or rhuang1@kennesaw.edu, Ritter can be reached at (352) or jay.ritter@warrington.ufl.edu, and Zhang can be reached at (803) or zhang@moore.sc.edu. We thank Daniel Bradley and seminar participants at the University of South Florida and Peking University for helpful comments. Kris Newcamp and Jenifer Snape provided excellent research assistance.

2 1. Introduction Buyout groups (private equity firms) have been playing a more and more important role in initial public offerings (IPOs). From 1990 to 2000, buyout groups sponsored 11% of all IPOs in the U.S. For 2001 to 2011, the percentage has increased to 32%. The extant literature suggests that reverse leveraged buyouts (RLBOs) tend to have better financial performance than other IPOs (Degeorge and Zeckhauser (1993), Holthausen and Larcker (1996), Cao and Lerner (2009), and Guo, Hotchkiss, and Song (2011)). Buyout groups potentially play an important role in the firms that they sponsor not only before but also after the IPO. Cao and Lerner (2009) and Cao (2011) report that buyout groups continue to own a large percentage of shares of their portfolio firms and serve on the board of directors during at least the first several years after RLBOs. Reverse leveraged buyouts, or RLBOs, are IPOs of buyout-backed private firms that were publicly traded and went through public-to-private leveraged buyout transactions. RLBOs are not the only type of IPOs backed by buyout groups. Private equity firms also engage in leveraged buyouts of private firms or divisions of public and private firms and then bring some of them public through IPOs. Jensen (1989) argues that buyout groups bring strong investor monitoring and managerial discipline to their portfolio firms. He suggests that firms that go through leveraged buyouts have a long-term optimal corporate governance structure. 1 In contrast, many commentators have argued that the financial promoters gain at the expense of other stakeholders, including the government through lower taxes due to the tax deductibility of interest payments, rather than creating social value (Shleifer and Summers (1988)). An unanswered question is whether investor monitoring and improved managerial discipline, which apparently benefit equity holders, come at the expense of other stakeholders. For IPOs, does the superior financial performance of buyout-backed IPOs documented in the literature simply come from the legacy operating improvements due to the leveraged buyout? Or is it at least partly related to the presence of buyout groups after the IPO and their interactions with other stakeholders? In this paper, we shed light 1 Almost all buyout partnerships are structured with a clause that cash or shares must be distributed to the limited partners within years of investing. Jensen (1989) does not discuss this mandatory exit feature of the standard partnership contract. 1

3 on the importance of the long-term presence of private equity firms and the importance of their interactions with other stakeholders. More particularly, we examine this issue by studying bond offerings after IPOs by firms that are sponsored by buyout groups. Bondholders are important stakeholders for buyout-backed firms, and the conflicts of interest between bondholders and shareholders are well documented. Warga and Welch (1993) provide evidence that the existing bondholders of a firm are harmed when it is acquired through a leveraged buyout. More generally, buyout groups, as shareholders, have an incentive to push their portfolio firms to make investment decisions to the detriment of the firms bondholders. Equity can be viewed as a call option on the firm, and the option s value increases when the volatility of the underlying assets increases. Therefore, shareholders of a levered firm have an incentive to take risky projects to transfer wealth from bondholders (Jensen and Meckling (1976)). This risk-shifting problem is more severe when a firm s managers are incentivized to pursue short-term gains in their firm s stock price. In addition to investment decisions, buyout groups could also adopt an aggressive payout policy that could potentially harm bondholders. There is anecdotal evidence that buyout groups sometimes pay themselves big dividends shortly before the IPOs of their portfolio firms. Buyout groups play an important role in our sample firms that conducted bond offerings during the first five years after the IPO. We use hand-collected data on post-ipo ownership and directorship from EDGAR on the Securities and Exchange Commission (SEC) website. Consistent with Cao and Lerner (2009) and Cao (2011), for a firm in our sample, buyout groups on average own more than 20% of the firm s equity at the end of the first five years after the IPO. For more than 90% of the firms after the first two years since the IPO, and for more than 60% of the firms after the first five years, buyout groups still have at least one director on the board of a sponsored firm. Our evidence is consistent with the notion that buyout groups are powerful shareholders of their portfolio firms, and they are potentially able to pursue their own interests at the expense of bond holders. If bond investors are concerned about such power and the incentive of buyout groups to expropriate them, they will price protect themselves. We thus have the wealth expropriation hypothesis: Because buyout groups have the incentive and possible 2

4 power to expropriate the bondholders of their portfolio firms, such possibilities increase the ex ante cost of public debt financing of the buyout-backed IPO firms. The reputational concerns of buyout groups can help to alleviate their incentives to expropriate bondholders. Buyout groups often deal with bond investors repeatedly. If one firm owned by a buyout group exploits its bondholders, all firms owned and to be owned by the buyout group will likely face a higher risk premium on their bonds and more restrictive covenants (see, e.g., Diamond (1989), Klein and Leffler (1981), Shapiro (1983), Fang (2005), and Massa and Zaldokas (2011)). Buyout groups reputation capital can be viewed as the present values of buyout groups (significant) share of the savings due to lower borrowing costs for their portfolio firms. To protect their reputation capital, buyout groups are likely to avoid opportunistic behavior that hurts bondholders. Buyout groups reputational concern would also motivate them to help their portfolio firms adopt corporate governance and managerial compensation structures that are friendly to bondholders. Buyout groups are even likely to use their own resources to help their portfolio firms avoid costly bankruptcies (see Moody s (2009, 2010)). Since all these arguments are rooted in buyout groups protection and/or acquisition of reputation capital, we call them the reputation acquisition hypothesis. We first test the wealth expropriation hypothesis and the reputation acquisition hypothesis by examining the determination of credit ratings and yield spreads of bond offerings by IPO firms. We study bond offerings after IPOs because information on the involvement of buyout groups in IPO firms is publicly available. Unlike bank loans, publicly issued bonds are almost always rated by both Standard & Poor s (S&P), Moody s and, increasingly, Fitch. We can thus study rating agencies view of the credit risk of bonds offered by buyout groups portfolio firms. Under the reputation acquisition hypothesis, buyout sponsorship of bond-issuing IPO firms will result in higher ratings, everything else being equal. Under the wealth expropriation hypothesis, the predictions would be the opposite. It is important to note that even if either of the hypotheses is true, we will not necessarily find a statistically significant relation between buyout sponsorship and credit ratings. First, credit ratings can be 3

5 biased because of imperfections in the rating process (e.g., John, Lynch, and Puri (2003)). The recent controversies over ratings given to mortgage-backed securities have amply demonstrated this. Second, since rating agencies do not buy the bonds with their own funds, they do not always have an incentive to do adequate due diligence and provide unbiased ratings (e.g., Griffin and Tang (2011)). Third, if rating agencies believe that buyout groups reputational concern largely offsets their wealth expropriation incentive, then we would find an insignificant relation between buyout sponsorship and credit ratings. Bond investors have their vote through determining the required yields on bond offerings. Besides the major credit rating agencies, fixed income analysts at many financial research firms, including investment banks, provide advice to bond investors. Bond investors, such as bond mutual funds and hedge funds, also often do their own research. If the wealth expropriation hypothesis dominates and investors view bonds offered by buyout groups portfolio firms as being riskier, they will require a higher promised return on the bonds. On the other hand, if the reputation acquisition hypothesis dominates and bond investors recognize the value of the buyout groups reputational concerns, buyout sponsorship will be associated with lower bond yield spreads, everything else being equal. We use bonds offered during by IPO firms to study the effect of buyout sponsorship on credit ratings and yield spreads. Since buyout groups often continue to play an important role in their portfolio firms in the first several years after the firms IPOs, we focus on bonds offered no more than five years after IPOs. Because we require bond issuers stock returns during the one year period prior to bond offerings, we also exclude bonds offered during the first year after the IPO. We thus focus on a sample of 431 bonds issued at least one year but no more than five years after IPOs. We estimate ordered logit models for the determination of S&P and Moody s ratings of these bonds at the time of issuance. After controlling for borrower and issue characteristics, we find that bonds offered by buyout-backed IPO firms and those by other IPO firms receive similar credit ratings. This finding suggests that the rating agencies view bonds offered after buyout-backed IPOs and other IPOs as having similar credit risk. 4

6 We estimate Ordinary Least Squares (OLS) regressions for the determination of offering yield spreads of these bonds. We find that yield spreads on bonds issued by buyout-backed IPO firms are on average 67 basis points lower than those on bonds issued by other IPO firms after controlling for observed issuer and issue characteristics and unobserved characteristics as captured by credit ratings. For an average bond offering of $350 million by our sample IPO firms, the 67 basis point lower yield spread represents a saving of $2.35 million per year on interest payments. For an average maturity of ten years of the bond offerings in our sample, this can be translated into a $23.5 million savings if the bond is not retired early. This statistically and economically significant effect of buyout sponsorship on bond yield spreads suggests that investors view bonds issued after buyout-backed IPOs as being less risky than those issued after other IPOs. This provides strong support for the reputation acquisition hypothesis. An issuing firm can use bond covenants to lower the yield on its bond. As a robustness test, we analyze whether buyout-backed firms and other firms use bond covenants differently, and if there is a difference, whether the difference explains the lower cost of debt for buyout-backed firms. We follow Billett, King, and Mauer (2007), Chava, Kumar, and Warga (2010), and Mansi, Qi, and Wald (2011) and construct an index for the use of bond covenants. We find that buyout-backed IPO firms do not use more covenants in their bond contracts, and that the use of bond covenants does not affect the relations between bond yields and buyout sponsorship that we have identified. The bond yield regression results are consistent with the reputation acquisition hypothesis, suggesting that, due to their reputational concerns, buyout groups adopt corporate governance structures and policies that are friendly to bondholders. To corroborate the results on bond yields and to shed further light on the importance of the presence of buyout groups after IPOs, we test two more hypotheses. The over-investment hypothesis argues that buyout-backed IPO firms invest more and take on riskier projects around bond offerings. The excessive dividend hypothesis suggests that buyout-backed IPO firms are more likely to pay dividends. The rationale for these two hypotheses is simple. With the significant infusion of capital through bond offerings, buyout groups as powerful shareholders could take 5

7 on more and riskier projects or pay dividends if their only goal is to maximize their short-term gains. 2 We find that buyout-backed IPO firms are less likely to pay dividends and invest less than other IPO firms during the fiscal years of the bond offerings. These findings, taken together with our earlier findings of the effects of buyout sponsorship on yield spreads of bonds, suggest that buyout groups do not engage in wealth expropriation via their portfolio firms. Buyout groups reputational concerns help their portfolio firms even after the firms IPOs. The contribution of the paper is three fold. First, the increasing importance of private equity in IPOs has drawn researchers attention to the influence of private equity firms on the stock and operating performances of a firm after its IPO (Cao and Lerner (2009), Cao (2011), and Guo, Hotchkiss, and Song (2011)). External debt financing shortly after the IPO provides an important way to shed light on how private equity firms can influence a firm after the IPO. Our paper thus provides important evidence on the interactions between private equity firms and bond investors and the effects of such interactions on external financing. Second, this paper is related to the literature on the cost of debt and corporate governance. Empirically, several papers find supportive evidence that shareholder type, corporate governance, and managerial compensation are significantly related to the cost of debt. Anderson, Mansi, and Reeb (2003) find that founding family ownership is negatively related to the cost of debt. Ashbaugh-Skaife, Collins, and LaFond (2006) present evidence that firms with stronger corporate governance receive higher credit ratings from Standard and Poor s. Both papers suggest that firms with founding families are less likely to be motivated by short-term gains in their stock prices and are therefore more likely to avoid costly bankruptcies. Oritz-Molina (2006) provides evidence that managerial ownership is positively related to at-issue yield spreads on corporate bonds, and that bond investors anticipate higher risk-taking incentives from managerial stock options than from equity ownership. Francis, Hasan, John, and Waisman (2010) 2 We assume that the underinvestment problem is not a concern around bond offerings since the issuing firm has or is expected to have a significant amount of fresh capital infusion through the public bond offering. Existing empirical studies generally document a tendency of security issuers to over-invest rather than under-invest (e.g., Titman, Wei, and Xie, 2004) and Billett, Flannery, and Garfinkel (2011)). 6

8 find that state antitakeover laws tend to reduce the cost of debt. They suggest that state antitakeover laws help to align the interest of managers with that of bondholders and thus reduce the risk-shifting and under-investment problems. In a study of 3,468 firms in 22 countries, Lin, Ma, Malatesta, and Xuan (2011) provide evidence that firms in which a major blockholder has more voting rights than cash flow rights pay a higher interest rate on bank loans. We provide evidence on whether the reputational concerns of increasingly important private equity firms can alleviate their expropriation incentives and lower the cost of debt for their portfolio firms. Finally, this paper adds to our understanding of private equity firms, especially their reputational concerns and external financing costs. In a closely related paper, Demiroglu and James (2010) present evidence that the reputational concerns of buyout groups help to reduce the agency conflicts between shareholders and banks. Using a sample of 180 public-to-private LBOs in the US from January 1, 1997 to August 15, 2007, they find that borrowing costs are lower for LBO loans sponsored by high reputation buyout groups. Our paper is also related to two concurrent papers. Hotchkiss, Smith, and Strömberg (2011) show that private equity-backed firms are not more likely to default on their loans, everything else being equal. Furthermore, a buyout-sponsored firm that is in bankruptcy is more likely to survive due to the financial and reputational capital of the sponsoring firm. Cain, Davidoff, and Macias (2011) provide evidence that some private equity firms do have to incur higher contract termination costs when they fail to execute an agreed buyout contract and suffer a reputational loss. Our paper adds to this growing literature in at least two important regards. First, the existing literature largely focuses on bank loans, while we study publicly issued bonds and shed light on how bondholders and credit rating agencies view the presence of buyout groups. Second, the literature examines buyout groups target firms in their private status, while we examine these firms after IPOs and help to understand whether and how buyout groups have long-lasting influence on their portfolio firms. The rest of this paper is organized as follows. Section 2 describes the data. In Sections 3, we report the regression results on the effect of buyout sponsorship on credit ratings and yield spreads. We 7

9 discuss the influence of buyout groups on investment and dividend policies of their portfolio firms in Section 4. Robustness checks are in Section 5, and Section 6 concludes. 2. Data and Descriptive Statistics 2.1. Sample Construction and Distribution We use Thomson Reuters s SDC Global New Issues database to identify all public and 144A straight bond offerings of U.S. domestic non-financial firms from Our sample of bond offerings starts from 1983 because Moody s began issuing notch ratings after April 1982, instead of just letter ratings (see, e.g., Livingston and Zhou (2010)). We identify 12,287 public and 144A straight bond offerings that can be linked to the Center for Research in Security Prices (CRSP) database. Excluding floating rate, putable, exchangeable, perpetual, unit, and subordinated issues reduces the sample to 9,409 issues. Key issue characteristics (ratings by both Moody s and S&P, maturity, gross proceeds, and yield to maturity) are available for 7,926 issues. The issuers of 7,744 issues can be found in Standard & Poor s Compustat using the links provided in the CRSP/Compusat merged database. We obtain IPO information from the SDC database for firms that went public during that account for 1,457 bond issues. 3 Lagged values of key firm characteristics from CRSP/Compustat are available for a total of 1,299 post-ipo bond issues by 424 firms, including 431 issues by 209 firms after at least one year and within five years since the IPO. For the rest of the paper, we call the 1,299 bond issues, which include bond offerings at any time after one year since the IPO, the extended sample, and we call the 431 issues that are between one and five years after the IPO the focused sample or the (IPO+1, IPO+5] sample. 4 3 We do not include IPOs prior to 1980, because we do not know whether they are backed by buyout groups, although anecdotal evidence suggests that very few were. We thank Jerry Cao for kindly sharing his classifications of buyout-backed IPOs from As is common in the literature, closed-end funds, Real Estate Investment Trusts (REITs), Special Purpose Acquisition Companies (SPACs), banks and savings & loans (S&Ls), American Depositary Receipts (ADRs), units, partnerships, and IPOs with an offer price of less than $5 are excluded. We also exclude other financial IPOs because we do not examine bond offerings by financial firms in this paper. 4 For the focused sample, United Parcel Service Inc. (UPS) is the most frequent issuer and had 87 of the 431 issues. The second most frequent issuer, Northwest Airlines, had nine issues. Our major regression results are robust to 8

10 We report the sample distribution and the summary statistics for both the extended sample and the focused sample in this and the next sub-sections. Bond and bond issuer characteristics can be quite different depending on whether the issuer s IPO has buyout sponsorship. To highlight the differences between the two categories of bonds, we also report the sample distribution and the summary statistics for each category separately. Figure 1 reports the sample distribution sorted on several different dimensions. Graph A of Figure 1 shows the sample distribution sorted by IPO type and the number of years from the IPO to the bond offering date. Newly public firms often have greater financing needs and are more likely to raise external capital (Helwege and Liang (1996)). It is interesting to know how quickly these firms start to access the public debt market. Firms offer bonds to the public even during the first several years after their IPOs. For example, during the second year after their IPO, the buyout-backed firms have 25 bond offerings and the other (non-buyout-backed) firms have 118 bond offerings. Only a small number of bonds are offered more than 13 years after buyout-backed IPOs, partly because a firm would have had to go public before 1997 to compete 13 post-ipo years by December 31, As the time since the IPO increases, the influence of buyout groups in the IPO firms is likely to decrease. We thus focus on the period of after one year but no more than five years since the IPO, during which period the buyout-backed firms have 93 bond offerings and the other firms have 338 bond offerings, or a total of 431 bond offerings. For comparison purposes, we also present some results for the extended sample, which includes all of the 1,299 bonds offered at least one year after the IPO. Graphs B and C of Figure 1 show the distribution of the (IPO+1, IPO+5)] sample and the extended sample, respectively, by IPO type and credit ratings. Note that the lowest S&P rating and the lowest Moody s rating for the bonds in the extended sample are CCC and Caa3, respectively. Graph B whether we include the UPS issues or not. Among the 209 firms, 142 firms had one bond issue, 37 firms had two issues, and 30 firms had more than two issues. In our regressions, we correct the standard errors of the coefficients for potential clustering at the firm level. 9

11 shows the distribution of the bonds in the (IPO+1, IPO+5] sample. 5 Nearly 45% and 48% of the 431 bonds are rated below investment grade by S&P and Moody s, respectively. The bonds offered by the buyout-backed IPO firms are more likely to be rated speculative grade than the bonds by the other firms, perhaps because buyout groups can help high risk firms offer bonds to the general public. For example, based on the S&P rating, roughly 69% of the bonds by buyout-backed IPO firms and 39% of the bonds by the other firms are rated speculative grade. In the (IPO+1, IPO+5)] sample, the non-buyout-backed IPO firms have 86 AAA rated bonds. In contrast, the buyout-backed firms have only one bond with an S&P rating of A+ or higher (rated AA). Graph C shows the distribution of the bonds in the extended sample by IPO type and credit ratings. About 48% and 50% of the 1,299 bonds are rated below investment grade by S&P and Moody s, respectively. For the extended sample, the bonds by the buyout-backed IPO firms continue to receive lower ratings than the bonds by the other firms, and about 61% of the bonds by the buyout-backed IPO firms and 45% of the bonds by the other firms are rated below investment grade by Standard and Poor s. Only two bonds issued by the buyout-backed firms have an S&P rating or A+ or higher, and none have a Moody s rating of A1 or higher Variable Definitions and Summary Statistics We first briefly describe the variables used in our credit rating and yield regressions in this subsection. We will describe the additional variables used in our investment and dividend regressions later. Following the literature (e.g., Anderson, Mansi, and Reeb (2003) and Ashbaugh-Skaife, Collins, and LaFond (2006)), we convert letter ratings by Standard and Poor s and Moody s into scores with the highest rating (AAA by S&P and Aaa by Moody s) receiving a value of 19 and the lowest rating (CCC- or Caa3 in our sample) receiving a value of 1. 6 We use these rating scores as the dependent variable in our credit rating regressions. We denote the S&P rating score as SP_RATING and the Moody s rating 5 Moody s rating has a similar pattern to that of S&P s, and we mainly focus on the S&P rating in our discussion. For example, all of the 86 AAA rated (by S&P) and 87 Aaa rated (by Moody s) bonds were issued by UPS. Only one of the 87 issues by UPS was rated below AAA by Standard and Poor s. 6 Note that we do not have any bond with a rating of below CCC- or Caa3 in our final samples. It is virtually impossible for firms to offer new bonds with a rating of below CCC- or Caa3 to the public. 10

12 score as MDY_RATING. The dependent variable in our yield spread regressions is the percentage yield spread (YIELD_SPREAD (%)), defined as the difference between the bond s percentage yield-tomaturity and the percentage yield-to-maturity on the constant maturity Treasury security with a similar maturity at the time of issuance. Among the independent variables, we focus on a dummy variable (BUYOUT) that equals one for a bond offered by a firm that has its IPO sponsored by one or more buyout groups, and zero otherwise. Note that the buyout-backed IPOs include both reverse leveraged buyouts, or RLBOs, and IPOs of buyout-backed private firms or divisions of public or private firms that have never gone through publicto-private transactions. Strömberg (2007) shows that most buyout activities consist of acquisitions of private firms rather than public firms. We follow the literature to choose the control variables in credit rating and yield spread regressions (e.g., Anderson, Mansi, and Reeb (2003), Ashbaugh-Skaife, Collins, and LaFond (2006), Blume, Lim, and MacKinlay (1998), and Livingston and Zhou (2002, 2010)). Table 1 reports the detailed definitions and the summary statistics (means, medians, and standard deviations) of these variables. Given the limited space in the table, we provide detailed discussions on the interest coverage ratio (ICR) variables here. We use four interest coverage ratio variables, ICR i, t-1 (i=0, 5, 10, 20), where the subscript t-1 refers to the fact that the variable is measured for the fiscal year before the bond offering year, to capture the non-linear effect of the ICR on credit risk (see Ashbaugh-Skaife, Collins, and LaFond (2006) and Blume, Lim, and MacKinlay (1998)). The ICR t-1 is calculated as (operating income after depreciation + interest expense) / interest expense during the fiscal year immediately prior to the bond offering date. We then set ICR t-1 to zero if it is negative and to 100 if it is greater than 100, because a value less than zero or greater than 100 is unlikely to convey additional information. We define ICR i, t-1 (i=0, 5, 10, 20) as follows: 11

13 ICR 0, t-1 ICR 5, t-1 ICR 10, t-1 ICR 20, t-1 0 ICR t-1 <5 ICR t ICR t-1 <10 5 ICR t ICR t-1 < ICR t ICR t-1 < ICR t-1 20 Overall, Table 1 suggests that the buyout-backed IPO firms in the (IPO+1, IPO+5] sample are riskier than the buyout-backed IPO firms in the extended sample, and that the buyout-backed IPO firms are riskier than the other IPO firms in both samples, although the risk difference between the two types of firms is smaller in the extended sample. Because the sub-sample of non-buyout-backed IPOs includes 87 bonds by United Parcel Service Inc. (UPS), we also report the summary statistics for the sub-sample after excluding the UPS issues. Panel A of Table 1 reports the conditional and unconditional means and medians for the (IPO+1, IPO+5] sample. Regardless of whether the UPS issues are excluded, bonds issued by buyout-backed firms have lower rating scores, indicating lower credit ratings. For both S&P and Moody s ratings, the bonds offered by buyout-backed IPOs have a mean value slightly above 7, which is BB- for S&P ratings and Ba3 for Moody s. For the bonds offered by non-buyout backed IPOs, the average rating score, with AAA=19, when the UPS issues are included is slightly above 11, or BBB for S&P and Baa2 for Moody s, and the average score drops to 8.35 when the UPS issues are excluded. The mean YIELD_SPREAD (%) is 3.28% on the bonds offered after buyout-backed IPOs and 2.43% (2.97%) on the bonds after the other IPOs if the UPS issues are included (excluded). The difference of 0.85% (0.31%) is economically significant, especially if we compare it to the mean values. The medians of YIELD_SPREAD (%) on the two categories of bonds are 2.67% and 1.38%, respectively, with the difference being 1.29%. The difference in the medians shrinks to 0.13% if we exclude the 87 UPS issues. The mean value of a dummy variable equals the fraction of observations for which the dummy variable equals one. For example, about 18% of the bonds by the buyout-backed IPO firms are shelf registered. The bonds by the buyout-backed IPO firms are less likely to be shelf registered and more 12

14 likely to be offered in the Rule 144A market. These results are consistent with the findings in the literature that the Rule 144A market allows low credit quality firms to issue speculative grade bonds quickly to meet unexpected financing needs (Denis and Mihov (2003), Fenn (2000), Livingston and Zhou (2002), and Huang and Ramirez (2010)). The buyout-backed IPO firms are smaller than the other bond issuers, as measured by the market capitalization, especially if the UPS issues are included. Both the buyout-backed and the other IPO firms that conduct bond offerings are generally much older than the overall IPO firms, which have a median age of about eight years, as reported in Table 2 of Loughran and Ritter (2004) and updated on Jay Ritter s website. Non-buyout-backed IPO firms are much more likely to be dividend payers, even if we exclude UPS. The issuers of bonds after buyout-backed IPOs are more likely than the other issuers to have incurred a loss in the fiscal year prior to the bond offering date. On average, the buyout-backed IPO firms have lower interest coverage ratios ICR 0, t-1 - ICR 10, t-1 than the other IPO firms, while the opposite is true for ICR 20, t-1. Note that a higher interest coverage ratio is desirable. The buyout-backed firms have higher mean and median leverage ratios and betas and lower mean and median market-to-book ratios than the other firms. Panel B of Table 1 reports the summary statistics for the extended sample. The bonds issued by the buyout-backed firms continue to have lower credit ratings and higher yield spreads than the bonds by other IPO firms. The differences in the issuer characteristics between the two categories of bonds also suggest that the buyout-backed IPO firms are generally riskier than the other firms, although the differences are often smaller for the extended sample Ownership and Directorship for Buyout- and VC-Sponsored IPO Firms The wealth expropriation and the reputation acquisition hypotheses, as well as the discussions of the regression results in Sections 3 and 4, rely on an implicit assumption that buyout groups play an important role in their portfolio firms after the IPO. Although anecdotal evidence and some limited evidence in the literature suggest that this assumption is valid, it is useful to provide direct evidence for the IPO firms in our sample. Because we make some comparisons between buyout groups and venture 13

15 capital (VC) sponsors in our robustness checks, and also because it is an interesting digression to know how VC firms do after the IPO of their sponsored firms, we collect data from EDGAR on the SEC website for all buyout- and VC-backed IPO firms starting on May 16, 1996 that did bond offerings and are thus in our (IPO+1, IPO+5] sample. We start at May 16, 1996 because it is the offer date of the first IPO for which the IPO prospectus is available through EDGAR. We only include IPOs that have IPO prospectuses in EDGAR so that we can use the prospectus to determine the names of the buyout or VC sponsors. We have 46 IPOs, including 34 buyout-backed and 12 VC-backed ones, that have an IPO prospectus in EDGAR. 7 For these 46 IPOs, we read through their IPO prospectus and the first five years proxy statements to collect the ownership and directorship information for their IPO sponsors and other institutional investors. We report the ownership and directorship information for the 46 IPOs in Table 2. Panel A of Table 2 reports the information for the lead investor/sponsor for buyout-sponsored IPOs, and Panel B does it for VC-sponsored IPOs. We define a lead investor or a lead sponsor as the investor that has the largest equity ownership immediately after a firm s IPO. For buyout-backed IPO firms in Panel A, the average equity ownership of the lead buyout sponsor remains above 20% for the first five years after the IPO, while the median remains above 10% for the first four years. Note that due to club deals in which several buyout firms jointly control a portfolio company, the lead buyout firm s average ownership share is lower than the combined shares (Demiroglu and James (2010)). The mean and median numbers of directors on the board that are affiliated with the lead buyout sponsor remain at one or more for the first five years. For more than 60% of the sponsored firms for the first five years (90% for the first two years), the lead buyout sponsor has one or more board seats. This ownership and directorship pattern validates the implicit assumption for our hypotheses that buyout firms remain important stakeholders for their sponsored firms after IPO. 7 We have 209 IPO firms that issued bonds for the (IPO+1, IPO+5] sample, and 91 of them had an IPO after May 16, of the 91 firms are sponsored by private equity or VC. 14

16 For VC-backed IPOs in Panel B of Table 2, the lead VC sponsor unloads its equity stake at a faster rate and the average and median ownership only remains above 10% for the first year. However, the median number of lead VC-affiliated directors remains at one for the first five years after the IPO, and nearly 90% of the firms have their VC-affiliated directors on the board for the first four years after IPO. Because few VC-sponsored IPO firms issue bonds to the public within five years of the IPO, we want to caution that the number of VC-backed firms for which we have information through EDGAR is very small only 12 firms. But the data do suggest that lead VC sponsors remain influential for the first few years after the IPO. For both buyout- and VC-backed firms, institutional investors other than the lead sponsor can and do get involved. We define the institutional investors, excluding the lead as defined above, that have reported equity ownership in the IPO prospectus as co-investors. We report the ownership and directorship information for the co-investors in Panel C of Table 2. Note that we set the ownership and directorship at zero if a firm does not have co-investors. Panel C also reports the information on how new institutional investors, defined as those that do not appear in the IPO prospectus, gradually increase their ownership after a firm s IPO. For both buyout- and VC-backed IPOs, co-investors have a significant ownership stake before and immediately after the IPO. For a majority of the firms that they invest in, the co-investors also have their affiliated directors on the board for the first few years after the IPO. For new institutional investors, VC-backed firms seem to attract them at a faster pace. 3. Buyout Sponsorship, Credit Ratings, and Yield Spreads 3.1. The Effect of Buyout Groups on Credit Ratings Credit ratings are useful to issuers, investment banks, and investors. Rating agencies do extensive research on the credit worthiness of LBOs. A special comment by Moody s dated November 2009 finds that companies affiliated with the 14 largest buyout groups have experienced similar default rates to other companies over the course of the January 2008 September 2009 period (see Moody s (2009)). Another special comment by Moody s dated March 2010 finds that nearly half of U.S. non- 15

17 financial corporations that defaulted in 2009 had private equity sponsors and that creditors of private equity-backed companies may realize better recoveries than other creditors (see Moody s (2010)). Neither comment fully controls for other issue and issuer risk attributes and both of Moody s comments are based on a sample concentrated on a short period of time during which a major financial crisis occurred. In this section we do multivariate analysis of the effect of buyout groups on credit ratings and yield spreads controlling for all related issue and issuer risk attributes using bond offerings over a longer period of time. We are thus able to make more robust statistical inferences on the role of buyout groups in bond offerings of their portfolio firms. We estimate several variations of the following equation to evaluate the effect of buyout groups on credit ratings. Note that in this and all of the following equations, a subscript t-1 for a variable indicates that the variable is measured using information for the fiscal year prior to the bond offering. (1) SP_RATING/MDY_RATING = f (BUYOUT dummy, DEFAULT_SPREAD, LN(MATURITY), SHELF dummy, RULE_144A dummy, FIRST_BOND dummy, LN(NUM_BONDS), LN(MARKET_CAP) t-1, LN(AGE), DIV_PAYER t-1 dummy, ROA t-1, LOSS t-1 dummy, ICR i, t-1 (i=0,5,10,20), LEVERAGE_RATIO t-1, BETA t-1, STD_RETURN t-1, RETURN t-1, MARKET_TO_BOOK t-1, TANGIBILITY t-1, UTILITY t-1 dummy, YEAR dummies). Since the credit rating score takes 19 ordinal (i.e., categorical and ordered) values, we estimate ordered logit regressions. Note that the actual values of the rating score in the ordered logit regressions are irrelevant except that larger values correspond to higher rating categories. Table 3 reports the results of the ordered logit regressions. The first two regressions use the (IPO+1, IPO+5] sample of 431 bond issues and the last two regressions use the extended sample of 1,299 bond issues. The dependent variable is the rating score by S&P in regressions (1) and (3), and the rating score by Moody s in regressions (2) and (4). We also estimate these regressions by excluding the UPS issues and our major results (not tabulated) are essentially the same. We are particularly interested in the coefficient on the BUYOUT dummy variable. The coefficients for this variable are never statistically significant in any of the four regressions. The results 16

18 suggest that, after controlling for observable issue and issuer characteristics, neither S&P nor Moody s views bonds offered by the buyout-backed IPO firms as being riskier than bonds offered by the other IPO firms. The coefficients for the control variables are largely expected and are consistent with the literature. The coefficient for LN(PROCEEDS) is negative and statistically significant in all four regressions, suggesting that holding other observable characteristics constant, larger bond offerings receive lower ratings, perhaps because larger bond offerings are likely to increase the interest burden and the default risk of the issuers. The coefficient for the RULE_144A dummy is negative in all four regressions and statistically significant in regressions (1), (3), and (4). The negative coefficient suggests that bonds offered in the Rule 144A market receive lower credit ratings, consistent with the finding in the literature that low credit quality firms issue bonds in the 144A market due to desire for the speed of issuance (Fenn (2000) and Huang and Ramirez (2010)). The coefficients for LN(NUM_BONDS) and the FIRST_BOND dummy variable are statistically significant at the 1% or 5% levels for the focused sample, but they are insignificant for the extended sample. The unexpected positive relation between the FIRST_BOND dummy and ratings is perhaps because rating agencies want to attract first-time issuers. The positive relation between LN(NUM_BONDS) and credit ratings suggests that frequent issuers receive higher credit ratings. 8 This is perhaps because rating agencies favor their frequent customers or because frequent interactions have resulted in less information asymmetry between rating agencies and the issuers. The positive relation between LN(MARKET_CAP) t-1 and ratings suggests that bonds offered by larger firms receive higher credit ratings. This is expected because larger firms are likely to be less risky. The coefficients for the DIV_PAYER t-1 dummy are statistically significant for the extended sample at the 1% level, while being only marginally significant for the focused sample. These findings are consistent with the hypothesis that being able to pay dividends is more relevant as a signal of stable profitability for 8 When the 87 UPS issues are excluded from the (IPO+1, IPO+5] sample, the coefficient on LN(NUM_BONDS) in regression (1) changes from 0.64 to 0.49 and is statistically significant at the 5% level. 17

19 older and more mature firms. Profitable firms should have lower default risk and thus higher credit ratings. Consistent with this expectation, the coefficient on ROA t-1 is positive and statistically significant in regression (2). The coefficient for the LOSS t-1 dummy in regression (1) is negative and statistically significant at the 10% level, suggesting that firms losing money receive lower credit ratings. The positive coefficient on ICR 5, t-1 is expected since higher interest coverage ratios imply greater capacities for making interest payments and thus lower default risk. The coefficients for ICR 10, t-1 and ICR 20, t-1 are only statistically significant for the extended sample, suggesting that the nonlinearity of the interest coverage ratio is more relevant for the issuing firms with a longer public record. Since firms with a higher stock return volatility are riskier, the negative relation between STD_RETURN t-1 (%) and credit ratings is also expected. Firms with a higher stock market valuation should receive higher credit ratings. Inconsistent with this expectation, there is some evidence that firms with a higher market-to-book ratio and pre-issue stock return receive lower credit ratings, likely because rating agencies are concerned about the large financing needs of growth firms, and the regression specification also controls for LN(MARKET_CAP) t The Effect of Buyout Groups on Yield Spreads Credit rating agencies and other bond market analysts are likely to have different opinions about the credit worthiness of a bond. Using a sample of over 3,200 private equity-backed companies acquired in a buyout or similar transaction between 2000 and 2009 and held through , a publication dated March 2010 by the Private Equity Council finds that, during the financial crisis of , private equity-backed businesses defaulted at less than one-half the rate of comparable companies: 2.84% versus 6.17% per year (see Thomas (2010)). In this section we study bond investors view of buyout groups role in their portfolio firms post-ipo bond offerings. We hope to shed light on the debate on whether buyout groups are associated with riskier debt (or reckless leverage in light of the context of the great recession of ). More importantly, we use the bond offerings by buyout-backed IPO firms to shed light on how buyout groups continue to work with their portfolio firms and other investors even after their IPOs. 18

20 If the wealth expropriation hypothesis is more relevant and bond investors are more concerned with the wealth expropriation incentives of buyout groups, these bond investors would view bonds offered after buyout-backed IPOs as being riskier than bonds offered after other IPOs. In turn they will require a higher risk premium on the bonds offered after buyout-backed IPOs. On the other hand, if the reputation acquisition hypothesis is more relevant and bond investors have developed a trust with buyout groups, the investors in bonds issued by buyout-backed firms would face less default risk and a higher recovery rate if default does happen. They will then charge a relatively lower yield on the bonds offered after buyout-backed IPOs. To distinguish these competing arguments, we estimate several variations of the following equation: YIELD_SPREAD(%) = f (BUYOUT dummy, DEFAULT_SPREAD, LN(MATURITY), SHELF dummy, RULE_144A dummy, FIRST_BOND dummy, LN(NUM_BONDS), (2) LN(MARKET_CAP) t-1, LN(AGE), DIV_PAYER t-1 dummy, ROA t-1, LOSS t-1 dummy, ICR i, t-1 (i=0,5,10,20), LEVERAGE_RATIO t-1, BETA t-1, STD_RETURN t-1, RETURN t-1, MARKET_TO_BOOK t-1, TANGIBILITY t-1, UTILITY t-1 dummy, YEAR dummies, SP_RATING_RES, MDY_RATING_RES). In the previous sub-section, we examined the variables that are expected to explain credit ratings. In this sub-section, we continue to include these variables as independent variables in the yield spread regressions defined in Eq. (2). If bond investors and credit rating agencies have the same interpretation of information, then statistically significant variables in credit rating regressions will continue to be statistically significant with an opposite sign in yield spread regressions that do not include credit ratings, while statistically insignificant variables will remain statistically insignificant. Credit rating agencies such as Standard & Poor s and Moody s use information beyond CRSP/Compustat to evaluate credit risk. Controlling for credit ratings in yield spread regressions should help to sharpen our explanation for the determination of yield spreads. However, if credit ratings are included as additional independent variables in yield spread regressions, they are likely to pick up the effects of the other independent variables. Similar to Anderson, Mansi, and Reeb (2003), we thus include purged S&P and Moody s ratings as additional independent variables in our yield spread regressions to 19

21 avoid this problem. The purged S&P rating (SP_RATING_RES) is the residual from an OLS regression with the S&P rating as the dependent variable and the independent variables used in the previous subsection as independent variables. Thus, the purged S&P rating is orthogonal to the independent variables. The purged Moody s rating (MDY_RATING_RES) is the residual from an OLS regression that uses the Moody s rating as the dependent variable and further includes the S&P rating, in addition to the other independent variables, as an independent variable. Thus the purged Moody s rating is also orthogonal to the S&P rating. Table 4 reports the regression results for the determination of yield spreads. We analyze both the (IPO+1, IPO+5] sample and the extended sample. But to save space, we focus on the (IPO+1, IPO+5] sample in the table and in our discussions. In all of the four regressions in Table 4, year dummy variables are included to capture changes in the macroeconomic environment across time. For brevity, the coefficients and the t-statistics for the year dummies are not reported. Regressions (1), (2), and (3) are estimated for the (IPO+1, IPO+5] sample, and regression (4) is estimated for the extended sample. These regressions are also estimated after excluding the 87 UPS issues. Since the major results remain essentially the same, they are not tabulated. We use regression (1) as the baseline regression. The coefficient for the BUYOUT dummy variable in regression (1), -0.67, is statistically significant at the 1% level. The magnitude of this coefficient suggests that yield spreads of bonds offered by buyout-backed IPO firms are on average 67 basis points lower than bonds by other firms (e.g., 1.94% versus 2.61%). Given the average proceeds of $350 million for the bonds issued by the buyout-backed IPO firms in the sample, the reduction in the yield spread by 67 basis points represents average savings of roughly $2.35 million each year for an average bond issue. We include NET_DEBT t, which is defined as the change in the book value of debt (excluding convertible debt) during the bond offering fiscal year scaled by the beginning of year assets, as an additional control variable in regression (2). The use of current bond offering proceeds could affect the risk level of the firm. For example, it could be less risky if the proceeds are used to retire senior debt compared to the proceeds being used to take on risky projects. This effect may not be captured by other 20