February 08, 2006

New Research Compares Effects of Debt Financing Vs. Capital on IPOS of Common Stock

Studying nearly 6,000 IPO firms from 1980 to 2002, Neeley School professors Christopher Barry and Vassil Mihov found a striking difference between debt financing versus venture capital on the firms' initial returns and long-run performance. 

 "Our single most important finding was that the market is best able to
value securities backed by high levels of debt," says Dr. Barry, who holds the Lowdon Chair of Finance at the Neeley School.

When companies with large amounts of debt go public, they are easier to value, so the offer price during an IPO and the subsequent trading price are generally similar.

Dr. Barry explains that the kinds of information required by a lender helps assess an IPO company more accurately, while venture capitalists tend to invest in riskier firms with the aim of finding a few "home-run hitters."

"Lenders are primarily interested in protecting themselves from the potential downside, while venture capitalists are betting on an upside," he says.

This translates into a much lower upside potential for IPO companies with large amounts of debt, but it also means less risk of loss. In contrast, venture-backed firms have greater potential for large returns, but at much greater risk.

The paper, entitled "Debt Financing, Venture Capital, and Initial Public Offerings,"  was presented by Dr. Mihov at the Frontiers of Finance conference in January in the Netherland Antilles, and is scheduled to be presented by Dr. Barry and Dr. Mihov at the Financial Intermediation Research Society conference in Shanghai this June.

The 23-year period examined by the study covered four distinct IPO cycles, including the Internet bubble of 1999-2000, says Dr. Mihov. IPO cycles are defined by the numbers of companies going public and the size of initial returns.

The study also found that debt-financed IPOs exhibit lower levels of valuation uncertainty due to the rigorous requirements of obtaining bank leverage. This results in initial stock offerings selling for close to their true value and thus lower initial returns relative to venture-financed companies. Higher levels of debt financing led to increasingly accurate valuation and still lower initial returns.

By comparison, because a large portion of the perceived value of venture-financed IPOs lies in intangible assets, these firms have greater valuation uncertainty and greater initial returns. This indicates the stocks were underpriced at the IPO although the companies experienced losses prior to the IPO. This underpricing effect was magnified during the Internet bubble period of 1999-2000, when an uncommonly large number of companies went public and had extreme first-day returns.

Another observed phenomenon is that debt-backed IPOs have lower performance in the long term, and that higher levels of debt are associated with increasingly negative performance even after the data are adjusted for certain variables, while venture-backed IPO firms possess the potential for much greater growth over time. The upside potential for venture-financed firms is much higher, although many suffer losses in value.

In fact, the study indicates that venture-backed firms reap approximately double the long-term
returns of debt-backed firms.

"Debt-backed companies, in the long run, don't perform as well as those with venture backing," says Dr. Barry. "Many venture-backed IPO firms lose money but, because there is some potential of an extremely high rate of return, average long-term returns are higher for companies with venture capital than those without."

The dampening effect of debt financing is even more pronounced in recent IPO cycles than in earlier ones. However, says Dr. Mihov, the reasons for the underperformance of debt-backed IPO firms are not entirely clear.

"One persistent question we are left with is: Why do debt-financed IPOs underperform in the long term?," says Dr. Mihov. "Perhaps the accepted models of measuring performance don't fully account for the amount of leverage. Certain methodologies are well accepted but may not be doing as good a job as expected. Are these companies truly underperforming, or are the models not truly incorporating the effects of leverage." 



Elaine Cole
PR/Event Manager
Neeley School of Business