Equity shares are a common instrument through which firms raise capital, allowing those firms to gain access to a liquid capital market. However, the issuance of public equity comes with tradeoffs – including volatile stock prices, ownership dilution, and a potentially high cost of capital. An interesting alternative to a traditional equity IPO is a debt IPO. A debt IPO is the first issuance of corporate debt to the public by private companies that seek to raise money in a liquid capital market.
Companies that opt for debt IPOs enjoy a cheaper cost of capital and better terms for subsequent public offerings compared to equity IPO counterparts. In this article we will discuss the institutional details of a debt IPO, compare the benefits of a debt IPO relative to an equity IPO, and describe a successful debt IPO, that of United Parcel Service (UPS).
Potential Exemption from Disclosure Requirements
Debt IPO firms face similar filing and reporting requirements demanded for public equity companies; however, the nature of public debt ownership provides debt IPO firms the potential capability to be exempt from the SEC reporting requirements.
Issuers of public debt are required to file with the SEC and include in their prospectus essentially the same contextual contents as for a registration statement on form S-1 of an offering of equity securities, plus a description of the terms of the debt securities. Also, any companies with public debt are required under Section 15(d)6 of the Exchange Act to have their periodic reports filed with the SEC. Debt IPO firms comply with essentially the same S-1 filing and periodic reporting requirements (i.e., filings on Forms 10-K, 10-Q and 8-K)that apply to equity IPO firms, which presents a significant reporting burden to the firms over the period that the publicly-traded debt securities are outstanding.
However, unlike public equity whose ownership can span across thousands of shareholders, public debt ownership usually rests upon a small group of institutional investors. In the U.S., unlike the openness to retail investors that the public equity market offers, the public debt market is regulated by U.S. securities law to be restricted primarily to accredited investors (defined in Rule 501) and Qualified Institutional Buyers (defined in Rule 144A) who have at least $100 million of securities under management.1 Also, the typical $1 million-plus size of a typical public debt trade tends to keep individuals from investing in the debt market directly. Hence, debt securities ownership is typically confined to a small group of institutional investors who possess the sufficient financial capability and qualifications outlined by the securities laws. Under certain conditions, debt IPO issuers can rightfully suspend their filing of periodic SEC reports and other public company obligations. If either of the following requirements are met, firms with public debt are required to provide less public disclosure of private information than is required of their equity IPO counterparts:
- There are fewer than 300 holders of the debt securities offered under the registration statement or 1,200 holders in the case of banks, bank holding companies and savings and loan holding companies.
- The securities are held by less than 500 non-accredited holders or 2,000 holders, and the company’s total assets have been no more than $10 million at the end of each of its last three fiscal years.
Such is the case for Revel AC Inc., a private operator of an Atlantic City resort and casino that first issued $304.4 million Second Lien notes to the public in 2011 to finance a business combination. Once Revel undertook its debt IPO, registered its debt security with the SEC, and completed its first 2013 annual report, Revel filed a 15-15D statement2 to rightfully suspend the duty to file with the SEC periodic reports. At the time of filing the Form 15, Revel’s Second Lien notes were held by fewer than 300 persons. The ability to suspend periodic reporting frees the company from sizeable reporting financial costs, as well as non-financial costs associated with publicizing private information to rivals within the industry.
The Cost of Equity and Cost of Debt
The lower cost of debt compared to the cost of equity is also one of the key factors in the decision to make a debt IPO rather than a traditional equity IPO.
For issuing companies, the cost of debt is the estimate of the annual rate at which they can borrow, and the cost of equity is what the companies expect to return to their investors every year. Debt is cheaper than equity because debt is less risky. In other words, the reason why the cost of debt is lower than the cost of equity is due to creditors’ insistence on lower returns compared to the returns demanded by equity owners due to the safeguards and advantages that are associated with debt claims: priority of rights for assets in the event of liquidation, obligatory covenants that maintain firms’ debt coverage and financial ratios above certain levels, and tax shields not available with equity. According to a publication by Professor Aswath Damodaran from New York University’s Finance Department, the annual cost of equity averages 8.21% while the annual cost of debt averages 3.67% among 7,053 U.S. companies surveyed within 94 industries (as of January 2020).3
For issuing companies, debt is also a relatively more predictable financing instrument than is equity because the cost of debt to a company is finite and limited to the extent of original principal and fixed interest expense. Equity, in contrast, provides an unlimited upside to new investors and is more costly for profitable companies as it sacrifices the growing profits to the owners of the newly issued equity shares.
Although debt is cheaper than equity, the amount of debt a company can assume is capped at a certain leverage level, proxied by the firm’s debt-to-equity ratio or the debt-to-EBITDA ratio. Lenders have their own policies regarding how much credit risk they are comfortable accepting and are reluctant to lend to companies that are too highly leveraged. Also, debt financing typically requires periodic cash payment of interest (and sometimes amortization of principal). Hence, debt financing is often not a financing option available to companies with negative operating income or unstable cash flows. In addition, debt financing is often not an option for companies whose assets provide poor collateral such as companies in service industries or companies which have most of their value in intangible intellectual property.
Ownership & Exits
Debt IPOs help finance firms in an economic downturn without ownership dilution and allow sponsors to delay their exits of healthy investments and prevent suboptimal return on investment.
Past evidence of companies going public with debt indicates that debt-IPO firms are more likely to be backed by a financial sponsor (e.g. venture capital or private equity). These firms typically are older, yet possess a steady growth rate, exhibit superior operating performance, and spend little on research and development. What is the common theme of these firms that financial sponsors look for? Two words: cash flows. These operational and financial properties provide a consistent and predictable stream of net cash inflow necessary to service periodic debt obligations and principal payments.
The ultimate goal of private financial sponsors is exit – realizing returns by selling their shares either through private placement or public offering. However, when the market conditions are not favorable – the period where exit multiples and firms’ valuation have yet to reach their peak – it is better to hold on to healthy investments and delay exits through equity sales until the economic cycle rebounds. A hasty private placement or public equity offering in the time of recession will significantly reduce the value of the ownership shares of the private financial sponsors (due to investors’ pessimism) and pose substandard return on investment (ROI) to those financial sponsors.
Also, when an economic downturn hits, companies have to race for additional financing to continue operations and survive. At first, these firms would seek to max out their cheap financing sources, namely cash from operations and private debts. However, the problem with private debts, such as credit lines and senior loans, is that the amount is limited. Banks and financial institutions’ policies cap the amount of money they can lend up to a certain leverage threshold, and banks, or syndicates of banks, only have so much available to lend to businesses. At some point in a recession, when firms reach the maximum amount of debts available from private lenders, management/ owners would have to decide between whether to look for public debt financing or sell off their shares at a discounted price for cash and dilute ownership. In such a situation, debt IPOs come in handy to provide firms the financing sources not available from private lenders, because the pool of public capital market is large and public investors are flexible to take on more risks than are banks.
With debt IPOs, financial sponsors of private companies can comfortably postpone their equity exits while simultaneously obtaining additional financing through public borrowing not available from their current private creditors.
Post-Issuance: Subsequent Equity Offerings
Firms that have gone through a debt-IPO obtain a significant edge for subsequent equity offerings. In research conducted by Glushkov et al., debt-IPO firms’ fees charged by equity underwriters are lower, the amount raised through the offering is double, and the median IPO underpricing is less than a third of that of matching IPO firms that go public via equity with no prior public debt in place.4 Because companies that undertook debt IPOs have publicized their private financial data – hence reducing information asymmetry between the firms and public investors –, investors are more comfortable to invest their money. In addition, with the strong cash flows and broader base of collateral assets, debt-IPO firms face a lower chance of underpricing from subsequent equity offering. Bankers find it easier to make the investment case for companies with healthy operations, and investors are more willing to invest in firms that are transparent with their reporting. As the likelihood of underpricing decreases, managers are more willing to raise more capital.
Case Study – United Parcel Service of America Debt IPO
United Parcel Service of America (NYSE: UPS) was founded in 1907 and undertook its initial public offering July 21, 1999. However, a decade before its equity offering, in December 1989, UPS undertook a debt IPO.
In the 1980s, the need for air shipment soared as public demand for quicker delivery services accelerated. UPS’s plan for international expansion and penetration to increase sky traffic – in response to the industry race for overnight air delivery service – urged the company to obtain a great deal of capital to finance its projects. UPS’s financing options were private debt, public debt, and equity offerings.
However, at the time, stock compensation played an integral role for UPS executives and the company’s culture of “ownership by management”. In addition, employees had the option to receive stock compensation, and 99% of voting rights resided within the management team and employees.5 The common rationale within the company was to stay away from a public equity offering to avoid ownership dilution and to safeguard the voting rights among its employees. Thus, an equity IPO was not a viable option (though the plan for subsequent public equity issuance was foreseeable). Private debt capacity had hit the limit, and banks were concerned about taking on the additional leverage risk outside of their comfort zone. In order to preserve the ownership culture and finance its rapid expansion, UPS opted for a debt IPO and issued $700 million in 8.375 percent 30-year debentures maturing in 2020. The size of this debt offering was in the top 2 percent of all public debt issues that year.
Eventually, UPS undertook an equity IPO in 1999 to obtain shares for acquisitions. The decision to use a debt IPO prepared the company to develop strong financial metrics and reporting capacity for a subsequent, successful public equity offering in 1999.
The use of public debt issuance to access capital markets is both an alternative worth considering and a solid steppingstone for subsequent equity issuance for companies that choose to do so. Companies that opt for a debt IPO enjoy a lower expense from publicizing IPO information, cheaper cost of capital, and better terms for subsequent public offerings compared to equity counterparts where owners have to give up voting rights and ownership in exchange for cash not available in the private capital market.
- Castillo, Ryan, et al. Thomson Reuters. “Debt capital markets in the United States: regulatory overview”. Sep 01 2020.
- Revel AC, Inc.’s 2013 Form 15.
- Damodaran, Aswath. Damodaran Online. “Cost of Capital by Sector (US)”. Jan 2020.
- Glushkov, Denys, et al. SSRN. “Why Do Firms Go Public Through Debt Instead of Equity?”. May 28, 2018.
- Gilpin, Kenneth. The New York Times. “Workers Ready to Cash In as U.P.S. Goes Public”. Nov 11, 1999.