Private Equity Firms’ Reputational Concerns and the Costs of Debt Financing
Rongbing Huang, Jay R. Ritter and Donghang Zhang
Journal of Financial and Quantitative Analysis, Vol. 51, Issue 1 (November) 2016, pp. 29-54
Overview Private equity (PE) firms, also known as buyout groups, are major shareholders of many companies. PE firms are controversial, with many commentators arguing that these financial sponsors gain at the expense of other stakeholders. PE firms have an incentive to push their portfolio companies to pursue risky projects and pay themselves big dividends. If potential bondholders are concerned about such wealth expropriation incentives, they will “price protect” themselves by asking for higher interest rates on the bonds. The reputational concerns of PE firms can help to alleviate their incentives to expropriate bondholders. PE firms generally have more than one portfolio company and often deal with bond investors repeatedly. If one of these companies exploits its bondholders, all companies owned and to be owned by the PE firm will likely face a higher interest rate on their bonds and more restrictive covenants. Using bonds offered during 1992-2011 by companies after their initial public offerings (IPOs), we find that interest rates on bonds offered by PE-backed companies are on average 70 basis points lower, holding other things constant. We also find that PE-backed companies have more conservative investment and dividend policies after bond offerings compared to non-PE-backed companies. These results suggest that PE firms’ reputational concerns dominate their wealth expropriation incentives and help their portfolio companies reduce the costs of debt.
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