Debt Financing and Initial Public Offerings

We examine the effects of debt financing on initial public offerings (IPOs) of common stock using data on more than 6,000 IPOs during the period 1980-2002. We show that the characteristics of firms with high levels of debt financing are consistent with less uncertainty about firm value, and we find that debt financing is associated with significantly lower levels of underpricing of IPOs. Our results support the James and Wier (1990) theory that borrowing should have the effect of reducing underpricing. The results also confirm the James and Wier theory that as the level of debt financing increases, the degree of underpricing declines, a result that was not obtained in the empirical tests of James and Wier for the period 1980-1983. We also document that the characteristics of firms with debt financing are very different from those with venture capital financing, consistent with the theory of Ueda (2004). We find that the effects of debt financing differ over time and that firms with high levels of debt financing had much lower initial returns than low-debt firms during times of greater valuation uncertainty, especially during the bubble period of 1999-2000. We also examine the effects of debt financing on the long-term performance of firms following their IPOs. We find that higher levels of debt financing are associated with negative long-run performance, especially for firms without venture capital backing. We find these results using calendar time analyses that avoid pseudo-market timing effects and after taking into account the effects of size, book-to-market, and systematic risk. Debt Financing and Initial Public Offerings There have been numerous studies of initial public offerings (IPOs), but few have examined the role and effects of debt financing on the process of going public. James and Wier (1990) examine data over 1980-1983 and show that companies that have borrowing relationships when they go public tend to have lower initial returns (or, less underpricing) than firms without such relationships. Using a large sample of more than 6,000 IPOs during 1980-2002, we demonstrate that the effects of debt backing continue through recent times and in fact have become much stronger in recent periods. We also show, in contrast to James and Wier’s results for the period 1980-1983, that larger amounts of debt (as a percentage of total assets) are associated with even larger reductions in underpricing since the 1990s. For the full period of our sample, firms in the highest quartile of debt financing averaged 18.3% lower first day returns than firms in the lowest quartile of debt financing. During the bubble period of 1999-2000, the difference was more than 40%. We also contrast the underpricing of debt-backed and venture capital-backed IPOs. Ueda (2004) hypothesizes that venture capital-backed firms should have comparatively low collateral, high risk, high growth prospects, higher expected returns, and larger size than firms backed by bank debt. Our examination of firms without venture capital backing and with high debt financing, in contrast with venture-backed firms with low debt, generally confirm the expectations of her theory. The one exception is that the debt-backed firms tend to have larger size when measured by assets or revenues (but not when measured by market capitalization following their IPOs). We find that debt-financed firms had generally lower initial returns than venture capital-backed