May 15, 2006
Debt-heavy IPOs
Posted by Gordon Smith

The W$J has an interesting article about IPO companies with lots of debt:

So far this year, one-third of the 64 initial public offerings issued warnings in their prospectuses about the risks associated with their debt levels.... Twenty percent carried net tangible book-value deficits even after raising money through their IPOs, meaning that, if those companies were liquidated the day they came public, stockholders would receive nothing.

Is debt a bad thing? We are still having the same debate about debt that was raging in the late 1980s: debt-as-burden v. debt-as-discipline. This is a silly debate in the abstract because getting the right amount of debt is the trick. Easier said than done.

One argument that is -- hmm, how to say this diplomatically? -- not helpful comes from John Coyle, head of J.P. Morgan's financial-sponsors group: "As a company deleverages, it adds to its earnings capacity. So in a way, investors in these IPOs know there is some future earnings growth that is already in the bag -- as the leverage comes down, earnings will go up."

This might be an interesting insight in Accounting 101, but it doesn't tell us anything useful about the highly leveraged companies that are hitting the public markets. The notion that "future earnings growth ... is already in the bag" brushes aside the main concern about high levels of indebtedness: uncertainty over future earnings. A slight downturn, either for the highly leveraged company or its industry, can place substantial constraints on the highly leveraged company's ability to operate.

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