News at Smith

Fearless Idea 14: Reduce the Cost of Debt

Mar 14, 2017
World Class Faculty & Research

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SMITH BRAIN TRUST — Public companies — owned by shareholders with stock — have the advantage of being able to easily tap into financial markets when they need money, either by selling more equity as stock or often by issuing portions of their debt as bonds. Private companies — owned by the company’s founders, a management group or private investors such as a private equity group — can also sell off their debt as public bonds. But for them, the cost is much higher.

New research from professor Hanna Lee at the University of Maryland’s Robert H. Smith School of Business and three co-authors examines why. The findings have implications for firms weighing different ownership types and how that will impact the cost of capital. 

Privately owned firms aren’t required to disclose and report financial information like public companies must. The financial health of these companies isn’t as transparent, leading bond ratings agencies to place higher risk on them and therefore making it more costly for them to offer debt. And often the higher risk rating is not unwarranted, according to the research, which finds private ownership is associated with a higher frequency of default.

Lee and her co-authors surmise this is a result of private companies’ difficulty in accessing capital markets when in distress and most in need of cash. The problem is especially pronounced during recessions, when access to capital is even more critical.

The research, which looked at firms offering public debt in any year from 1987 to 2010, finds that private equity-owned firms suffer the highest cost of debt and worst credit ratings. The researchers offer the explanation that private equity groups usually take more risks to meet their goal of improving a company’s value enough to sell it, merge with another company or go public with an IPO.

Firms backed by less-known private equity groups feel this effect more than the largest and best-known private equity players.

Read more: Lee wrote the working paper, “Private Ownership and the Cost of Public Debt: Evidence from the Bond Market,” with Brad A. Badertscher of the University of Notre Dame, Dan Givoly of Penn State University and Sharon P. Katz of Columbia University. It is under review at Management Science.

Hanna Lee is an assistant professor of accounting and information assurance at the University of Maryland’s Robert H. Smith School of Business.

Research interests: Predictive information in financial statements, usefulness of accounting information in debt markets, default prediction, disclosure, and financial reporting quality. 

Selected accomplishments: Presented her study investigating the increase in forecasting accuracy of hazard rate bankruptcy predication models with creditor coordination effects at the 2011 American Accounting Association Annual Meetings. Completed her doctoral work at Columbia University and earned a master’s degree in statistics from Harvard University, a BS at Seoul National University, and studied economics for a summer at the London School of Economics. Worked professionally for Goldman Sachs in New York, Deutsche Bank and Citibank in Seoul, South Korea, and AsiaNet Corp.

About this series: The Smith School faculty is celebrating Women’s History Month 2017 in partnership with ADVANCE, an initiative to transform the University of Maryland by investing in a culture of inclusive excellence. Daily faculty spotlights support activities from the school’s Office of Diversity Initiatives, culminating with the sixth annual Women Leading Women forum on March 30, 2017.

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About the University of Maryland's Robert H. Smith School of Business 

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and part-time MBA, executive MBA, online MBA, specialty masters, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.