Understanding the Risks of Privatization

How Ownership Structure Affects the Cost of Debt

While privatization comes with benefits — like not being beholden to market speculation or a chorus of diverse shareholders — it also carries risks. Privately held companies, for instance, have limited access to public equity markets, which complicates their ability to keep operations afloat when cash is tight.

New research by Hanna Lee, assistant professor of accounting and information assurance at the University of Maryland’s Robert H. Smith School of Business, further demonstrates why privately owned companies are risky investments.

Lee and three co-authors analyzed a sample of public bonds to determine how the cost of public debt differs between privately and publicly owned companies. Their research revealed that, after controlling for factors identified by past research as affecting the cost of debt (including firm fundamentals, bond characteristics and the firm’s information environment), the cost of public debt issued by privately owned companies — as captured by ratings and yield spreads — is significantly higher than that issued by publicly owned companies.

The researchers also found that distress events happened more regularly for private firms, at least relative to what would be expected based on their fundamentals. This creates a greater default risk for their creditors, which is likely related to the aforementioned dilemma of public equity markets being largely out of reach for private firms. What’s more, private firms experience a higher cost of debt during recessions, periods in which accessibility to the capital market is critical to avoid default.

But not all privatization is created equal. The research sheds light on how ownership type also influences bond spreads and credit ratings. Specifically, ownership by private equity (PE) firms is associated with a higher cost of debt. That’s consistent with previous research indicating that more separation of ownership and control in PE-backed companies may lead to more risk taking. Size matters, too. Ownership by large PE firms is associated with a lower cost of debt to their investees as compared to ownership by smaller PE firms. This makes sense considering large PE firms have greater reputational concerns as repeated players in the capital markets.

So in the battle between public and private ownership, which takes the crown? The research suggests that going the public route may be better suited for the risk-averse. Although here’s one last revelation to consider: Private, employee- or family-owned companies are often considered less risky than their PE-owned counterparts. That, too, can likely be attributed to the effects of a disconnect between ownership and management in companies owned by PE firms. 

Read more: Private Ownership and the Cost of Debt: Evidence from the Bond Market is featured in Management Science.