Academic journal article Financial Management

Do Firms Time Equity Offerings? Evidence from the 1930s and 1940s

Academic journal article Financial Management

Do Firms Time Equity Offerings? Evidence from the 1930s and 1940s

Article excerpt

We investigate whether the timing of equity sales to exploit market overvaluation may account for the reported poor post-offer stock performance of firms issuing equity. We posit that rights offers, targeted to a firm's current shareholders, are less likely to be timed to exploit overvaluation. Our study compares firm commitment and rights offerings during 1933-1949 when rights offers were common. We find that abnormal returns for firms electing the firm commitment method were significantly negative over the year following the offer, while those for firms using rights were not. This suggests that firm commitments were timed, while rights offers were not.

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Do managers elect to raise equity capital when the market appears to value a firm more highly than the value perceived by insiders? Investors seem to think so, as indicated by the significant stock price decline that tends to accompany announcements of seasoned equity offerings (SEOs). What are we to make, then, of the finding of significantly poorer stock price performance in the months after an offering (see Loughran and Ritter, 1995; Spiess and Affleck-Graves, 1995; Jegadeesh, 2000; and Ritter, 2003)?

Some researchers claim that underperformance may result from the selling of overpriced equity and the failure of market participants to react fully to the negative information conveyed in the announcement. Others argue that much, if not all, of the apparent underperformance may be the result of methodological problems such as improperly controlling for risk. Whether or not post-offer performance is abnormal, and whether the result is tied to offer timing, has important implications for market efficiency and managers considering equity offers.

We take a different tack in evaluating post-offer performance, and compare the stock performance of two types of equity offerings: rights offers and firm commitment seasoned equity offerings. The offerings are drawn from a unique data set from the 1930s and 1940s, when rights were as commonly used as firm commitments (which is not the case now). We conjecture that managers wishing to exploit private information and an overvalued stock price are more likely to do so at the expense of new outside investors by choosing a firm commitment over a rights offering.

Myers and Majluf (1984) argue that in firm commitment offerings managers would be expected to be more concerned with the welfare of insiders (including themselves) than with new investors in the firm's equity. Rights offerings, which involve a pro-rata distribution of rights, are aimed at current shareholders, although holders are usually allowed to sell their rights if they wish. Following the logic in Myers and Majluf, this would suggest that the incentive to time offers will be much weaker if not absent altogether in the case of rights offerings.

The idea that managers may have different incentives when they choose a rights offering versus a firm commitment provides us with an approach to examine the importance of market timing in equity financing. We examine whether post-offer price performance is related to the decision to issue rights instead of a firm commitment offering. If market timing is an important factor affecting post-issue stock returns, we would expect to find significant differences in stock performance after rights offerings and after firm commitments. A significantly weaker stock performance after a firm commitment offering would be consistent with the notion that firm commitments are timed.

We focus on comparing the performance of firms that have all raised equity capital, although they differ in their methods. Estimating the difference in performance following the two types of equity offerings has certain robustness benefits. To the extent that performance estimates are biased by the methods used to compute abnormal returns, this bias is likely to be mitigated if we measure the relative performance following each type of equity offering, especially if we control for size of the offer, firm leverage, and other firm attributes. …

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