Public vs. Private Equity*

Many corporate executives view private equity as a last resort, as expensive capital that should be tapped only by companies that don't have access to presumably cheaper public equity. The reality of private equity, however, is more complex, and potentially quite rewarding, for both shareholders and management. This paper surveys some of the academic work on the costs and benefits of public vs. private equity, contrasting the private equity investment process with its public counterpart and exploring how such a process may add value. The importance of public equity, particularly for very large companies and growth companies with large capital requirements, is indisputable. But as investment bankers and other practitioners have noted, under certain circumstances the public markets effectively become “closed” to some public companies. Moreover, the cost of equity raised in public markets involves much more than the direct costs of underwriters, attorneys, and accountants. Some indication of the indirect costs is provided by the market's typically negative reaction to announcements of seasoned equity offerings. Although the negative reaction averages about 3%, in some cases stock prices drop by as much as 10%, thereby diluting the value of existing stockholders. Most academics attribute this reaction to the informational disadvantage of public stockholders. Private equity is designed in large part to overcome this information problem by replacing the monitoring performed by the typical public company board with the oversight of better informed and more highly motivated owners. A growing body of academic research suggests that private equity investors add value to the companies they invest in, and that the best investors are consistently effective in so doing. What's more, even public companies that tap private equity seem to benefit. As the author found in his own research on PIPES (Private Investment in Public Equity Securities) transactions, even though such securities are issued to private equity investors at a discount to the prevailing market price, the average market response to the announcement of such transactions is a positive 10%. In short, the participation of private equity investors is perceived to create value, and some of this value is shared with the rest of the market.     

Hedge Fund Involvement in Convertible Securities

Convertible arbitrage hedge funds combine long positions in convertible securities with short positions in the underlying stock. In effect, hedge funds use their knowledge of the borrowing and short‐sale market to hedge themselves while distributing equity exposure to a large number of well‐diversified investors through their short positions. The authors argue that many “would‐be” equity issuers that would otherwise pay high costs in a secondary equity issue choose instead to issue convertible debt to hedge funds that in turn distribute equity exposure to institutional investors. This allows companies to receive “equity‐like” financing today at lower cost than a secondary equity offering. The authors' findings also suggest that more convertibles will be privately placed with hedge funds when issuer and market conditions suggest that shorting costs will be lower.     

The Rise of Accelerated Seasoned Equity Underwritings

Seasoned equity offerings (SEOs) executed through accelerated underwritings have recently seen significant increases in global market share, and now account for a majority of the proceeds from both U.S. and European SEOs. Based on their study of over 30,000 global SEOs during the period 1991‐2004, the authors conclude that accelerated offerings occur more rapidly (as their name suggests), raise more capital, and require fewer underwriters than conventional fully marketed SEOs. Accelerated transactions also typically involve larger, better‐known companies that tend to be selling substantial amounts of secondary as well as primary secondary shares (whereas traditional SEOs consist almost entirely of primary shares). Besides speed of execution, the growing popularity of accelerated deals is also attributed to lower spreads, the reduced price risk for issuers resulting from the brief underwriting period, and “market‐impact” costs that are no larger than those that accompany traditional SEOs. Indeed, according to the authors' estimates, accelerated deals reduce the total issuance costs of U.S. issuers—in the form of lower spreads, market‐impact costs, and underpricing—by 250 basis points, on average, while the cost reduction for European sellers is said to be close to 400 basis points. The authors also present an analysis of SEO investment banking syndicates that illustrates that accelerated deals yield much smaller, more capital‐intensive, and presumably riskier underwriting syndicates that generate comparable revenues over much shorter transactions periods. In so doing, they enable larger, more reputable banks to “buy” market share and league table rankings. The authors' findings underscore three major trends that are shaping global investment banking. First, the fact that accelerated deals are marketed almost exclusively to institutional investors, and that these underwriting methods are gaining market share, suggests the declining importance of retail investors in equity markets everywhere. Second, the rise of accelerated deals both promotes and reflects increasing concentration in the investment banking industry, since only the largest banks have the capital base and risk tolerance required to buy large share blocks outright and assume all or most of the price risk of later resale. Finally, the increasing use of accelerated underwritings for SEOs provides another case of the “commoditization” of financial transactions characterized by relatively low asymmetric information. Since ATs can be employed for shares of only large and well‐known companies, these offerings are executed very quickly and cheaply—in much the same way plain vanilla corporate bonds are sold—and with minimal need for the placement and marketing services that investment banks use for IPOs and other non‐transparent security offerings.     

董事高管责任保险、权益资本成本与上市公司再融资能力

基于公司治理角度,使用2002~2012年沪深引进董事高管责任保险的上市公司为样本,考察了董事高管责任保险、权益资本成本和上市公司再融资能力三者之间的相互关系。研究表明：董事高管责任保险与上市公司的再融资能力负相关,与权益资本成本呈显著正相关关系;权益资本成本在董事高管责任保险和上市公司再融资能力影响机制中发挥中介作用。具体地,投资者因规避责任保险机制庇护下公司高管自利行为可招致的风险,导致上市公司权益资本成本增加,从而降低了公司再融资能力。     

HOW DO CFOs MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS?

This paper summarizes the findings of the authors' recent survey of 392 CFOs about the current practice of corporate finance, with main focus on the areas of capital budgeting and capital structure. The findings of the survey are predictable in some respects but surprising in others. For example, although the discounted cash flow method taught in our business schools is much more widely used as a project evaluation method than it was ten or 20 years ago, the popularity of the payback method continues despite shortcomings that have been pointed out for years. In setting capital structure policy, CFOs appear to place less emphasis on formal leverage targets that reflect the trade‐off between the costs and benefits of debt than on “informal” criteria such as credit ratings and financial flexibility. And despite the efforts of academics to demonstrate that EPS dilution per se should be irrelevant to stock valuation, avoiding dilution of EPS was the most cited reason for companies reluctance to issue equity. But despite such apparent contradictions between theory and practice, finance theory does seem to be gaining ground. For example, large companies were much more likely than their smaller counterparts to use DCF and NPV techniques, while small firms still tended to rely heavily on the payback criterion. And a majority of the CFOs of the large companies said they had “strict” or “somewhat strict” target debt ratios, whereas only a third of small firms claimed to have such targets. What does the future hold? On the one hand, the authors suggest that we are likely to see greater corporate acceptance of certain aspects of financial theory, including the use of real options techniques for evaluating corporate investments. But we are also likely to see further modifications and refinements of the theory, particularly with respect to smaller companies that have limited access to capital markets.     

An Unconventional Conglomerateur: Henry Singleton and Teledyne

Capital allocation involves decisions about raising and returning capital, and about acquiring and selling companies—all of which can have major effects on shareholder value. Rather than judging CEOs by growth in revenues or earnings, the author argues that they should be judged by increases in the per share value of the companies they manage and also in comparison with the returns generated by peer firms and the broader market. Successful CEOs have been able to overcome the “institutional imperative”—the tendency of managers to focus on the sheer size of their enterprises and to avoid doing things that might be seen as unconventional. In this chapter from his recent book, The Outsiders, which provides accounts of eight remarkably successful and long‐tenured CEOs, the author describes the successful management by Henry Singleton of the conglomerate Teledyne from 1963 to 1990, a period during which the company's shareholders enjoyed annualized returns of over 20%. During the 1960s, the company produced high returns mainly by making large acquisitions funded by new equity issues. During the 1970s and '80s, by contrast, Teledyne used massive share repurchases to return excess capital to shareholders. Thus, Singleton adjusted his capital allocation strategy in response to changes in product and financial markets—and to changes in the perceived difference between market and intrinsic values. When investors provided capital with relatively low required rates of return, as in the 1960s, Singleton was an aggressive buyer investor in a wide range of businesses. But when interest rates were high and equity valuations were low, as in the 1970s and early 1980s, Singleton used share repurchases to create value by reducing investment and limiting growth. The company's shareholders were well rewarded in both environments.     

Strategic Financial Management: Lessons from Seasoned Equity Offerings

Each of today's three dominant academic theories of capital structure has trouble explaining the financing behavior of companies that have seasoned equity offerings (SEOs). In conflict with the tradeoff theory, the authors’ recent studies of some 7,000 SEOs by U.S. industrial companies over the period 1970‐2017 notes that the vast majority of them—on the order of 80%—had the effect of moving the companies away from, rather than toward, their target leverage ratios. Inconsistent with the pecking‐order theory, SEO issuers have tended to be financially healthy companies with low leverage and considerable unused debt capacity. And at odds with the market‐timing theory, SEOs appear to be driven more by the capital requirements associated with large investment projects than by favorable market conditions. The authors’ findings also show that, in the years following their stock offerings, the SEO companies tend to issue one or more debt offerings, which have the effect of raising their leverage back toward their targets. Whereas each of the three theories assumes some degree of shortsightedness among financial managers, the authors’ findings suggest that long‐run‐value‐maximizing CFOs manage their capital structures strategically as opposed to opportunistically. They consider the company's current leverage in relation to its longer‐run target, its investment opportunities and long‐term capital requirements, and the costs and benefits of alternative sequences of financing transactions. This framework, which the authors call strategic financial management, aims to provide if not a unifying, then a more integrated, explanation—one that draws on each of the three main theories to provide a more convincing account of the financing and leverage decisions of SEO issuers.     

Analysts' Roundtable on Integrating ESG into Investment Decision‐Making

In this third of the three discussions that took place at the SASB 2016 Symposium, practitioners of a broad range of investment approaches—active as well as passive in both equities and fixed‐income—explain how and why they use ESG information when evaluating companies and making their investment decisions. There was general agreement that successful ESG investing depends on integrating ESG factors with the methods and data of traditional “fundamental” financial statement analysis. And in support of this claim, a number of the panelists noted that some of the world's best “business value investors,” including Warren Buffett, have long incorporated environmental, social, and governance considerations into their investment decision‐making. In the analysis of such active fundamental investors, ESG concerns tend to show up as risk factors that can translate into higher costs of capital and lower values. And companies' effectiveness in managing such factors, as ref lected in high ESG scores and rankings, is viewed by many fundamental investors as an indicator of management “quality,” a reliable demonstration of the corporate commitment to investing in the company's future. Moreover, some fixed‐income investors are equally if not more concerned than equity investors about ESG exposures. ESG factors can have pronounced effects on performance by generating “tail risks” that can materialize in both going‐concern and default scenarios. And the rating agencies have long attempted to reflect some of these risks in their analysis, though with mixed success. What is relatively new, however, is the frequency with which fixed income investors are engaging companies on ESG topics. And even large institutional investors with heavily indexed portfolios have become more aggressive in engaging their portfolio companies on ESG issues. Although the traditional ESG filters used by such investors were designed mainly just to screen out tobacco, firearms, and other “sin” shares from equity portfolios, investors' interest in “tilting” their portfolios toward positive sustainability factors, in the form of lowcarbon and gender‐balanced ETFs and other kinds of “smart beta” portfolios, has gained considerable momentum.     

STERN STEWART ROUNDTABLE ON CAPITAL STRUCTURE AND STOCK REPURCHASE

This roundtable brings together a small group of finance theorists and practitioners to discuss two important—and in most companies closely related—financial policy decisions: (1) the optimal mix of debt and equity and (2) the amount (and form) of cash distributions to shareholders. The result is an interesting set of comments and exchanges that show current theory and corporate practice to be consistent in some respects, but at odds in others. In the first part of this two‐part discussion, the University of Rochester's Clifford Smith presents a broad theoretical framework in which companies set leverage targets by weighing tax and other benefits of debt against potential costs of financial distress, particularly in the form of underinvestment. According to this theory, mature companies with stable cash flows and limited investment opportunities should make extensive use of debt, while growth companies should be funded primarily (if not entirely) with equity. But, as becomes clear in the case study of PepsiCo that follows the opening discussion, putting theory into practice is far from straightforward. Consistent with the theory, Pepsi does have a target leverage ratio, and management has attempted to adhere to that target through a policy of regular stock repurchase. But if the company's decision‐making process appears consistent with the framework mentioned above, it also relies on conventional ratingagency criteria to an extent that surprises some of the panelists. Moreover, Pepsi's policy of maintaining a single‐A credit rating sets off an interesting debate about the value of preserving access to capital markets “under all conditions.” In the second part of the discussion, Rice University's David Ikenberry begins by offering four main corporate motives for stock repurchases: (1) to increase (or at least maintain) the target corporate leverage ratio; (2) to distribute excess capital and so prevent managers from destroying value by reinvesting in low‐return projects; (3) to substitute for dividends, thereby providing a more flexible and tax efficient means of distributing excess capital; and (4) to “signal” and, in some cases, profit from undervaluation of the firm's shares. As in the first part of the discussion, the case of Pepsi largely supports the theory. Assistant Treasurer Rick Thevenet notes that, in 2000, the company generated free cash flow of $3 billion, of which $800 million was paid out in dividends and another $1.4 billion in stock buybacks. And each of the four motives cited above appears to have been at work in the design or execution of Pepsi's buyback policy. There is also some discussion of a fifth motive for buybacks—the desire to boost earnings per share. Although this motive is perhaps the most widely cited by corporate managers, the idea that EPS considerations should be driving corporate buyback programs is shown to rest on flawed reasoning. Moreover, questions are raised about what appears to be an EPS‐driven phenomenon: the corporate practice of attempting to buy back as many shares at the lowest price possible—and the lack of disclosure that often surrounds such a practice. In closing, Dennis Soter offers the novel suggestion that corporate buyback policy should not be designed to transfer wealth from selling to remaining shareholders, but rather to “share the gains from value‐creating transactions.” Through more and better disclosure about their repurchase activities (and Pepsi's policy appears to be a model worth emulating), companies are likely to establish greater credibility with investors, thereby increasing the liquidity and long run value of their shares.     

Capital raising in the offshore market

US corporations can raise capital in the offshore market using Regulation S, adopted by the Securities and Exchange Commission (SEC) in 1990 and modified in 1996. We examine how offshore offerings are done under Regulation S, what types of companies use this market, the discount companies offer investors to compensate for illiquidity in the market, and the impact of the new disclosure requirements on capital raising in the offshore market. We find that small firms tend to raise capital in this market. During our sample period before the 1996 rule change the median market capitalization of reporting firms was $16.82 million with a median stock price of $1.13. The mean and median discount offered to foreign investors was 32.84% and 40.53%, respectively. Offerings during this period resulted in average share dilution of 11.97%. We find that before the disclosure requirements, firms were “gaming the system” by giving foreign investors just enough time to resell the securities back into the United States before the initial sale became public information. After the rule changes, Regulation S offerings are not perceived to be “shady”, and larger firms are now using the market, resulting in lower average discount and dilution.     

Are Performance Shares Shareholder Friendly?

Performance shares, or PSUs, have become the largest element of pay for top executives in corporate America. Their spread was ignited by institutional investors looking for more “shareholder‐friendly” equity awards—as opposed to restricted stock and stock options, which have been characterized as “non‐performance” equity. Although that characterization has been challenged by many directors and compensation professionals, proxy advisers like Institutional Shareholder Services have continued to insist that the majority of stock be granted based on performance, compelling public companies to conform to that standard. With over a decade of experience with PSUs, the evidence is in regarding their net effect:

• PSUs greatly complicate long‐term incentives. Pay disclosures are dominated by discussion of PSUs, including metrics, goals, performance and vesting, and any differences in one grant year versus the next over three overlapping periods.
• PSUs may be contributing to the increase in pay. Companies issuing a significant portion of their long‐term incentives in the form of PSUs have been granting about 35% more in value than companies granting only restricted stock and stock options.
• Shareholders don't appear to be getting anything for that added complexity and cost. S&P 500 companies using PSUs have underperformed their sector peers, and companies using solely “non‐performance” equity have significantly outperformed their sector peers, and in every single year over the last decade.

Given these findings on PSUs, it is time for institutional investors and their proxy advisors to reconsider their view of these vehicles as “shareholder‐friendly,” and rethink their unqualified promotion of their use by the companies they invest in.     

Stock‐Based Compensation in a Concentrated Ownership Setting: An Empirical Investigation

Stock‐based compensation has been viewed as an important mechanism for tying managers’ wealth to firm performance, and thus alleviating the agency conflict between the shareholders and the managers when ownership is diffused. However, in a concentrated ownership structure, controlling owners are usually the management of the firm; they can engage in self‐dealing activities to the detriment of minority shareholders’ interests. Yet, outside investors may anticipate the problem and discount the share price for the entrenchment behaviors they observe. In this study, we investigate how controlling owners trade off the benefits and the costs of using stock‐based compensation. Based on a sample of Taiwanese firms, our evidence shows that stock‐based compensation is negatively related to the agency problem embedded in a concentrated ownership structure. This relationship is evident among firms with more frequent equity offerings. Overall, our empirical evidence suggests that controlling owners consider the negative price effects of stock‐based compensation and trade off these costs with the benefits of expropriating minority shareholders’ interests, particularly when firms seek more external equity capital. Our results hold after controlling for selection bias and share collateral by controlling owners.     

Why Do Firms Issue Equity after Splitting Stocks?

This paper examines the motivations of firms that conduct seasoned equity offerings (SEOs) after splitting stocks. We find no difference in equity announcement and issue period returns between these firms and other equity‐issuing firms, suggesting that firms do not split stocks to reveal information and reduce adverse selection costs at the subsequent SEO. However, because investors react positively to split announcements, firms that issue equity after splitting stocks sell new shares at a higher price and raise more funds. We also find that firms split stocks to make the subsequent SEO more marketable to individual investors who are attracted to low‐priced shares.     

Toward a New Corporate Reorganization Paradigm

Chapter 11 is becoming an increasingly flexible, market‐driven forum for determining who will become the owners of financially troubled enterprises. With increasing frequency, distressed companies are sold in Chapter 11 as going concerns. At the same time, distressed investors, including hedge funds and private equity investors, are actively trading the debt of such companies in much the same way that equity investors trade the stock of solvent companies. Market forces drive the troubled company's debt obligations into the hands of those investors who value the enterprise most highly and who want to decide whether to reorganize or to sell it. One way or the other, the Chapter 11 process is used to effect an orderly transfer of control of the enterprise into new hands, whether the creditors themselves or a third party. But if the market‐oriented elements of this new reorganization process promise to increase creditor recoveries and preserve the values of corporate assets, other recent developments could present obstacles to achieving these goals. In particular, the increased complexity of corporate capital structures and investment patterns—including the issuance of second‐lien debt and the dispersion of investment risks among numerous parties through the use of derivatives and other instruments—threatens to increase inter‐creditor conflicts and reduce transparency in the restructuring process. These factors, coupled with provisions added to the Bankruptcy Code that selectively permit “opt‐out” behavior by favored constituencies, could interfere with the ability of troubled companies to reorganize as the next cycle of defaults unfolds.     

SOME NEW EVIDENCE ON WHY COMPANIES USE CONVERTIBLE BONDS

The popular argument for convertibles holds that they provide issuers with "cheap" debt and allow them to sell equity at a premium over current value. Objecting to the "free lunch" implied by such an argument, financial economists have offered other explanations that show how the combination of debt and equity built into convertibles can serve to reduce information and agency costs faced by companies and their investors.
In this article, the authors use the results of their recent study to reconcile the two positions. Following Jeremy Stein's view of convertibles as "backdoor equity," the authors argue that convertible bond financing is an attractive alternative for companies that have large growth potential but find both conventional debt and equity financing very costly. Such companies are often deterred from funding their capital investments with straight public bonds by their high risk, relatively short track records, and high expected costs of financial distress. At the same time, the information "asymmetry" between management and outside investors can make equity very expensive in such cases. In layman's terms, management may feel that the company's share price does not accurately reflect its growth prospects, or be concerned that the mere announcement of a new equity offering will cause the share price to fall sharply.
To the extent the stock market is persuaded that management's choice of convertibles is based on this combination of promising growth prospects with limited financing options, it is likely to respond more favorably to the announcement of a new convertible offering. The authors furnish evidence in support of this argument by reporting that the market reacts less negatively to those convertible issuers with higher post-issue capital expenditures and higher market-to-book ratios, but with lower credit ratings and higher (post-offering) debt-equity ratios.     

Firm Value and the Choice of Offering Method in Initial Public Offerings

A firm raising capital in an initial public offering faces the problems of choosing between a firm-commitment and a best-efforts offering and of how to convey information about its value to potential investors. The offering method chosen affects both the firm's cost of obtaining capital and investors' perceptions about firm value. A partially pooling, partially separating equilibrium is found where high-valued firms have information about their values revealed in a firm-commitment offering, while low-valued firms use best-efforts offerings and are unable to distinguish themselves from other firms.     

U.S. Corporate Governance: Accomplishments and Failings A Discussion with Michael Jensen and Robert Monks

Two of America's most prominent shareholder activists discuss three major issues surrounding the U.S. corporate governance system: (1) the case for increasing shareholder “democracy” by expanding investor access to the corporate proxy; (2) lessons for public companies in the success of private equity; and (3) the current level and design of CEO pay. On the first of the three subjects, Robert Monks suggests that the U.S. should adopt the British convention of the “extraordinary general meeting,” or “EGM,” which gives a majority of shareholders who attend the meeting the right to remove any or all of a company's directors “with or without cause.” Such shareholder meetings are permitted in virtually all developed economies outside the U.S. because, as Monks goes on to say, they represent “a far more efficient and effective solution than the idea of having shareholders nominate people for the simple reason that even very involved, financially sophisticated fiduciaries are not the best people to nominate directors.” Moreover, according to both Jensen and Monks, corporate boards in the U.K. do a better job than their U.S. counterparts of monitoring top management on behalf of shareholders. In contrast to the U.S., where the majority of companies continue to be run by CEO/Chairmen, over 90% of English companies are now chaired by outside directors, contributing to “a culture of independent‐minded chairmen capable of providing a high level of oversight.” In the U.S., by contrast, most corporate directors continue to view themselves as “employees of the CEO.” And, as a result, U.S. boards generally fail to exercise effective oversight and control until outside forces—often in the form of activist investors such as hedge funds and private equity—bring about a “crisis.” In companies owned and run by private equity firms, by contrast, top management is vigorously monitored and controlled by a board made up of the firm's largest investors. And the fact that the rewards to the operating heads of successful private equity‐controlled firms are typically multiples of those received by comparably effective public company CEOs suggests that the problem with U.S. CEO pay is not its level, but its lack of correlation with performance.     

Voluntary Disclosure and Information Asymmetry: Evidence from the 2005 Securities Offering Reform

In 2005, the Securities and Exchange Commission enacted the Securities Offering Reform (Reform), which relaxes “gun‐jumping” restrictions, thereby allowing firms to more freely disclose information before equity offerings. We examine the effect of the Reform on voluntary disclosure behavior before equity offerings and the associated economic consequences. We find that firms provide significantly more preoffering disclosures after the Reform. Further, we find that these preoffering disclosures are associated with a decrease in information asymmetry and a reduction in the cost of raising equity capital. Our findings not only inform the debate on the market effect of the Reform, but also speak to the literature on the relation between voluntary disclosure and information asymmetry by examining the effect of quasi‐exogenous changes in voluntary disclosure on information asymmetry, and thus a firm's cost of capital.