Improved corporate governance and Chinese seasoned equity offering announcement effects

Corporate governance and thus overall investor protection in China improved after the Split Share Structure Reform and the release of the new company law in 2005. This study examines the impact of improved corporate governance and investor protection on the market's reaction to seasoned equity offering (SEO) announcements in China. The market reacts to post‐2005 SEOs positively, while it reacts to pre‐2005 SEOs negatively. The different market reactions are attributed to the market's different perceptions of firms' intentions behind SEO decisions – that is, investors are more optimistic and have more trust in SEO issuers when they believe they are better protected.     

CEO Ownership and Discretionary Investments

Abstract:  This study investigates empirically the relationship between CEO ownership and discretionary investments such as R&D and capital expenditures. We assert that the under-investment problem is high for R&D-intensive projects, while the over-investment problem is high for capital expenditures because of differences in risk between the two types of investments. Building on the linkages between investments and investment-related agency problems, we hypothesize that the relationship between CEO ownership and investments depends on whether increasing ownership mitigates or exacerbates the under- or over-investment problem. We find a non-linear association between CEO stock ownership and R&D investments; R&D investments increase and then decline across increasing levels of ownership. Further, we find that R&D investments and CEO stock options are positively associated at high levels of option holdings. In contrast, capital expenditures do not vary with CEO ownership (stock or options). Finally, consistent with our underlying assumption, we find that the influence of R&D investments on future firm risk is significantly larger than that of capital expenditures. Our findings indicate that managerial risk aversion affects discretionary investments.     

Stock Returns and Operating Performance of Securities Issuers

We examine long‐run stock returns and operating performance around firms’ offerings of common stock, convertible debt, and straight debt from 1985 to 1990. We find that pre‐issue abnormal returns are positive and significant for stock issuers, but not for convertible and straight debt issuers. The post‐issue mean returns show that common stock and convertible debt issuers experience underperformance during the post‐issue periods, but straight debt issuers do not. Consistent with these results, common stock issuers experience the best pre‐issue operating performance among all three types of issuers, and operating performance declines during the post‐issue periods for common stock and convertible debt issuers. Using a new approach in linear model estimations to correct heteroskedasticity and to adjust for finite sample, we find a positive relation between post‐issue operating performance and issue‐period stock price reactions. The results suggest that future operating performance is anticipated at the issue and that securities issues provide information on issuers’ future performance.     

Shareholder governance, bondholder governance, and managerial risk-taking

We examine the relation between the overall corporate governance structure and managerial risk-taking behavior. We find that the overall governance structure has a significant impact on how managers make decisions on investment policy: strong bondholder governance motivates more low-risk investments such as capital expenditure and lower high-risk investments such as R&D expenditures, whereas weak shareholder governance (entrenched managers) leads to more R&D expenditures. Moreover, we find that the effects of governance on investment policy differ significantly between speculative and investment-grade firms. For speculative firms, strong bondholder or shareholder governance leads to more capital expenditures and low R&D investments. For investment-grade firms, strong bondholder or shareholder governance leads to low capital expenditures and an insignificant impact on R&D investments. Furthermore, financing and investment covenants exhibit strong binding power to deter risky investments. Finally, a more dependent (or a less independent) board is associated with low capital expenditures and high R&D investments.     

The Information Content of Share Repurchase Programs

Contrary to the implications of many payout theories, we find that announcements of open‐market share repurchase programs are not followed by an increase in operating performance. However, we find that repurchasing firms experience a significant reduction in systematic risk and cost of capital relative to non‐repurchasing firms. Further, consistent with the free cash‐flow hypothesis, we find that the market reaction to share repurchase announcements is more positive among those firms that are more likely to overinvest. Finally, we find evidence to indicate that investors underreact to repurchase announcements because they initially underestimate the decline in cost of capital.     

Does CEO reputation matter for capital investments?

This paper examines the association between CEO reputation and corporate capital investments. The efficient contracting hypothesis predicts a positive association between CEO reputation and wealth effects of corporate capital investments. In contrast, the rent extraction hypothesis predicts that the wealth effects of capital investments are negatively associated with CEO reputation. We find that the stock market's responses to announcements of capital investments are more favorable for firms with more reputable CEOs. Moreover, CEO reputation mitigates the negative stock price reaction associated with announcements of capital investments by firms with high free cash flow and low growth opportunities. Additional analysis indicates that firms with more reputable CEOs exhibit significantly better post-investment operating performance improvements than those with less reputable CEOs, especially in firms with high free cash flow and low growth opportunities. Collectively, our results suggest that the efficient contracting hypothesis dominates the rent extraction hypothesis in terms of net economic impact of capital investments on the investing firm.     

Information spillovers around seasoned equity offerings

We examine information spillovers in the context of seasoned equity offerings (SEOs). Rival firms react significantly positively (0.26%) to primary SEO announcements, indicative of a competitive effect, but negatively (− 0.35%) to secondary share announcements, which is evidence of a contagion effect. Consistent with the view that primary equity offerings signal favorable industry prospects because firms presumably issue new shares to invest in profitable projects, we find that the rival response is positively related to analysts' EPS growth forecasts. However, when insiders are selling their shares through a secondary offer, this may suggest overvaluation and thus negatively impacts rival firms. Consistent with this view, we find when VCs sell through a secondary offerings, rivals experience a more significant negative reaction. We find rival firms are more likely to follow their peers and conduct a primary SEO if the market reacts favorably to their peer's SEO announcement. Finally, rival firms outperform secondary share issuers of equity, but not primary share issuers. Collectively, the findings support the view that insiders take advantage of windows of opportunity when they sell their own shares, but not when they raise capital for investing purposes.     

Use of the Proceeds and Long‐term Performance of French SEO Firms

This paper examines the long‐term stock performance of French SEO with rights by looking at the intended use of the proceeds. Firms that raise equity for pure capital structure motives are separated from the ones that use the SEO proceeds to finance specific investment projects. Issuers in the first category are concerned about preserving their financial flexibility and they are expected to evolve in a capital structure irrelevancy framework. On the other hand, issuers in the second category are more inclined to be sensitive to adverse selection problems or agency conflicts and thus, they should be more exposed to under‐reaction on the long‐run. According to a matching firm methodology, ‘Financing New Investment’ issuers underperform their benchmark at a rate of 4% to 8% per year over a 36‐month horizon while ‘Capital Structure’ issuers do not show any abnormal performance. These results are robust according to alternative Beta pricing models. In addition, managers of both issuer's types time the SEO after a period of positive abnormal performance in order to sell overpriced securities. However, only the ‘Financing New Investment’ sample experiences a performance reversal; the abnormal returns decreasing gradually from the issue on, to become significantly negative 24 months after the event.     

Two‐Sided Matching: How Corporate Issuers and Their Underwriters Choose Each Other

In this article, the authors update and confirm the findings of a 2005 article that was the first to view corporate underwriter choices as the outcome of a two‐sided matching process in which issuers look to the abilities of the underwriters offering their services and underwriters focus on the quality of the issuers that wish to use their services. This view offers a contrast with both the conventional representation of issuer‐underwriter associations as one‐sided decisions (by either issuers or underwriters) and the classical economist's representation of a competitive market in which prices serve as the primary market‐clearing mechanism. In their examination of both initial public offerings (IPOs) and seasoned equity offerings (SEOs) during the period 1980–2010, the authors continue to find strong evidence that higher‐quality issuers associate with more reputable underwriters and lower‐quality issuers match with lower reputation underwriters. Moreover, when examining cases of underwriter switching between an IPO and SEOs by the same issuer, they find that cases involving the largest divergence in the relative rankings of issuer and underwriter were the most likely to produce a change of underwriter—and that issuers that experienced larger post‐ IPO increases in quality were more likely to find more reputable underwriters for their SEOs (than for their IPOs). The authors also find that the larger the number of offerings brought to market in a given year, the smaller the market share of the top‐tier underwriters, likely reflecting the willingness of the most reputable underwriters to turn down business to maintain quality and reputation. Finally, the most reputable underwriters appear to benefit from the fact that the issuers whose IPOs they underwrite end up raising larger amounts of capital, both at the time of the IPO and in the larger and more frequent seasoned offerings by such issuers that come after the IPO. This evidence in support of two‐sided matching suggests that, especially for high‐quality issuers, the reputation of the underwriters they contract with for security offerings is likely to be more important than the underwriting fees they incur. What's more, the authors' finding that the most reputable underwriters are less likely to lose high‐quality clients and have more stable market share—and that the higher‐quality issuers they attract end up raising larger amounts of capital over their lives as public companies—suggests that underwriters' investments in building and preserving their reputations have a large expected payoff.     

Examining bank SEOs: Are offers made by undercapitalized banks different?

Despite extensive monitoring, banking operations are often considered opaque, and despite explicit capital adequacy regulation, banks may have substantial discretion in their financing. Both monitoring and capital regulation have changed substantially over time, with the adoption of FDICIA being one important breakpoint. This article empirically studies seasoned equity offerings (SEOs) by banks to understand how opacity and capital regulation interact to determine the timing of bank SEOs and their market valuation. SEOs both by banks that are undercapitalized relative to regulatory standards and also well-capitalized banks are fully discretionary when it comes to SEOs, even before FDICIA. Both undercapitalized and well-capitalized banks experience similar and significantly negative stock price reactions to SEO announcements, and also have similar prior patterns of insider trading and similar economic drivers of the issuance decision. Moreover, post-SEO abnormal stock returns are similar to benchmark returns for both types of issuers in the long run, suggesting that, contrary to the well-documented evidence for industrial SEOs, investors understand the value implications of bank SEOs upon announcement. The evidence implies that undercapitalized banks' SEOs are more discretionary and that all bank SEOs are less opaque than implied by earlier studies.     

Excess cash holdings and investment: the moderating roles of financial constraints and managerial entrenchment

Our study investigates the relationship between excess cash holdings and investment behaviour under two dimensions of financial constraints and managerial entrenchment, based upon a sample of Taiwanese firms operating in an environment characterized by poor legal protection for investors, with data covering the years 2000–2006. We find that excess cash is significantly correlated with capital expenditure, particularly for firms financially constrained and with severe managerial entrenchment. However, the evidence shows that excess cash is insensitive to R&D expenditure under these two dimensions.     

Voluntary disclosure and its impact on share prices: Evidence from the UK biotechnology sector

In the UK, SSAP 13 requires that firms immediately expense most of their R&D expenditures. The reported earnings of high-R&D expenditure firms are therefore likely to convey less value-relevant information to investors than those of less research-intensive firms. Using a sample of firms from the high-R&D UK biotechnology/pharmaceutical sector, we find that earnings announcements have a much lower price impact than drug development announcements. We also find that there are significantly more ‘good news’ voluntary announcements than ‘bad news’ announcements. Furthermore, our findings indicate that these firms are more likely to announce late than early stage developments, and that the pattern of disclosures, and the market’s reaction to them, varies between larger, dominant firms and their smaller counterparts.     

Seasoned equity offerings and customer–supplier relationships

We investigate how seasoned equity offerings (SEOs) by issuers with large customers affect both trading partners’ market values and the relationship's health. We hypothesize that SEOs reveal adverse information about an issuer's major customers and find that issuers and their large customers experience negative returns on SEO announcements. These results are more pronounced when customers have higher levels of information asymmetry and when customer-supplier relationships are particularly important. Large customers of issuers experience larger declines in post-SEO sales, operating performance, and credit ratings than large customers of non-issuers. Also, SEO issuer sales to large customers and relationship duration significantly decline.     

More Evidence That Corporate R&D Investment (and Effective Boards) Can Increase Firm Value

The authors find that higher R&D expenditures generally lead to both higher expected future cash flow and a lower cost of equity. In addition, they find that the positive connections between R&D spending and higher expected future cash flow and lower cost of equity are stronger in companies with more effective boards (as indicated by measures of director independence and experience). Such findings should help senior executives overcome any concern that investors may not give full credit to R&D investments because they are fully expensed and lead to lower reported earnings in the short term.     

Earnings Variability and Disclosure of R&D: Evidence from Press Releases

This study explores press releases in the pharmaceutical industry to expand our understanding of how investments in R&D outlays influence uncertainty of future earnings. The findings make two contributions to the literature. First, they provide evidence that equal investments in different R&D ventures are associated with differential variability of future earnings. This result suggests that non‐financial information contained in press releases captures attributes of firm‐specific R&D investments that are not revealed through R&D expenditures reported in financial statements. Second, prior studies have indicated that investments in pharmaceutical R&D are associated with the highest variability of future earnings among all industries. The results, however, suggest that for a large class of low‐risk pharmaceutical R&D investments, the relative variability of future earnings is low and similar to that generated by capital expenditures. The findings hold when we control for endogeneity in voluntary disclosure of press releases.     

Monitoring via staging: Evidence from Private investments in public equity

I study the causes and consequences of staging in the setting of private investments in public equities (PIPEs). I find that, in PIPE investments, as in venture capital staging, the staging strategy is used by investors as a monitoring mechanism to mitigate information asymmetry and agency problems. Moreover, strategic investors and investors investing alone are more likely to utilize staging. I show also that staging reduces the cost of financing and has positive implications for PIPE issuers’ long-run stock performance.     

Voluntary disclosure of corporate venture capital investments

In this paper, we investigate drivers of corporate venture capital investment announcements. Consistent with voluntary information disclosure theories, we find that a public announcement is less likely to be made when the start-up firm is in the seed stage but more likely when the parent company is large, active in concentrated markets and in non-high-tech industries; spends heavily on internal R&D and capital expenditures; has low leverage ratio; and faces more information asymmetry problems. In addition, corporate venture capital programs managed externally disclose more often than internal programs. We find that parent companies facing more severe asymmetric information problems enjoy the highest abnormal returns in response to announcements. This study contributes to the literature on voluntary information disclosure in that it evidences that larger corporations use disclosure of some of their investments in innovative startups strategically as a way to convey valuable information to the market.     

THE ENDOGENEITY OF INFORMATION ASYMMETRY AND CORPORATE FINANCING DECISIONS

Firms endogenize the extent of information asymmetry by choosing the optimal level and channels of direct communication with the capital markets. Firms choose more communication when they have a greater potential demand for external financing (characterized by higher growth, less cash, and higher leverage). We demonstrate that a higher level of communication is associated with a higher probability of equity issuance. We further document that the previously observed negative market reaction to seasoned equity offering (SEO) announcements is attributed only to low‐communication firms; high‐communication SEO firms experience no significant adverse market reaction.     

The non-7% solution

While the vast majority of underwriters charge a gross spread of exactly 7%, as documented in Chen and Ritter (2000), more than a third charge something other than 7%. Among offerings of $50 million and below where underwriters charge the firm other than 7%, two-thirds of issuers pay more than published NASD¹ compensation guidelines. When underwriters charge less than expected, they do not trade-off IPO compensation with underpricing. However, our evidence suggests a trade-off between IPO compensation and future SEO business among underwriters that charge something other than 7% and less than expected. Underwriters that overcharge may provide a signal to investors about future underperformance.     

The announcement impact of seasoned equity offerings on bondholder wealth

Previous studies document a negative return to equity on the announcement of an SEO. However, the effects of SEO announcements on bonds have received little attention. We find that bondholders experience a significant positive return on the announcement of an SEO and this effect is more pronounced for bonds with lower ratings. We examine alternate explanations for bond market reactions to SEO announcements including the leverage risk reduction, wealth transfer, and information signaling hypotheses. Overall, our results are most consistent with the leverage risk reduction hypothesis.