Private placements of common equity and the industry rival response

Abstract

This study examines the intra-industry signalling effects of private equity issue announcements. The results show that the average industry reaction to a private equity announcement is negative. However, evidence of a contagion effect also exists. Specifically, the competitive response among industry rivals is significantly stronger for private equity issues during bear stock markets. In fact, the industry rival reaction for nonhigh-tech firms is significantly negative during bear markets only, while it is significantly positive during bull markets. These findings highlight the importance of stock market conditions in influencing the signals sent by private equity issues and the resulting shareholder wealth effects.

Notes

¹ Studies by Wruck (1989), Hertzel and Smith (1993) and Alli and Thompson (1993), Hertzel and Rees (1998), Goh et al . (1999) show significant positive stock price reactions to private placements of common stock.

² Hertzel and Smith (1993) hypothesize that outside private investors are able to acquire inside information and investigate firm value at a low cost through the negotiating process involved in a private placement. As for financial institutions, it is well acknowledged in the existing literature that they have either a cost advantage or the necessary technology to produce the needed information for assessing firm value (Diamond, 1984; James, 1987; Lummer and McConnell, 1989). The role of information production is especially prominent in small, young and risky firms that are typically associated with relatively severe information asymmetry problems (Carey et al ., 1993).

³ Hertzel and Smith (1993) show that with reduced asymmetric information, private equity placements can resolve the under investment problem associated with public equity offers presented in Myers and Majluf (1984), namely, forgoing profitable investment opportunities. It is preferred to issue equity privately if the existing stockholders could retain more firm value than they would in a public placement. They suggest that firms might use private equity placements intentionally to signal undervaluation by the market. Such a signal is made costly and hence credible, by the resale restrictions associated with such placements.

⁴ Carey et al . (1993) suggest that small, young and risky firms might not have an opportunity to access the marketplace, which could force them to the private marketplace. However, Darrough and Stoughton (1990) show that in an entry game, when small growing firms face a high entry cost, the incentive to hide proprietary information is a greater concern.

⁵ To ensure that the parameter estimates are not sensitive to the estimation period chosen, we also used a post-estimation period which extended from day +51 (i.e., 51 days after the announcement) to day +250. The findings using the post-estimation period are similar to the finding based on the pre-estimation period, suggesting that there is not a significant bias in using the pre-announcement period to estimate the market model parameters.

⁶ Similar to the procedure used by Firth (1996), each announcing firm is matched with industry partners based on 4-digit SIC codes and the abnormal return for the nonreporting firm is regressed on different explanatory variables. While this procedure may cause some industry-matched firms to have the same announcement date, Karafiath (1994) specifically addresses this econometric issue, showing that the ordinary least squares (OLS) estimator is well-specified in certain situations in which firms have common event dates. In fact, using Monte Carlo simulations, Karafiath demonstrates that correcting for cross-sectional correlation does not appear to have any advantage over using the OLS covariance matrix.

⁷ Most private equity placements increase ownership concentration of extant large shareholders or create additional large shareholders that may serve as monitors (Wruck, 1989). However, Hertzel and Smith (1993) and Morck et al . (1988) note that the benefit of increased monitoring might be more important in large firms because they usually are more liquid with relatively low managerial ownership. Small firms, on the other hand, appear to have a relatively high managerial share ownership and are more likely to participate in developing speculative products. Consequently, because most private placements are initiated by small firms, private placements of equity probably are driven more by the need to raise capital or to signal the market than to restructure ownership. In support of this theory, Wu (2004) finds that private placements of equity do not appear to be motivated by the demand for enhanced monitoring.

⁸ Karafiath (1994) points out that if there is information leakage prior to the announcement, or if the news is anticipated by the market, then using OLS regressions may not be the optimal approach. For this study, however, anticipation/information leakage does not appear to an issue, since the average abnormal returns for the announcing firms prior to the declaration day are insignificantly different from zero and since the event periods have been screened for other types of announcements which may have been useful for partially predicting the private equity issue.

⁹ We include these variables in a separate model because their inclusion caused a reduction in sample size, since not all firms had available information for these variables.