Raising Capital Theory and Evidence

Introduction New information announcements about security offerings by publicly listed firms can cause one of three reactions in the financial markets: (i) positive, (ii) negative, or (iii) indifferent reactions. These responses are measured in the average two-day common stock price reactions adjusted for general market price changes (abnormal returns) to announcements of public issues of common stock, preferred stock, convertible preferred stock, straight debt and convertible debt.

Stock markets react to such news by adjusting the market value of the company either upwards or downwards. to take account of the newly announced information. In 1986, Clifford W. Smith Jr. , took note of some very important patterns about the stock market’s reactions security offerings and explored them through his article entitled Raising Capital: Theory and Evidence. His primary finding was that, on average, announcements either lead to reductions in the market valuations of companies issuing securities or being ‘insignificantly different from zero. Furthermore he noted that there is usually no significant positive reaction to the valuation of a company as a result of a new security offer announcement. His findings also differentiated and drew correlations among the types of security offerings and the intensity of market response. The stock market’s reaction to common stock offers was ‘more strongly negative’ than when preference stock and debt capital was issued. As a senior claim to common stock, it could be argued that issuing debt capital communicates information about management’s confidence in the firm to the financial markets.

Smith also observed that stock markets react more unfavorably to announcements of issue of convertible loans when compared to issuance of non convertible loans. Given the characteristics of convertible loans, which contain elements of common stock, these negative reactions seemed to fit the general pattern of findings. Once a firm has decided on the type of security to issue it must then take into account the different methods of marketing it. These options include pro-rata issuance to existing stockholders, hiring underwriters to issue securities publicly, or private placement of securities.

Against this backdrop, Clifford W. Smith laid out two primary objectives to be addressed in the article: (i) to examine evidence on market response to security offerings by public expectations, and (ii) to evaluate methods of marketing corporate securities. This report draws upon and provides critiques of Smith’s survey of three less credible explanations, (Optimal Capital Structure, Earning Per Share Dilution, and Price Pressures) and three more important explanations for the market reactions to security offerings: (i) Unanticipated Announcements; (ii) Insider Information; and (iii) Ownership Changes.

Additionally, the report tracks the evolution of the decision-making process from choice of security, through Smith’s three identified tradeoffs in marketing corporate securities: (i) rights versus underwritten offerings; (ii) negotiated versus competitive bid contracts; and (iii) traditional versus shelf registration. The special case of initial public offerings (IPO) is also evaluated. Finally, the report provides an overall evaluation of Smith’s body of work in relation to present day finance.

Survey of Potential Explanations for Market Responses Optimal Capital Structure (OCS) As explained in chapters 15 and 16 of the Financial Management textbook, firms organize their capital to maximize the wealth of the firm, and achieve the lowest weighted average cost of capital. Therefore, in this context the OCS argument puts forth an idea purported by some financial economists that negative market response could be related to investors fear of a new issuance moving a firm’s capital structure away from its optimum.

However, this does not align well with evidence that shows a consistently negative response, whereas investors to always bear an unfavorable outlook if the OCS argument alone held true. In effect, this would imply that equity issuance always move the capital structure away from its optimal level - which is inaccurate. Earnings Per Share (EPS) Dilution The first commonly cited argument by financial analysts to explain the above-mentioned findings is that negative adjustments to firm valuations occur as a result of equity offerings that cause short-term reductions of earnings per share, as well as a reduction in the return on equity.

The argument is based upon the premise that increasing the number of shares will immediately increase the denominator of the EPS calculation (Net Income less preferred stock/Number of shares outstanding). As such, more shares outstanding equals lower earnings per share. The assumption is that investors main objective is to maximize their EPS and automatically will reduce their estimates to any issuance of equity. This would seem at odds with modern finance theory as the goal of shareholders is to maximize share price and not necessarily earnings per share.

Particularly in cases where investors are cognizant and approving of the use of funds from an equity issuance (i. e. the capital expenditure program is value creating), then the share price would, if anything, rise. Smith quickly dismisses this theory highlighting that the market is far more sophisticated than the implied mechanical reactions to the increase in the number of shares outstanding. Additionally, there is immense difficulty in isolating causality of reductions in earnings per share as the only reason for negative stock price effects from equity issue announcements.

Price Pressures Similar to EPS dilution, the Price Pressure theory is related to announcements of equity or convertible issues. The theory assumes a downward sloping demand curve for shares of any company, therefore requiring discounts in market prices proportional to the size of the issuance. This theory too, however, has many flaws and little empirical evidence. Given the availability of close substitutes Smith argues that the demand curve for corporate securities is more horizontal than downward sloping. Furthermore, Smith cites three separate studies to disprove the theory.

Scholes (1972) dissertation found that although prices declined for distribution of large blocks of shares, that the reduction is better explained by the information communicated by the stock issuance than the result of price pressure. Kalay and Shimrat (1986) discovered that bond prices reactions to new equity offers also dropped. This is important because according to the logic of price pressures, bond prices should either remain unaffected or even rise as a result of its senior claim on a firms cash flows.

Therefore, price pressures alone could not be the answer. Finally, Linn and Pinegar (1985) found that preferred stock prices did not fall as with announcements, closing the argument that price pressures could provide a sufficient argument. Unanticipated Announcements Timing and/or awareness of announcements weighs heavily on their revisions of firm valuation. According to Smith, the magnitude of stock prices change at an announcement will vary inversely with the degree of predictability of the announcement if other effects are held constant.

This is precisely because stock price changes only reflect the unanticipated component of the announcement. In order to maintain a firm within its target capital structure range, debt repayment must be matched with new debt issuance. Similarly, the predictability of earnings will determine the predictability of the new externally obtained equity funds. In general, a new debt issue is likely to be more predictable than a new equity issue because principal repayments are more predictable than earnings.

Another reason for the greater predictability of public debt offerings is related to the cost structures of public versus private debt. Flotation costs for publicly placed debt have a larger fixed component and more pronounced economies of scale than bank debt. If potential security holders can observe the amount of bank borrowing and the pattern of public debt issuance, then predictable announcements of public bond issues should have smaller price reactions. Therefore, Smith finds some validity to the unanticipated announcements argument with regard to debt versus equity offerings.

Insider Information Financial theory suggests that when managers have a number of financing alternatives and choose equity as the preferred source of funding, this decision is interpreted by the investors as a negative signal regarding the future of the firm. The results show that in general the market reaction to these announcements is significantly negative. The negative announcement effects imply that market participants perceive the decision to issue additional equity as an unfavorable signal about the future prospects of the firm.

On the other hand, investors may perceive that management is overconfident about its future profitability and operating performance, and is in fact timing the issuance of its offerings when the market conditions are favorable. In both circumstances there is recognition that managers possess more accurate and relevant information than do outside investors. As such, investors will discount the stock prices of companies issuing new offerings. Smith argues that new security offerings affect investors’ outlook via two primary channels: (i) implied changes in net operating cash flows, and (ii) the leverage change.

According to Smith, investors ultimately care about the company’s ability to generate cash flows and therefore will make inferences about the changes in operating cash flows from announcement that do no explicitly link the sources with the use of funds. Funds may be raised either to fund new capital investments or to compensate for a shortfall in cash or operating performance. Following this line of reasoning, the more explicit a firm’s intentions, the better (if pursuing a capital investment).

Insofar as leverage is concerned, the market responds remarkably favorable to leverage increasing and the opposite to leverage decreasing transactions. This theory seems intuitive with the evidence given that security offerings with less sensitivity to the firm’s value will be viewed by investors as signs of a positive outlook by management. In sum, Smith finds the insider information theory to have reasonable explanatory power of market reactions. Changes in Ownership Key changes in ownership and control of the firm are also reflected in the observed price reaction.

Smith finds that announcements of “transactions that increase ownership concentration raise share prices, while those that reduce concentration lower share prices”. Therefore, the insider information impact is offset by the positive signals sent to investors. Additionally, on average voluntary organizational restructuring tends to benefit shareholders. For example, he cites Schipper and Smith (1986) examination of firms that sell common stock of a previously wholly owned subsidiary. These ‘equity carve-outs’ are associated with significant positive returns for the ive days around the announcement. There are important control implications of the public sale of a minority interest in a subsidiary. Schipper and Smith also found that 94 percent of the carve-outs adopted incentive compensation plans based on the subsidiary’s stock. The evidence from equity carve-outs is also consistent with the insider information argument. If management expects that the subsidiary is undervalued, then by segregating the subsidiary’s cash flows and selling separate equity claims, the firm can more effectively capture that gain.

Some security sales involve potentially important ownership structure changes, which lends credence to this explanation. Development of Smithsonian findings: From selection to marketing corporate securities Once Smith identified the three main arguments that play a vital role in a firm’s choice of corporate securities, he develops his ideas further by ushering us through the marketing methods decision-making process. To tackle this second objective Smith outlines the alternative methods.

The firm can offer securities on a pro rata basis to its own stockholders through a rights offering; it can hire an underwriter to offer the securities for sale to the public; or it can opt for private placement. Hiring an underwriter would require negotiations between the firm and the underwriter on the terms of the offering. Conversely, the firm could choose to structure the offering internally and tender it for competitive bidding. The underwriting contract can be a firm commitment or a best efforts offering.

Finally, under its traditional registration procedures the issue would be registered with the Securities and Exchange Commission (SEC), unless it can employ shelf registration in which the firm registers all securities it intends to sell over a period of two years. Rights versus Underwritten offerings Particularly given the issues identified with insider information it should be less of a surprise that 80% of equity offerings employ underwriters despite being 3 to 30 times more expensive than rights offerings. In an underwritten offering the firm sells the issue to a financial intermediary investment bank), which then resells the issue to the public. Therefore, given the information asymmetry between investors and management, Smith rationalized that the performance of due diligence by investment banks and their effective monitoring mechanisms of firms’ activities provide an “implicit guarantee” to investors when securities are resold. Conversely, in a rights offering, while the stockholder receives a warrant to buy the security, the onus is on the investor to forecast the value of the firm without the backing an insider.

Therefore, even though there is a higher cost to the firms to use underwriters, Smith contends that their usage increases the value of the firm by reducing the information gap between management and investors - thereby raising the price investors are willing to pay for the security. Negotiated versus Competitive Bid Contracts In similar fashion to the rights vs. underwritten offerings tradeoff, negotiated contracts are used far more frequently than competitive bids despite higher flotation costs. Yet again information disparity plays a key role.

Again, investors receive an implicit guarantee of monitoring in the case of negotiated offerings because the “issuing firm has less control over the terms and financing of the offer” and hence investors are less susceptible to exploitation. Furthermore, the firm also reaps a benefit by having some measure of control over the use of information by investment bankers who place and unsuccessful bid. As such, Smith notes that the majority of firms that use the competitive bidding process are those that are required to do so by law. That being said, he notes that there are occasions in which the competitive bidding process is more valuable.

When there is little disparity between the management and the investors‘ perceptions of market value, and/or with senior claims such as debt, the savings achieved through the competitive bidding process can be more pronounced and worthwhile for the firm. This point, however, does not take away from the importance of the insider information theory. Shelf versus Traditional Registration All public security offerings require registration with the SEC. In this tradeoff, both information asymmetry and unanticipated announcements become relevant.

Under traditional registration procedures investors can count upon greater assurance of the management’s intentions for the offering as multiple entities (investment bank, audit firm, law firm etc) play a role in the participants in filing. On the other hand, as previously stated, qualifying firms - those authorized by Rule 415 with more than $150 million of stock held by investors unaffiliated with the company - avail themselves of shelf registration. This means that the firms can register the dollar amount of securities they anticipate will be sold over the coming two years and issue them at management’s discretion.

Therefore, Smith anticipates that stock price reactions to offerings from shelf registration could be more negative given the flexibility for management to exploit the information gap and the timing of the issuance. As such, he also argues that shelf registration should be more frequently used with senior claims such as debt rather than with equity offerings. Special Case of IPOs Smith acknowledges that the obvious outlier to these dynamics is the case of initial public offerings, in which neither the firm nor the investors has the upper hand in the information game.

Uncertainty about the market clearing price of the offering as well as analysis of the market reactions to the initial announcement are unlikely to provide productive recommendations. Therefore, Smith claims that this leads to separate pricing, contractual and management issues. If securities are underpriced then both informed and uniformed investors will submit bids and full subscription is more likely. Conversely, if overpriced the informed investors will not submit bids and the issue will be undersubscribed.

Additionally, Smith asserts that the greater the uncertainty about the after-market price of an IPO, the more attractive best efforts contracts are to investors as overpriced offerings would be more likely to cancelled altogether if sales fall short of the contractual minimum. Finally, if a Green Shoe option is included in the contractual arrangement between the firm and the investment bank, Smith affirms that there less likelihood for the investor that the issue would be overpriced since the option would be taken after the investment bank’s due diligence - another implicit guarantee.

Critical Evaluation There are certain elements that must be reviewed in greater scope given the age of the academic piece. Smith’s findings and recommendations were geared toward, and therefore can only be applied to developed markets. The operating assumption of the paper is that firms have the choice of what instruments to employ when raising capital, which carries latent within it, the opportunity for insider information. However, when a firm's financing alternatives are limited, the market participants may not perceive the announcement of a stock offering as a negative signal.

In developing economies alternative sources of capital are usually limited, and therefore, analysis of market reaction to stock offering announcements in such economies may yield results different from those in developed economies. In those markets where investors as a whole may not be as informed, sophistication and rational judgments cannot always be assumed. Therefore, further research would need to be carried out to assess stock price reactions to announcements of security offerings in other markets before concluding upon universal applicability.

It is also worth mentioning that significant value is generally created by what is on the left side of the balance sheet. In other words, Smith’s research outcomes could have been different if the announcement on the stock market was that of an investment program and not that of a common stock offer announcement. Given that management in many firms may not have understood this subtlety, the average abnormal returns could have shown slightly different readings had the announcements been categorized by left-side or right-side balance sheet.

As analyzed throughout the course of this report, Clifford Smith answer the questions of why stock prices of companies announcing new stock and convertible offers systematically experience reductions. Primarily owing to the insider information which management can exploit at the investors’ expense via overvalued equity or convertible offerings, market responses reflect this lack of trust, power and risk exposure by reducing their firm aluation estimates. As such Smith’s argument that firms should be sensitive to investor interpretations of these announcements, and that they clearly state their intentions for the use of funds is critical on both sides of the equation. He has shown that the basis for interaction between the firm and the market is not solely about maximizing the capital raised in each individual offering, but in nurturing trust over the medium to long term.

In sum, this body of work is extremely significant to our understanding of how to select, how to price, and how to market corporate securities. References: Avner Kalay and Adam Shimrat, “Firm Value and Seasoned Equity Issue: Price Pressure, Wealth Redistribution, or Negative Information,” New York University 1986. Clifford W. Smith, “Alternative Methods for Raising Capital: Rights versus Under-Written Offerings,” Journal of Financial Economics 5 (1973), 273-307. Clifford W. Smith, “Raising Capital: Theory and Evidence,” Journal of Financial Economics 5 (1986).

Katherine Schipper and Abbie Smith, “A Comparison of Equity Carve-Outs and Seasoned Equity Offerings: Share Price Effects and Corporate Restructuring,” Journal of Financial Economics 15 (1986), pp. 153-186. Scholes, “Market for Securities: Substitution versus Price Pressure and the Effects of Information on Share Prices,” Journal of Business 45 (1972), 179-211. Scott Lian and J. Michael Pinegar, “The Effect of Issuing Preferred Stock on Common Stockholder Wealth,” University of Iowa, 1985.

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