"Investment Banking and Securities Issuance" Chapter 9 of North-Holland Handbook ofthe Economics of Finance edited by George Constantinides,Milton Harris,and Rene Stulz,forthcoming 2002 Jay R.Ritter University of Florida ritter@dale.cba.ufl.edu http://bear.cba.ufl.edu/ritter September 16,2002 JEL classifications:G24,G32,G14 JEL keywords:Corporate finance;initial public offerings;seasoned equity offerings; underwriting;investment banking Abstract This chapter analyzes the securities issuance process,focusing on initial public offerings (IPOs)and seasoned equity offerings(SEOs).The IPO literature documents three empirical patterns:1)short-run underpricing,2)long-run underperformance(although this is contentious), and 3)extreme time-series fluctuations in volume and underpricing.While the chapter mainly focuses on evidence from the U.S.,evidence from other countries is generally consistent with the U.S.patterns.A large literature explaining the short-run underpricing of IPOs exists,with asymmetric information models predominating.The SEO literature documents 1)negative announcement effects,2)the setting of offer prices at a discount from the market price,3)long- run underperformance,and 4)large fluctuations in volume.In addition to long-run underperformance relative to other stocks,there is some evidence that issuers succeed at timing their equity offerings for periods when future market returns are low.When examining a large class of corporate financing activities,including equity offerings,convertible bond offerings, bond offerings,open market repurchases,stock-and cash-financed mergers and acquisitions,and dividend increases or decreases,several patterns emerge.In general,the announcement effects are negative for activities that provide cash to the firm,and positive for activities that pay cash out of the firm.Furthermore,the market generally underreacts,in that long-run abnormal returns are usually of the same sign as the announcement effect.In spite of the large expenditure of resources on analyst coverage,there is little academic work emphasizing the importance of the marketing of financial securities.Only recently have papers began to focus on the corporate financing implications if firms face variations in the cost of external financing due to the mispricing of securities by the market
“Investment Banking and Securities Issuance” Chapter 9 of North-Holland Handbook of the Economics of Finance edited by George Constantinides, Milton Harris, and René Stulz, forthcoming 2002 Jay R. Ritter University of Florida ritter@dale.cba.ufl.edu http://bear.cba.ufl.edu/ritter September 16, 2002 JEL classifications: G24, G32, G14 JEL keywords: Corporate finance; initial public offerings; seasoned equity offerings; underwriting; investment banking Abstract This chapter analyzes the securities issuance process, focusing on initial public offerings (IPOs) and seasoned equity offerings (SEOs). The IPO literature documents three empirical patterns: 1) short-run underpricing, 2) long-run underperformance (although this is contentious), and 3) extreme time-series fluctuations in volume and underpricing. While the chapter mainly focuses on evidence from the U.S., evidence from other countries is generally consistent with the U.S. patterns. A large literature explaining the short-run underpricing of IPOs exists, with asymmetric information models predominating. The SEO literature documents 1) negative announcement effects, 2) the setting of offer prices at a discount from the market price, 3) longrun underperformance, and 4) large fluctuations in volume. In addition to long-run underperformance relative to other stocks, there is some evidence that issuers succeed at timing their equity offerings for periods when future market returns are low. When examining a large class of corporate financing activities, including equity offerings, convertible bond offerings, bond offerings, open market repurchases, stock- and cash-financed mergers and acquisitions, and dividend increases or decreases, several patterns emerge. In general, the announcement effects are negative for activities that provide cash to the firm, and positive for activities that pay cash out of the firm. Furthermore, the market generally underreacts, in that long-run abnormal returns are usually of the same sign as the announcement effect. In spite of the large expenditure of resources on analyst coverage, there is little academic work emphasizing the importance of the marketing of financial securities. Only recently have papers began to focus on the corporate financing implications if firms face variations in the cost of external financing due to the mispricing of securities by the market
"Investment Banking and Securities Issuance" Chapter 9 of North-Holland Handbook of the Economics of Finance edited by George Constantinides,Milton Harris,and Rene Stulz,forthcoming 2002 Jay R.Ritter University of Florida August 22,2002 This draft has benefited from comments from seminar participants at Emory University,the University of California at Davis,Korea University,Chung-Ang University (Korea),the Hong Kong University of Science and Technology,and City University of Hong Kong,and from Alon Brav,Hsuan-Chi Chen,Raghu Rau,Rene Stulz,Anand Vijh,Kent Womack,and Li-Anne Woo. The comments of Tim Loughran are particularly appreciated,as is research assistance from Donghang Zhang 1.Introduction 1.1 Overview This chapter analyzes the securities issuance process,largely taking the choice of what security to offer as given.Extensive attention is devoted to the controversies surrounding long-run returns on companies issuing equity,including both initial public offerings(IPOs)and seasoned equity offerings(SEOs).For IPOs,attention is also devoted to the mechanisms for selling IPOs, where considerable variation exists in global practices.Theories and evidence regarding the first- day returns on IPOs are also covered. Most of this chapter is devoted to equity issues,even though fixed-income securities swamp equities in terms of the dollar value of issue volume.This is not because debt securities are unimportant,but because the pricing and distribution of fixed-income securities is generally much more straightforward.Specifically,credit risk is the main determinant of the relative yield on corporate bonds of a given maturity,and independent rating agencies such as Moody's provide credit ratings on bonds.In contrast,the payoffs on equities have substantial upside potential as well as downside risk,and are thus more sensitive to firm-specific information. External financing is costly.When a firm decides to issue securities to the public,it almost always hires an intermediary,typically an investment banking firm.The issuing firm pays a commission,or gross spread,and receives the net proceeds when the securities are issued.In addition to the direct costs of issuing securities,an issuing firm that is already publicly traded frequently pays additional indirect costs through revaluations of its existing securities(the "announcement effect").These indirect costs may,at times,be much larger than the direct costs. A major reason for writing this chapter is that the stock market's reaction to securities offerings conveys information about the firm's investment and financing activities.The interpretation of these reactions sheds light on broader issues such as market informational efficiency and the importance of adverse selection and moral hazard in corporate settings. 2
2 “Investment Banking and Securities Issuance” Chapter 9 of North-Holland Handbook of the Economics of Finance edited by George Constantinides, Milton Harris, and René Stulz, forthcoming 2002 Jay R. Ritter University of Florida August 22, 2002 This draft has benefited from comments from seminar participants at Emory University, the University of California at Davis, Korea University, Chung-Ang University (Korea), the Hong Kong University of Science and Technology, and City University of Hong Kong, and from Alon Brav, Hsuan-Chi Chen, Raghu Rau, René Stulz, Anand Vijh, Kent Womack, and Li-Anne Woo. The comments of Tim Loughran are particularly appreciated, as is research assistance from Donghang Zhang. 1. Introduction 1.1 Overview This chapter analyzes the securities issuance process, largely taking the choice of what security to offer as given. Extensive attention is devoted to the controversies surrounding long-run returns on companies issuing equity, including both initial public offerings (IPOs) and seasoned equity offerings (SEOs). For IPOs, attention is also devoted to the mechanisms for selling IPOs, where considerable variation exists in global practices. Theories and evidence regarding the firstday returns on IPOs are also covered. Most of this chapter is devoted to equity issues, even though fixed-income securities swamp equities in terms of the dollar value of issue volume. This is not because debt securities are unimportant, but because the pricing and distribution of fixed-income securities is generally much more straightforward. Specifically, credit risk is the main determinant of the relative yield on corporate bonds of a given maturity, and independent rating agencies such as Moody’s provide credit ratings on bonds. In contrast, the payoffs on equities have substantial upside potential as well as downside risk, and are thus more sensitive to firm-specific information. External financing is costly. When a firm decides to issue securities to the public, it almost always hires an intermediary, typically an investment banking firm. The issuing firm pays a commission, or gross spread, and receives the net proceeds when the securities are issued. In addition to the direct costs of issuing securities, an issuing firm that is already publicly traded frequently pays additional indirect costs through revaluations of its existing securities (the “announcement effect”). These indirect costs may, at times, be much larger than the direct costs. A major reason for writing this chapter is that the stock market’s reaction to securities offerings conveys information about the firm’s investment and financing activities. The interpretation of these reactions sheds light on broader issues such as market informational efficiency and the importance of adverse selection and moral hazard in corporate settings
Investment banking firms are intermediaries that advise firms,distribute securities,and take principal positions.In the course of these activities,information is produced.Most investment banking firms are vertically integrated organizations that incorporate merger and acquisition(M&A)advisory services,capital raising services,securities trading and brokerage,and research coverage.Although there are distinctions,this chapter will use the terms investment bank,securities firm,and underwriter interchangeably.In Europe,universal banks have been permitted to perform both commercial and investment banking functions.In the U.S.,the Glass- Steagall Act separated commercial and investment banking functions from the 1930s to the 1990s. Commercial banks were permitted to take deposits from individuals that are guaranteed by the government (up to $100,000 per account-holder,as of 2001).In return for the government deposit guarantee,commercial banks were prohibited from certain activities,including taking equity positions in firms and underwriting corporate securities.The prohibition on underwriting securities was gradually relaxed,first for debt securities and then for equity securities.In 1999,the Glass-Steagall Act was finally repealed,although deposit insurance remains. The key difference between commercial banks and investment banks in the corporate financing function is that commercial banks primarily act as long-term principals,making direct loans to borrowers,whereas investment banks primarily act as short-term principals.Since investment banks are selling to investors the securities that firms issue,the marketing of financial securities is important.This is a topic that has no reason for coverage in a Modigliani-Miller framework,where markets are perfect and there is no role for marketing.An important tool in the marketing of financial securities,especially equities,is research coverage(forecasts and recommendations)by security analysts.Since the investment banking firm providing research reports also underwrites offerings,this is referred to "sell-side"coverage.There is a perception that analyst coverage has become more important over time,partly because for many industries (i.e.,biotechnology and technology companies),historical accounting information is of limited use in discerning whether new products and services will create economic value added.At the end of 2000,the Securities and Exchange Commission's Regulation FD(fair disclosure)went into effect.This regulation may affect the role of analysts,for it requires that information that a corporation provides to analysts must be publicly disclosed to others as well This chapter updates and extends previous surveys of the investment banking and securities issuance literature,notably Smith(1986)on the capital acquisition process,Eckbo and Masulis(1995)on seasoned equity offerings(SEOs),Ibbotson and Ritter(1995)on initial public offerings(IPOs),and Jenkinson and Ljungqvist(2001)on IPOs.For those interested in a comprehensive analysis of the literature on IPOs,the Jenkinson and Ljungqvist book goes into extensive detail.Ritter and Welch(2002)focus on the recent IPO literature,especially papers dealing with share allocations.Both the Smith survey and the Eckbo and Masulis survey are grounded in an equilibrium market efficiency framework,and neither discusses long-run performance issues.The Eckbo and Masulis survey has an extensive discussion of rights issues (equity issues where existing shareholders are given the right to purchase new shares at a fixed exercise price).Rights issues will not be covered here,partly because rights issues are not common in the U.S.and their use in other countries has been rapidly declining,and partly due to the excellent existing analysis.Many other topics in security issuance are mentioned in passing or not discussed at all.For example,will technology change the securities issuance process? 3
3 Investment banking firms are intermediaries that advise firms, distribute securities, and take principal positions. In the course of these activities, information is produced. Most investment banking firms are vertically integrated organizations that incorporate merger and acquisition (M&A) advisory services, capital raising services, securities trading and brokerage, and research coverage. Although there are distinctions, this chapter will use the terms investment bank, securities firm, and underwriter interchangeably. In Europe, universal banks have been permitted to perform both commercial and investment banking functions. In the U.S., the GlassSteagall Act separated commercial and investment banking functions from the 1930s to the 1990s. Commercial banks were permitted to take deposits from individuals that are guaranteed by the government (up to $100,000 per account-holder, as of 2001). In return for the government deposit guarantee, commercial banks were prohibited from certain activities, including taking equity positions in firms and underwriting corporate securities. The prohibition on underwriting securities was gradually relaxed, first for debt securities and then for equity securities. In 1999, the Glass-Steagall Act was finally repealed, although deposit insurance remains. The key difference between commercial banks and investment banks in the corporate financing function is that commercial banks primarily act as long-term principals, making direct loans to borrowers, whereas investment banks primarily act as short-term principals. Since investment banks are selling to investors the securities that firms issue, the marketing of financial securities is important. This is a topic that has no reason for coverage in a Modigliani-Miller framework, where markets are perfect and there is no role for marketing. An important tool in the marketing of financial securities, especially equities, is research coverage (forecasts and recommendations) by security analysts. Since the investment banking firm providing research reports also underwrites offerings, this is referred to “sell-side” coverage. There is a perception that analyst coverage has become more important over time, partly because for many industries (i.e., biotechnology and technology companies), historical accounting information is of limited use in discerning whether new products and services will create economic value added. At the end of 2000, the Securities and Exchange Commission’s Regulation FD (fair disclosure) went into effect. This regulation may affect the role of analysts, for it requires that information that a corporation provides to analysts must be publicly disclosed to others as well. This chapter updates and extends previous surveys of the investment banking and securities issuance literature, notably Smith (1986) on the capital acquisition process, Eckbo and Masulis (1995) on seasoned equity offerings (SEOs), Ibbotson and Ritter (1995) on initial public offerings (IPOs), and Jenkinson and Ljungqvist (2001) on IPOs. For those interested in a comprehensive analysis of the literature on IPOs, the Jenkinson and Ljungqvist book goes into extensive detail. Ritter and Welch (2002) focus on the recent IPO literature, especially papers dealing with share allocations. Both the Smith survey and the Eckbo and Masulis survey are grounded in an equilibrium market efficiency framework, and neither discusses long-run performance issues. The Eckbo and Masulis survey has an extensive discussion of rights issues (equity issues where existing shareholders are given the right to purchase new shares at a fixed exercise price). Rights issues will not be covered here, partly because rights issues are not common in the U.S. and their use in other countries has been rapidly declining, and partly due to the excellent existing analysis. Many other topics in security issuance are mentioned in passing or not discussed at all. For example, will technology change the securities issuance process?
Given the burgeoning literature on various aspects of security issuance,any coverage that is less than book-length must,unfortunately,be selective. Many important issues in corporate finance and macroeconomics are driven by the assumption that external finance is costly.Examples include theories of conglomerates (internal versus external capital markets),the effects of monetary policy (bank "capital crunches"and the "bank lending channel"of monetary policy transmission),financial development and growth. and financial accelerator models of business cycles.Because this literature is discussed by Stein (2002)in his chapter in this volume,this chapter will not focus on these important issues.This chapter also is related to other topics in this volume,including Barberis and Thaler's(2002) chapter on behavioral finance and Schwert's(2002)chapter on anomalies and market efficiency. This survey is somewhat U.S.-centric,largely reflecting the existing academic research literature.Although this is clearly a limitation,it is less of a limitation than it once was because capital markets are increasingly globally integrated,and U.S.institutional practices(in particular, book-building)and institutions are increasingly common throughout the world.As examples, Deutsche Bank's investment banking is headquartered in London;Credit Suisse First Boston, while nominally a Swiss firm,in 2000 was the lead manager on more IPOs in the U.S.than any other underwriter;and Goldman Sachs leads the league tables(market share tabulations)for M&A activity in Europe. 1.2 A briefhistory ofinvestment banking and securities regulation Until the 1970s,almost all investment banking firms were private partnerships,generally with a limited capital base.When underwriting large securities offerings,these partnerships almost always formed underwriting syndicates,in order to meet regulatory capital requirements,distribute the securities,and share risk.Many investment banking firms had "relationships"with corporations.In the 1970s,the investment banking industry began to change to a more "transactional"form,where corporations use different investment bankers for different services,on an as-needed basis.Investment banking firms have grown in size and scope,largely through mergers,and most of the larger firms have converted to publicly traded stock companies.A reason for the increase in size of investment banking firms is the increased importance of information technology,with large fixed costs and low marginal costs.With their new-found large capital bases and distribution channels,the historical rationale for forming syndicates to distribute securities has largely disappeared.Consistent with this,the number of investment banking firms participating in a given syndicate has shrunk noticeably over the last few decades.A syndicate is composed of one or more managing underwriters and from zero to over one hundred other syndicate members.The lead manager does most of the work and receives most of the fees(Chen and Ritter(2000)).All of the managers usually provide research coverage.Indeed,this is the major reason why syndicates still exist.Frequently,after a deal is completed,a"tombstone" advertisement listing the syndicate members is published in financial publications such as the Wall Street Journal. As a consequence of distributing the shares in an initial public offering,the lead underwriter knows where the shares are placed,which gives a natural advantage for making a market later on,since the underwriter knows whom to call if there is an order imbalance(Ellis, 4
4 Given the burgeoning literature on various aspects of security issuance, any coverage that is less than book-length must, unfortunately, be selective. Many important issues in corporate finance and macroeconomics are driven by the assumption that external finance is costly. Examples include theories of conglomerates (internal versus external capital markets), the effects of monetary policy (bank "capital crunches" and the "bank lending channel" of monetary policy transmission), financial development and growth, and financial accelerator models of business cycles. Because this literature is discussed by Stein (2002) in his chapter in this volume, this chapter will not focus on these important issues. This chapter also is related to other topics in this volume, including Barberis and Thaler’s (2002) chapter on behavioral finance and Schwert’s (2002) chapter on anomalies and market efficiency. This survey is somewhat U.S.-centric, largely reflecting the existing academic research literature. Although this is clearly a limitation, it is less of a limitation than it once was because capital markets are increasingly globally integrated, and U.S. institutional practices (in particular, book-building) and institutions are increasingly common throughout the world. As examples, Deutsche Bank’s investment banking is headquartered in London; Credit Suisse First Boston, while nominally a Swiss firm, in 2000 was the lead manager on more IPOs in the U.S. than any other underwriter; and Goldman Sachs leads the league tables (market share tabulations) for M&A activity in Europe. 1.2 A brief history of investment banking and securities regulation Until the 1970s, almost all investment banking firms were private partnerships, generally with a limited capital base. When underwriting large securities offerings, these partnerships almost always formed underwriting syndicates, in order to meet regulatory capital requirements, distribute the securities, and share risk. Many investment banking firms had “relationships” with corporations. In the 1970s, the investment banking industry began to change to a more “transactional” form, where corporations use different investment bankers for different services, on an as-needed basis. Investment banking firms have grown in size and scope, largely through mergers, and most of the larger firms have converted to publicly traded stock companies. A reason for the increase in size of investment banking firms is the increased importance of information technology, with large fixed costs and low marginal costs. With their new-found large capital bases and distribution channels, the historical rationale for forming syndicates to distribute securities has largely disappeared. Consistent with this, the number of investment banking firms participating in a given syndicate has shrunk noticeably over the last few decades. A syndicate is composed of one or more managing underwriters and from zero to over one hundred other syndicate members. The lead manager does most of the work and receives most of the fees (Chen and Ritter (2000)). All of the managers usually provide research coverage. Indeed, this is the major reason why syndicates still exist. Frequently, after a deal is completed, a “tombstone” advertisement listing the syndicate members is published in financial publications such as the Wall Street Journal. As a consequence of distributing the shares in an initial public offering, the lead underwriter knows where the shares are placed, which gives a natural advantage for making a market later on, since the underwriter knows whom to call if there is an order imbalance (Ellis
Michaely,and O'Hara(2000)).Advice on acquisitions and follow-on stock offerings frequently follows as well.The underwriter almost always assigns an analyst to follow the company and provide research coverage.Thus,securities underwriting capabilities are combined with M&A advisory capabilities,as well as sales and trading capabilities.All of these activities are information-intensive activities."Chinese walls,"which are supposed to be as impregnable as the Great Wall of China,whereby proprietary information possessed in the M&A advisory function is not disclosed to stock traders,are supposed to exist.In the course of assisting in the issuance of securities,investment bankers perform "due diligence"investigations.In the M&A advisory role, they produce"fairness opinions."Investment bankers are thus putting their reputations on the line, certifying for investors that the terms of the deal are fair and that material information is reflected in the price (Chemmanur and Fulghieri (1994)). In the U.S.,federal government regulation of securities markets is based upon a notion of caveat emptor (buyer beware)with full disclosure.The U.S.Securities and Exchange Commission(SEC)regulates securities markets.In addition,self-regulatory organizations such as the New York Stock Exchange and the National Association of Securities Dealers impose requirements on members,and the threat of class action lawsuits on behalf of investors constrains the actions of issuers and underwriters.Prospectuses are required to contain all material information,with specific requirements for the amount and form of accounting disclosures.In Europe,there is no prohibition on underwriters producing research reports immediately preceding a securities offering.In the U.S.,firms going public and their underwriters are prohibited from disclosing projections that are not in the prospectus during the "quiet period,"starting before a firm announces its IPO and ending 40 calendar days after the offer.An exception to this is that limited oral disclosures may be made during"road show" presentations,where attendance is restricted to institutional investors.In 1999,the SEC started permitting certain qualified individual investors to have access to webcasts of the road show. Typically,the managing underwriters issue research reports with "buy"or "strong buy" recommendations as soon as the quiet period ends.Michaely and Womack(1999)present evidence that sell-side analysts affiliated with managing underwriters face conflicts of interest The conventional wisdom is that analysts have become"cheerleaders."The three reasons for this are that 1)they are dependent upon access to corporate managers for information,2)their compensation is tied to whether their investment banking firm is chosen as a managing underwriter on equity or junk-bond offerings,or as an advisor on M&A deals,and 3)the institutional clients that pay attention to a report are likely to be long in the stock.In 2002,new rules were announced in an attempt to limit the conflicts of interest and alert investors to the conflicts On the front page of a prospectus,the offer price and underwriting discount(commission) are disclosed.The underwriter is prohibited from distributing any securities at a price above the stated offer price,although if the issue fails to sell out at the offer price,the underwriter may sell 1A due diligence investigation involves quizzing management to uncover material information,some of it proprietary in nature,that is relevant for valuation purposes.A fairness opinion is a formal statement that the terms of an M&A deal or leveraged buyout are reflective of"fair"market valuation,including appropriate control premiums or liquidity discounts. 5
5 Michaely, and O’Hara (2000)). Advice on acquisitions and follow-on stock offerings frequently follows as well. The underwriter almost always assigns an analyst to follow the company and provide research coverage. Thus, securities underwriting capabilities are combined with M&A advisory capabilities, as well as sales and trading capabilities. All of these activities are information-intensive activities. “Chinese walls,” which are supposed to be as impregnable as the Great Wall of China, whereby proprietary information possessed in the M&A advisory function is not disclosed to stock traders, are supposed to exist. In the course of assisting in the issuance of securities, investment bankers perform “due diligence” investigations. In the M&A advisory role, they produce “fairness opinions.” Investment bankers are thus putting their reputations on the line, certifying for investors that the terms of the deal are fair and that material information is reflected in the price (Chemmanur and Fulghieri (1994)).1 In the U.S., federal government regulation of securities markets is based upon a notion of caveat emptor (buyer beware) with full disclosure. The U.S. Securities and Exchange Commission (SEC) regulates securities markets. In addition, self-regulatory organizations such as the New York Stock Exchange and the National Association of Securities Dealers impose requirements on members, and the threat of class action lawsuits on behalf of investors constrains the actions of issuers and underwriters. Prospectuses are required to contain all material information, with specific requirements for the amount and form of accounting disclosures. In Europe, there is no prohibition on underwriters producing research reports immediately preceding a securities offering. In the U.S., firms going public and their underwriters are prohibited from disclosing projections that are not in the prospectus during the “quiet period,” starting before a firm announces its IPO and ending 40 calendar days after the offer. An exception to this is that limited oral disclosures may be made during “road show” presentations, where attendance is restricted to institutional investors. In 1999, the SEC started permitting certain qualified individual investors to have access to webcasts of the road show. Typically, the managing underwriters issue research reports with “buy” or “strong buy” recommendations as soon as the quiet period ends. Michaely and Womack (1999) present evidence that sell-side analysts affiliated with managing underwriters face conflicts of interest. The conventional wisdom is that analysts have become “cheerleaders.” The three reasons for this are that 1) they are dependent upon access to corporate managers for information, 2) their compensation is tied to whether their investment banking firm is chosen as a managing underwriter on equity or junk-bond offerings, or as an advisor on M&A deals, and 3) the institutional clients that pay attention to a report are likely to be long in the stock. In 2002, new rules were announced in an attempt to limit the conflicts of interest and alert investors to the conflicts. On the front page of a prospectus, the offer price and underwriting discount (commission) are disclosed. The underwriter is prohibited from distributing any securities at a price above the stated offer price, although if the issue fails to sell out at the offer price, the underwriter may sell 1 A due diligence investigation involves quizzing management to uncover material information, some of it proprietary in nature, that is relevant for valuation purposes. A fairness opinion is a formal statement that the terms of an M&A deal or leveraged buyout are reflective of “fair” market valuation, including appropriate control premiums or liquidity discounts
at a lower price.Because the underwriter cannot directly gain from any price appreciation above the offer price on unsold securities,while bearing the full downside of any price fall,there is every incentive to fully distribute the securities offered. Based on the logic of the efficient markets hypothesis,beginning in 1982 the SEC began permitting publicly traded firms meeting certain requirements(basically,large firms)to issue securities without distributing a prospectus.Instead,SEC Rule 415 states that by filing a letter with the SEC disclosing the intention of selling additional securities within the next two years,a firm can sell the securities whenever it wants.Existing disclosures,such as quarterly financial statements,are deemed to be sufficient information to investors.The securities can be taken off the shelf and sold,in what are known as"shelf'issues.In practice,shelf issues are commonly done for bond offerings.Before selling equity,however,many firms prefer to hire an investment banker and conduct a marketing campaign (the road show),complete with a prospectus.From 1984-1992 there were virtually no shelf equity offerings,but they have enjoyed a resurgence since then (Heron and Lie(2003)). 1.3 The information conveyed by investment and financing activities Smith's classic 1986 survey article "Investment Banking and the Capital Acquisition Process,"focused on announcement effects associated with securities offerings and other corporate actions.These transactions can be categorized on the basis of the leverage change and the implied cash flow change.For example,calling a convertible bond (forcing conversion into equity)decreases a firm's leverage and reduces its need for cash flow to meet interest payments, and repurchasing stock increases leverage and uses cash flow.The studies that he surveyed found that leverage-decreasing transactions on average are associated with negative announcement effects if new capital is raised(such as with equity issues).Leverage-increasing transactions on average are associated with positive announcement effects if no new capital is raised (such as with a share repurchase).As Smith pointed out,these patterns are difficult to reconcile with traditional tradeoff models of optimal capital structure.The patterns are consistent,however,with informational asymmetries and agency problems being of importance. There are several problems with interpreting announcement effects.First,and most mechanically,in an efficient market the announcement effect will measure the difference between the post-announcement valuation and what was expected beforehand.If investors had a high likelihood of an announcement occurring beforehand,this updating element is small,and the announcement effect vastly underestimates the impact of the event.Second,any financing activity implicitly is associated with an investment activity,and any investment activity is implicitly associated with a financing activity.Corporate financing and investment actions invariably convey information about both of these activities,due to the identity that sources of funds uses of funds.For example,if a firm raises external capital,the firm is implicitly conveying the information that internal funds will be insufficient to finance its activities(bad news).It is also conveying the information that it will be investing more than if it didn't finance externally.This may be good or bad news,depending upon the desirability of the investment.So the announcement effect depends upon the relative magnitude of multiple implicit and explicit pieces of information. 6
6 at a lower price. Because the underwriter cannot directly gain from any price appreciation above the offer price on unsold securities, while bearing the full downside of any price fall, there is every incentive to fully distribute the securities offered. Based on the logic of the efficient markets hypothesis, beginning in 1982 the SEC began permitting publicly traded firms meeting certain requirements (basically, large firms) to issue securities without distributing a prospectus. Instead, SEC Rule 415 states that by filing a letter with the SEC disclosing the intention of selling additional securities within the next two years, a firm can sell the securities whenever it wants. Existing disclosures, such as quarterly financial statements, are deemed to be sufficient information to investors. The securities can be taken off the shelf and sold, in what are known as “shelf” issues. In practice, shelf issues are commonly done for bond offerings. Before selling equity, however, many firms prefer to hire an investment banker and conduct a marketing campaign (the road show), complete with a prospectus. From 1984-1992 there were virtually no shelf equity offerings, but they have enjoyed a resurgence since then (Heron and Lie (2003)). 1.3 The information conveyed by investment and financing activities Smith’s classic 1986 survey article “Investment Banking and the Capital Acquisition Process,” focused on announcement effects associated with securities offerings and other corporate actions. These transactions can be categorized on the basis of the leverage change and the implied cash flow change. For example, calling a convertible bond (forcing conversion into equity) decreases a firm’s leverage and reduces its need for cash flow to meet interest payments, and repurchasing stock increases leverage and uses cash flow. The studies that he surveyed found that leverage-decreasing transactions on average are associated with negative announcement effects if new capital is raised (such as with equity issues). Leverage-increasing transactions on average are associated with positive announcement effects if no new capital is raised (such as with a share repurchase). As Smith pointed out, these patterns are difficult to reconcile with traditional tradeoff models of optimal capital structure. The patterns are consistent, however, with informational asymmetries and agency problems being of importance. There are several problems with interpreting announcement effects. First, and most mechanically, in an efficient market the announcement effect will measure the difference between the post-announcement valuation and what was expected beforehand. If investors had a high likelihood of an announcement occurring beforehand, this updating element is small, and the announcement effect vastly underestimates the impact of the event. Second, any financing activity implicitly is associated with an investment activity, and any investment activity is implicitly associated with a financing activity. Corporate financing and investment actions invariably convey information about both of these activities, due to the identity that sources of funds = uses of funds. For example, if a firm raises external capital, the firm is implicitly conveying the information that internal funds will be insufficient to finance its activities (bad news). It is also conveying the information that it will be investing more than if it didn’t finance externally. This may be good or bad news, depending upon the desirability of the investment. So the announcement effect depends upon the relative magnitude of multiple implicit and explicit pieces of information
A substantial literature,dating back to the mid-1980s,documents that the market reacts negatively,on average,to the announcement of equity issues in the U.S..Convertible bond issues generally are greeted with a moderate negative reaction.Bond offerings have slightly negative reactions,and share repurchases are greeted with positive announcement effects.In the last decade,researchers have examined the long-run performance of firms following these events.The long-run performance evidence shows that in general the market underreacts to the announcement. Most of the literature on long-run performance has focused on relative performance,i.e., do issuing companies underperform a benchmark?Baker and Wurgler(2000),however,present empirical evidence that issuing firms display market timing ability.Using U.S.data on issues of debt and equity (IPOs and SEOs),they find that the fraction of external financing that is equity predicts the following calendar year's stock market return with greater reliability than either the market dividend yield or the market's market-to-book ratio.Baker and Wurgler's sample covers returns from 1928 to 1997.Interestingly,the fraction of equity issuance was highest in 1929,a year that included the October stock market crash.When the sample period is split in two, however,their results hold in both subperiods. If firms can successfully time their equity offerings to take advantage ofwindows of opportunity,"they have a time-varying cost of external capital.How should this affect a firm's investment and financing policies?Stein(1996)addresses this important issue,and concludes that the normative answer depends upon the interaction of two assumptions.The first assumption is whether differences in the cost of external equity reflect misvaluations or differences in equilibrium expected returns.The second assumption is whether managers are trying to maximize short-run firm value or long-run firm value.If one assumes that a low expected return occurs because a stock is overvalued,then managers should issue stock but not invest in low return activities if they are focused on maximizing the wealth of long-term shareholders.On the other hand,if one assumes that low expected returns are rationally being forecast by investors,then a firm should issue stock and use a lower hurdle rate in choosing its investments,much as the neoclassical model of optimal investing and financing would recommend The remainder of this chapter discusses securities issuance.In Section 3,the short-run and long-run reactions to various corporate announcements will be summarized.In Section 4, initial public offerings will be analyzed in detail,with substantial focus on contractual mechanisms.But first,detailed attention is given to firms conducting seasoned equity offerings 2.Seasoned Equity Offerings(SEOs) When a firm that is already publicly traded sells additional stock,the new shares are perfect substitutes for the existing shares.For these transactions,the academic literature tends to use the term seasoned equity offering(SEO),as contrasted with an unseasoned equity offering, an IPO.Practitioners generally use the term follow-on offering,especially if the equity issue is within several years of the IPO.SEOs are also referred to as secondaries,although secondary offering is a term that can mean either a follow-on offering or shares being sold by existing 7
7 A substantial literature, dating back to the mid-1980s, documents that the market reacts negatively, on average, to the announcement of equity issues in the U.S.. Convertible bond issues generally are greeted with a moderate negative reaction. Bond offerings have slightly negative reactions, and share repurchases are greeted with positive announcement effects. In the last decade, researchers have examined the long-run performance of firms following these events. The long-run performance evidence shows that in general the market underreacts to the announcement. Most of the literature on long-run performance has focused on relative performance, i.e., do issuing companies underperform a benchmark? Baker and Wurgler (2000), however, present empirical evidence that issuing firms display market timing ability. Using U.S. data on issues of debt and equity (IPOs and SEOs), they find that the fraction of external financing that is equity predicts the following calendar year’s stock market return with greater reliability than either the market dividend yield or the market’s market-to-book ratio. Baker and Wurgler’s sample covers returns from 1928 to 1997. Interestingly, the fraction of equity issuance was highest in 1929, a year that included the October stock market crash. When the sample period is split in two, however, their results hold in both subperiods. If firms can successfully time their equity offerings to take advantage of “windows of opportunity,” they have a time-varying cost of external capital. How should this affect a firm’s investment and financing policies? Stein (1996) addresses this important issue, and concludes that the normative answer depends upon the interaction of two assumptions. The first assumption is whether differences in the cost of external equity reflect misvaluations or differences in equilibrium expected returns. The second assumption is whether managers are trying to maximize short-run firm value or long-run firm value. If one assumes that a low expected return occurs because a stock is overvalued, then managers should issue stock but not invest in low return activities if they are focused on maximizing the wealth of long-term shareholders. On the other hand, if one assumes that low expected returns are rationally being forecast by investors, then a firm should issue stock and use a lower hurdle rate in choosing its investments, much as the neoclassical model of optimal investing and financing would recommend. The remainder of this chapter discusses securities issuance. In Section 3, the short-run and long-run reactions to various corporate announcements will be summarized. In Section 4, initial public offerings will be analyzed in detail, with substantial focus on contractual mechanisms. But first, detailed attention is given to firms conducting seasoned equity offerings. 2. Seasoned Equity Offerings (SEOs) When a firm that is already publicly traded sells additional stock, the new shares are perfect substitutes for the existing shares. For these transactions, the academic literature tends to use the term seasoned equity offering (SEO), as contrasted with an unseasoned equity offering, an IPO. Practitioners generally use the term follow-on offering, especially if the equity issue is within several years of the IPO. SEOs are also referred to as secondaries, although secondary offering is a term that can mean either a follow-on offering or shares being sold by existing
shareholders,as opposed to a primary offer where the issuing firm is receiving the proceeds. (And on the subject of ambiguous terms,this chapter will use public ownership to mean stock that is traded in the market,rather than government ownership.Private ownership is used to mean non-traded stock,rather than being owned by the private sector. 2.1 Announcement effects Numerous studies have documented that in the U.S.there is an announcement effect of -2%,on average,for SEOs.The most popular explanation among academics for this negative announcement effect is that of the Myers and Majluf(1984)adverse selection model.Myers and Majluf assume that management wants to maximize the wealth of its existing shareholders in the long run.At any point in time,however,the current market price may be too high or too low relative to management's private information about the value of assets in place.In other words, strong-form market inefficiency is being assumed.If management thinks that the current market price is too low,the firm will not issue undervalued stock,for doing so dilutes the fractional ownership of existing shareholders.If management thinks that the current stock price is too high,however,the firm will issue equity if debt financing is not an option.Rational investors, knowing this decision rule,therefore interpret an equity issue announcement as conveying management's opinion that the stock is overvalued,and the stock price falls.2 How this negative announcement effect should be interpreted is a subject of debate.If a firm is issuing shares equal to 20%of its existing shares,a downward revaluation of 2%for the existing shares is a dollar amount equal to 10%of the proceeds being raised.If this 2%drop is viewed as a cost of an equity issue,then external equity capital is very expensive.On the other hand,if this 2%drop would have occurred when the basis for management's opinion regarding firm value was disclosed in some other manner,then the downward revaluation is not a cost of the equity issue for long-term shareholders.It is a cost only to those shareholders who would have sold their shares in between the equity issue announcement and when the negative news would have otherwise been impounded into the share price.If this is the case,then the negative announcement effect is mainly a matter of indifference to a firm where long-term shareholder wealth maximization is the objective,and external equity is not inordinately costly. As mentioned earlier,when a firm raises external equity capital,it not only conveys information about whether management thinks the firm is overvalued or not,but also suggests that something will be done with the funds raised.If the market interprets the equity issue as implying that a new positive net present value project will be undertaken,the announcement effect could be positive.On the other hand,if the market is concerned that the equity issue means that management will squander the funds on empire building,then the announcement effect could be interpreted as causally linked to the equity issue,in which case external equity is in fact very expensive.The rationale is that the additional equity resources are relaxing a constraint on management's tendency to engage in "empire-building,"or growth for the sake of growth.In other words,agency problems between shareholders and managers are intensified. 2 The Myers-Majluf predictions are very sensitive to the assumptions about the objective function of management, the portfolio rebalancing rules of investors,and the source of information asymmetries.Daniel and Titman(1995) discuss some of these issues in detail. 8
8 shareholders, as opposed to a primary offer where the issuing firm is receiving the proceeds. (And on the subject of ambiguous terms, this chapter will use public ownership to mean stock that is traded in the market, rather than government ownership. Private ownership is used to mean non-traded stock, rather than being owned by the private sector.) 2.1 Announcement effects Numerous studies have documented that in the U.S. there is an announcement effect of –2%, on average, for SEOs. The most popular explanation among academics for this negative announcement effect is that of the Myers and Majluf (1984) adverse selection model. Myers and Majluf assume that management wants to maximize the wealth of its existing shareholders in the long run. At any point in time, however, the current market price may be too high or too low relative to management’s private information about the value of assets in place. In other words, strong-form market inefficiency is being assumed. If management thinks that the current market price is too low, the firm will not issue undervalued stock, for doing so dilutes the fractional ownership of existing shareholders. If management thinks that the current stock price is too high, however, the firm will issue equity if debt financing is not an option. Rational investors, knowing this decision rule, therefore interpret an equity issue announcement as conveying management’s opinion that the stock is overvalued, and the stock price falls.2 How this negative announcement effect should be interpreted is a subject of debate. If a firm is issuing shares equal to 20% of its existing shares, a downward revaluation of 2% for the existing shares is a dollar amount equal to 10% of the proceeds being raised. If this 2% drop is viewed as a cost of an equity issue, then external equity capital is very expensive. On the other hand, if this 2% drop would have occurred when the basis for management’s opinion regarding firm value was disclosed in some other manner, then the downward revaluation is not a cost of the equity issue for long-term shareholders. It is a cost only to those shareholders who would have sold their shares in between the equity issue announcement and when the negative news would have otherwise been impounded into the share price. If this is the case, then the negative announcement effect is mainly a matter of indifference to a firm where long-term shareholder wealth maximization is the objective, and external equity is not inordinately costly. As mentioned earlier, when a firm raises external equity capital, it not only conveys information about whether management thinks the firm is overvalued or not, but also suggests that something will be done with the funds raised. If the market interprets the equity issue as implying that a new positive net present value project will be undertaken, the announcement effect could be positive. On the other hand, if the market is concerned that the equity issue means that management will squander the funds on empire building, then the announcement effect could be interpreted as causally linked to the equity issue, in which case external equity is in fact very expensive. The rationale is that the additional equity resources are relaxing a constraint on management’s tendency to engage in “empire-building,” or growth for the sake of growth. In other words, agency problems between shareholders and managers are intensified. 2 The Myers-Majluf predictions are very sensitive to the assumptions about the objective function of management, the portfolio rebalancing rules of investors, and the source of information asymmetries. Daniel and Titman (1995) discuss some of these issues in detail
A number of empirical studies have documented cross-sectional patterns in the equity issue announcement effect.In general,these results show that there is less of a negative reaction when a firm can convince the market that there is a good reason for issuing equity,and there is a more negative reaction when good motivations are not obvious.Jung,Kim,and Stulz (1996) report that firms with a high q(market value-to-replacement cost),reflecting good investment opportunities,have an announcement effect that is insignificantly different from zero.Choe, Masulis,and Nanda (1993)document that the announcement effect is less negative when the economy is in an expansionary segment of the business cycle,when there may be less adverse selection risk. Korajczyk,Lucas,and McDonald (1991)report that the announcement effect is less negative if it follows shortly after an earnings report,at which time there is presumed to be less asymmetric information.Houston and Ryngaert(1997)provide direct evidence that adverse selection concerns explain part of the negative announcement effect.They study bank mergers, where common stock is the dominant means of payment to the shareholders of target banks. Some merger agreements specify that the target shareholders will receive a fixed number of shares in the acquiring bank(a fixed ratio stock offer),and other merger agreements specify a variable number of shares that add up to a fixed dollar amount(a conditional stock offer).If target shareholders are concerned that the acquirer is offering overvalued stock,the conditional stock offer provides protection against price drops.Consistent with adverse selection concerns, the announcement effect is-3.3%for fixed ratio stock offers,but only-1.1%for conditional stock offers. In general,studies find that larger issues have more negative effects.One problem with interpreting the relation between issue size and announcement effects is that if there is an unusually negative reaction,the issue size may be cut back by the time the deal is completed Since existing empirical studies do not take this endogeneity into account,the empirical estimates of the effect of issue size on the announcement are subject to a simultaneous equations bias.This bias results in an underestimate of the magnitude of the effect of issue size on the stock price.Thus,academics undoubtedly underestimate the degree to which the demand curve for a stock is negatively sloped. On the issue date,SEOs are,on average,sold at a discount of about 3%relative to the market price on the day prior to issuing(Corwin(2003),Mola and Loughran(2002)).Mola and Loughran report that the size of this discount has grown over time,and that there has been an increasing tendency to set the offer price at an integer.For example,in recent years a stock trading at $31.75 would very likely be priced at $30.00 or $31.00,whereas in the 1980s it would have been more likely to be priced at $31.00 or $31.50. 2.2 Evidence on long-run performance The long-run performance of SEOs has been the subject of a number of studies,all of which find that firms conducting SEOs typically have high returns in the year before issuing. For example,Loughran and Ritter(1995)report an average return in the year before issuing of 72%.During the five years after issuing,however,the returns are below normal (about 11%per 9
9 A number of empirical studies have documented cross-sectional patterns in the equity issue announcement effect. In general, these results show that there is less of a negative reaction when a firm can convince the market that there is a good reason for issuing equity, and there is a more negative reaction when good motivations are not obvious. Jung, Kim, and Stulz (1996) report that firms with a high q (market value-to-replacement cost), reflecting good investment opportunities, have an announcement effect that is insignificantly different from zero. Choe, Masulis, and Nanda (1993) document that the announcement effect is less negative when the economy is in an expansionary segment of the business cycle, when there may be less adverse selection risk. Korajczyk, Lucas, and McDonald (1991) report that the announcement effect is less negative if it follows shortly after an earnings report, at which time there is presumed to be less asymmetric information. Houston and Ryngaert (1997) provide direct evidence that adverse selection concerns explain part of the negative announcement effect. They study bank mergers, where common stock is the dominant means of payment to the shareholders of target banks. Some merger agreements specify that the target shareholders will receive a fixed number of shares in the acquiring bank (a fixed ratio stock offer), and other merger agreements specify a variable number of shares that add up to a fixed dollar amount (a conditional stock offer). If target shareholders are concerned that the acquirer is offering overvalued stock, the conditional stock offer provides protection against price drops. Consistent with adverse selection concerns, the announcement effect is –3.3% for fixed ratio stock offers, but only –1.1% for conditional stock offers. In general, studies find that larger issues have more negative effects. One problem with interpreting the relation between issue size and announcement effects is that if there is an unusually negative reaction, the issue size may be cut back by the time the deal is completed. Since existing empirical studies do not take this endogeneity into account, the empirical estimates of the effect of issue size on the announcement are subject to a simultaneous equations bias. This bias results in an underestimate of the magnitude of the effect of issue size on the stock price. Thus, academics undoubtedly underestimate the degree to which the demand curve for a stock is negatively sloped. On the issue date, SEOs are, on average, sold at a discount of about 3% relative to the market price on the day prior to issuing (Corwin (2003), Mola and Loughran (2002)). Mola and Loughran report that the size of this discount has grown over time, and that there has been an increasing tendency to set the offer price at an integer. For example, in recent years a stock trading at $31.75 would very likely be priced at $30.00 or $31.00, whereas in the 1980s it would have been more likely to be priced at $31.00 or $31.50. 2.2 Evidence on long-run performance The long-run performance of SEOs has been the subject of a number of studies, all of which find that firms conducting SEOs typically have high returns in the year before issuing. For example, Loughran and Ritter (1995) report an average return in the year before issuing of 72%. During the five years after issuing, however, the returns are below normal (about 11% per
year,according to Table 1 below).Partly this is due to"market timing,"and partly it is due to abnormal performance relative to a benchmark.The conclusions regarding abnormal performance are hotly debated,and sensitive to the methodology employed and the sample used Figure 1 illustrates the evidence regarding average annual returns in the five years after issuing. The numbers show that,for 7,760 SEOs from 1970-2000,the average annual return in the five years after issuing is 10.8%.Nonissuing firms of the same size(market capitalization)have average annual returns of 14.4%.Therefore,relative to a size-matched benchmark,issuers underperform by 3.6%per year for five years. Table 1 Mean percentage returns on SEOs from 1970-2000 during the first five years after issuing First Second Geometric Six Six First Second Third Fourth Fifth Mean monthsmonths year year year year year years 1-5 SEO firms 6.7% 1.5% 9.4% 3.6% 10.9% 14.7% 15.9% 10.8% Size-matched 6.1% 7.0% 14.0% 12.9% 14.4% 15.3% 15.5% 14.4% Difference 0.6% -5.5% -4.6% -9.3% -3.5% -0.6% 0.4% -3.6% Number 7,502 7,475 7,504 7,226 6.603 5.936 5,188 7,760 SEO firms 7.4% 2.2% 10.6% 5.3% 12.3% 14.2% 14.2% 11.3% Style- 5.4% 5.6% 11.5% 13.6% 15.6% 16.9% 15.9% 14.7% matched Difference 2.0% -3.4% -0.9% -8.3% -3.3% -2.7% -1.7% -3.4% Number 6,638 6,622 6,638 6,289 5,711 5,123 4,448 6,638 All averages are equally weighted.For the first year,the returns are measured from the closing market price on the issue date until the sixth-month or one-year anniversary.All returns are equally weighted average returns for all seasoned equity offerings(SEOs)that are still traded on Nasdag,the Amex,or the NYSE at the start of a period.If an issuing firm is delisted within an event year,its return for that year is calculated by compounding the CRSP value-weighted market index for the rest of the year.The matching firm is treated as if it delisted on the same date. and its return for the remainder of the year is calculated using the CRSP VW index.Thus,once an SEO is delisted, by construction there is no abnormal performance for the remainder of the year.For the size-matched returns,each SEO is matched with a nonissuing firm having the same market capitalization (using the closing market price on the first day of trading for the SEO,and the market capitalization at the end of the previous month for the matching firms).For the style-matched returns,each SEO is matched with a nonissuing firm in the same size decile (using NYSE firms only for determining the decile breakpoints)having the closest book-to-market ratio.For nonissuing firms,the Compustat-listed book value of equity for the most recent fiscal year ending at least four months prior to the SEO date is used,along with the market cap at the close of trading at month-end prior to the month of the SEO with which it is matched.Nonissuing firms are those that have been listed on the Amex-Nasdag-NYSE for at least five years,without issuing equity for cash during that time.If a nonissuer subsequently issues equity,it is still used as the matching firm.If a nonissuer gets delisted prior to the delisting(or the fifth anniversary,or Dec.31,2001), the second-closest matching firm on the original IPO date is substituted,on a point-forward basis.For firms with multiple classes of stock outstanding,market cap is calculated based using only the class in the SEO for the SEO. For nonissuing firms,each class of stock is treated as if it is a separate firm.The sample size is 7,760 SEOs from 1970-2000 when size-matching is used,excluding SEOs with an offer price of less than $5.00,ADRs,REITs, closed-end funds,and unit offers.All SEOs are listed on CRSP for at least 6 months,and after Nasdag's inclusion, are listed within six months of going public.Returns are measured through December 31,2001.For partial event- years that end on this date,the last partial year is deleted from the computations.In other words,for an SEO that issued on March 15,2000,it's first-year return is included,but not the second-year return. 10
10 year, according to Table 1 below). Partly this is due to “market timing,” and partly it is due to abnormal performance relative to a benchmark. The conclusions regarding abnormal performance are hotly debated, and sensitive to the methodology employed and the sample used. Figure 1 illustrates the evidence regarding average annual returns in the five years after issuing. The numbers show that, for 7,760 SEOs from 1970-2000, the average annual return in the five years after issuing is 10.8%. Nonissuing firms of the same size (market capitalization) have average annual returns of 14.4%. Therefore, relative to a size-matched benchmark, issuers underperform by 3.6% per year for five years. Table 1 Mean percentage returns on SEOs from 1970-2000 during the first five years after issuing First six months Second six months First year Second year Third year Fourth year Fifth year Geometric Mean years 1-5 SEO firms 6.7% 1.5% 9.4% 3.6% 10.9% 14.7% 15.9% 10.8% Size-matched 6.1% 7.0% 14.0% 12.9% 14.4% 15.3% 15.5% 14.4% Difference 0.6% -5.5% -4.6% -9.3% -3.5% -0.6% 0.4% -3.6% Number 7,502 7,475 7,504 7,226 6,603 5,936 5,188 7,760 SEO firms 7.4% 2.2% 10.6% 5.3% 12.3% 14.2% 14.2% 11.3% Stylematched 5.4% 5.6% 11.5% 13.6% 15.6% 16.9% 15.9% 14.7% Difference 2.0% -3.4% -0.9% -8.3% -3.3% -2.7% -1.7% -3.4% Number 6,638 6,622 6,638 6,289 5,711 5,123 4,448 6,638 All averages are equally weighted. For the first year, the returns are measured from the closing market price on the issue date until the sixth-month or one-year anniversary. All returns are equally weighted average returns for all seasoned equity offerings (SEOs) that are still traded on Nasdaq, the Amex, or the NYSE at the start of a period. If an issuing firm is delisted within an event year, its return for that year is calculated by compounding the CRSP value-weighted market index for the rest of the year. The matching firm is treated as if it delisted on the same date, and its return for the remainder of the year is calculated using the CRSP VW index. Thus, once an SEO is delisted, by construction there is no abnormal performance for the remainder of the year. For the size-matched returns, each SEO is matched with a nonissuing firm having the same market capitalization (using the closing market price on the first day of trading for the SEO, and the market capitalization at the end of the previous month for the matching firms). For the style-matched returns, each SEO is matched with a nonissuing firm in the same size decile (using NYSE firms only for determining the decile breakpoints) having the closest book-to-market ratio. For nonissuing firms, the Compustat-listed book value of equity for the most recent fiscal year ending at least four months prior to the SEO date is used, along with the market cap at the close of trading at month-end prior to the month of the SEO with which it is matched. Nonissuing firms are those that have been listed on the Amex-Nasdaq-NYSE for at least five years, without issuing equity for cash during that time. If a nonissuer subsequently issues equity, it is still used as the matching firm. If a nonissuer gets delisted prior to the delisting (or the fifth anniversary, or Dec. 31, 2001), the second-closest matching firm on the original IPO date is substituted, on a point-forward basis. For firms with multiple classes of stock outstanding, market cap is calculated based using only the class in the SEO for the SEO. For nonissuing firms, each class of stock is treated as if it is a separate firm. The sample size is 7,760 SEOs from 1970-2000 when size-matching is used, excluding SEOs with an offer price of less than $5.00, ADRs, REITs, closed-end funds, and unit offers. All SEOs are listed on CRSP for at least 6 months, and after Nasdaq’s inclusion, are listed within six months of going public. Returns are measured through December 31, 2001. For partial eventyears that end on this date, the last partial year is deleted from the computations. In other words, for an SEO that issued on March 15, 2000, it’s first-year return is included, but not the second-year return