Under continuing journal review at March 15, 2005. Please do not cite without authors’ permission
Equity Private Placements, Liquid Assets and Firm Value
January 29, 2005
LeRoy D. Brooks
Edward J. and Louise E. Mellen Chair in Finance
Department of Economics and Finance
John M. and Mary Jo Boler School of Business
John Carroll University
University Heights, OH 44118-4581
[email protected]
J. Edward Graham*
Department of Economics and Finance
Cameron School of Business
University of North Carolina at Wilmington
Wilmington, NC 28403-3201
910-962-3516
[email protected]
*contact author
1
Equity Private Placements, Liquid Assets and Firm Value
Abstract
The study finds wealth enhancement from equity private placement issuances that add
additional liquid assets to financially slack-poor companies. This result runs counter to the
expected Jensen’s (1986) excess free-cash-flow problem, where the predominant results of
numerous studies find negative wealth effects from externally financing liquidity enhancements.
We also find greater announcement period returns for smaller firms and firms with better recent
prior performance. Investors appear to view either of these factors, together with the private
investor’s willingness to provide additional liquidity, as an asymmetric information release on
expected future survival and performance improvements.
(JEL: G14 and G32)
Keywords: Private equity offerings, financial slack, liquidity.
2
Introduction
The primary objective of this study is to measure the strength of an unexamined premise
that investors’ positive response to Equity Private Placement (EPP) announcements are related to
a firm’s need for more liquid resources.1 Most research examining liquidity additions (for
examples see: Lehn and Poulsen 1989, Mann and Sicherman 1991, Perfect, Peterson and
Peterson 1995, and Harford 1999) provides substantial evidence of an excess free-cash-flow
problem and an over-accumulation of liquidity.2 We examine EPPs since they more likely
represent a desirable liquidity enhancement event than would be found with public equity and
public and private debt offerings. This expectation comes from EPPs being offered by companies
that are likely precluded from using these alternative lower-cost external-funding methods. Our
study can be viewed as an “acid test” on seeing if the excess free-cash-flow condition dominates
the need for liquidity enhancement for even the more financially distressed firms found in EPPs,
relative to the less distressed firms generally found with seasoned public equity offerings.
Alternatively, EPPs may represent a wealth enhancing event for firms seeking external capital
that need more liquidity or financial slack. Irrespective of which of the two outcomes above hold,
the study will also contribute to a better understanding of investors’ evaluation, and consequent
valuation, of EPPs.
The conditions in the EPP issuance environment also are conducive to directly measuring
the valuation effects from liquidity enhancements. Most externally-funded liquidity-enhancing
1
Myers and Majluf (1984), Jensen (1986) and Stulz (1990) theoretically establish that firm value is first
enhanced and later reduced as the firm acquires liquidity. Capital markets are expected to favor the inflow of costly liquid
assets to avoid excessive stock-out costs, but penalize excessive liquidity due to excessive carrying costs.
2
Very limited evidence supports firm value enhancement from liquidity additions. For example, liquidity is
more valuable to firms with greater growth opportunities, according to Opler, Pinkowitz, Stulz, and Williamson (1999),
who find a relationship also between greater liquidity levels and riskier cash flows.
3
events occur jointly with the release of material other non-liquidity related information. The
reliable measurement of the effect from liquidity enhancement is then compromised. By its
decision to publicly procure funds through the sale of securities or corporate assets, management
also reveals asymmetric inside information on changes in past and expected future cash flows,
changes in growth prospects and shifts in risks. Separating the liquidity enhancement valuation
effect from these other information effects is difficult. Similar to Hadlock and James’s (2002)
measure of the costly alleviation of information asymmetries provided by bank debt rather than
public debt, EPPs may represent positive (or less negative) informational and greater liquidityenhancing roles than public equity offerings. This condition is expected to hold since managers
share at least some of their asymmetric information on liquidity and non-liquidity conditions with
private placement investors (Hertzel and Smith 1993). Thereby, the market for EPPs ameliorates
the information asymmetry problem from other non-liquidity related information releases found
in public equity offerings. Additionally, the Wruck (1989) adjusted-abnormal-returns measure
accounts for much of the resolution of information asymmetries occurring with an EPP
announcement relative to a seasoned public equity offering.
The initial publication of a firm’s decision to issue equity privately is commonly received
favorably.3 This is in contrast with general equity issues that are broadly seen as negative signals
by investors.4 Prior studies (see, for example, Wruck 1989, Fields and Mais 1991, Hertzel and
Smith 1993 and Janney and Folta 2003) attribute these atypical patterns to desirable information
releases and improvements in ownership structures associated with EPPs.
3
A private placement is a debt or equity issue that involves no public offering; as such, the issue is
commonly exempt from registration with the Securities and Exchange Commission (SEC).
4
See: Smith (1986), Asquith and Mullins (1986), Masulis and Korwar (1986) and Mikkelson and Partch
(1986). In addition, Spiess and Affleck-Graves (1995), Loughran and Ritter (1997) and Teoh, Welch and Wong
4
Hertzel and Rees (1998) find a positive relationship between a set of EPPs’ announcement
period abnormal returns and subsequent earnings increases in contrast to typically adverse signals
by public equity issues. Goh, Gombala, Lee and Liu (1999) also discover a positive relationship
between announcement period abnormal returns and analysts’ upward revisions of earnings
forecasts. The earnings improvements noted in these last two studies may be related in part to
value-enhancing impacts of adding needed liquidity, though this relationship is not directly
tested. Our objective is to determine if investors perceive liquidity enhancements as desirable.
Finding that they can be desirable, we then determine the company’s positive and negative
factors that affect the level of desirability.
Hertzel, Lemmon, Linck and Rees (2002) find long-term post-issue operating and stock
return underperformance for each of several years following EPPs.5 Barclay and Holderness
(2001) suggest that the placements serve to further entrench an underperforming management.
Alternative explanations come from behavioral finance where investors may overprice security
issuance in hot market conditions. As examples, Bayless and Chaplinsky (1996) and Chan,
Jegadeesh, and Lakonishok (1996) examine hot market conditions. Kahneman and Tversky
(1972), Barber and Odean (2000) (2001), and Ofeck and Richardson (2003) provide alternative
behavioral explanations and evidence. This literature and the Hertzel, et al. (2002) evidence are
consistent with a material component of the positive EPP announcement effect reflecting a
behavioral overvaluation bias and not the issuing companies’ true economic need for additional
liquidity.
(1998) also find that issuers suffer long run stock and operating underperformance after the offerings.
5
For seasoned equity offerings Spiess and Affleck-Graves (1995), Loughran and Ritter (1997) and Teoh,
Welch and Wong (1998) also find that issuers suffer long run stock and operating underperformance after the
offerings.
5
Consistent with a positive role for liquidity enhancement, and inconsistent with an excess
free-cash-flow problem, investors respond more positively to liquidity enhancements by betterperforming and smaller firms. Given the Hertzel, et al. (2002) and behavioral studies’ results, this
positive response might represent a faulty overvaluation of these securities. With this caveat
aside, also inconsistent with a Jensen’s (1986) excess free-cash-flow problem, a negative
response to liquidity enhancement is not found for the more liquid announcing firms. Existing
liquidity levels and recent firm performance likely serve as proxies for expected future better
performance and a better likelihood of survival, and stronger firms are rewarded more at
announcement. In all, an explicit consideration of the role of liquidity enhancements adds to our
understanding of the investors’ announcement date valuation behavior of EPP announcement
effects.
The next section provides the set of research questions and hypotheses. The third section
contains the empirical model that addresses our research questions, while the fourth section
describes the data and provides descriptive statistics and sample comparisons with prior similar
studies. Announcement period abnormal returns, factors contributing to them and the test of a
desirable liquidity hypothesis are presented and evaluated in the fifth section. The paper closes
with summary and concluding remarks.
Research Questions and Hypotheses
Does the desirable liquidity hypothesis or an excess free-cash-flow problem dominate with
EPP fund acquisitions?
It is unclear whether available liquidity influences market responses to EPPs. As Ang
(1991) notes, the value of financial slack – or funds available to a firm beyond those needed for
6
continuing operations – is controversial unto itself, independent of a firm's financing activities.
Jensen’s excess free-cash-flow problem appears to dominate investors’ evaluation of liquidity
additions. An extensive literature reveals the market's negative response to excess liquidity
accumulation, but very limited evidence (Smith and Kim (1994)) supports possible value
creation from liquidity enhancement. For example, Pilotte (1992) finds an excess free-cash-flow
problem with seasoned equity offerings while Smith and Kim (1994) do not.6 Hertzel and Smith
(1993) reveal that firms in financial distress - an indirect proxy for slack poverty - are favorably
treated when they announce EPPs. Hertzel and Smith do not, however, directly examine whether
announcement period returns are significantly related to available slack. Capital markets should
punish the accumulation of excess liquidity, but reward improved liquidity if it is needed by
slack-poor firms. In a more focused search for desirable liquidity enhancing events in testing for
the desirable liquidity hypothesis, we use additional liquidity variables not previously considered
when examining the investors reactions to EPP announcements. The objective is to more fully
describe investors’ responses to firms’ liquidity infusions from EPPs.
What are the variables associated with market responses to liquidity infusions for the firm?
Positive or negative stock price effects with liquidity enhancements should be related to a
firm’s specific characteristics. Greater liquid asset requirements and higher liquidity “optima”
exist for a firm with more growth options and/or more volatile cash flows. The higher liquidity
optima for the growing firm comes from very high stock-out costs, which arise from a greater
opportunity loss when the company cannot exercise valuable expiring growth options. Similarly,
6
Smith and Kim (1994) consider the potential for the mitigation of the under-investment issue of Myers and
Majluf (1984) and the free-cash-flow problem of Jensen (1986) by the combination of slack-poor firms with those
having excess free-cash-flow.
7
greater cash flow variance requires greater safety-stocks of liquidity. Management competence
also affects the optimal level of liquidity and the distance between the actual liquidity level and
the optimal level. An entrenched management with greater potential to misallocate liquid
resources lessens the ideal liquidity level, while managers retaining excess liquidity above the
optimal also incur greater marginal costs of free-cash-flow (Jensen (1986)). Thereby, growing
and riskier firms need higher liquidity levels than established firms that have lower valued
growth options and more stable cash flows.
Does the liquidity hypothesis persist after controlling for monitoring and other affecting
conditions?
To better isolate any liquidity effects, we also examine other firm characteristics that are
expected to measure and control for corporate control related monitoring effects and for the other
factors potentially contributing to the asymmetric information released at an EPP announcement.
Wu (2004) finds that EPP firms have more asymmetric information than public equity offering
firms. The monitoring hypothesis holds that greater monitoring of managers contributes to wealth
creation. EPP studies by Wruck (1989) and Hertzel and Smith (1993) show that transactions that
increase ownership concentration, such as a substantial stock position purchase by a private
investor, raise share prices. Hertzel and Smith (1993) argue that private investors initially provide
monitoring by requiring sufficient information from managers so that they can determine the
company’s true value, including the value of the projects to be funded with the EPP. While they
retain their ownership position in the company, private investors monitor the company.
Discounting the monitoring hypothesis, recent evidence by Wu (2004) demonstrates that EPP
investors do not engage in more monitoring than public offering investors. Nevertheless, we will
consider monitoring variables to see if investors are unsoundly overvaluing monitoring changes
8
that occur at the EPP announcement. This result, given Wu’s (2004) findings, would represent an
unsound behavioral overvaluation phenomenon if investor’s positively respond to monitoring
changes that provide no future company value improvements.
We will also consider differences in the asymmetric information released by other
company and issue characteristics that are related to specific possible hypotheses. These will be
considered when we define the variables and discuss the results. The results from prior literature
and our discussion above lead to tests of the desirable liquidity, excess free-cash-flow,
asymmetric information and monitoring hypotheses.
Methodology
Rather than the market "guessing" at the information release in a public equity issue
announcement, the private placement investor signals his or her belief in any "hidden" firm
value. This occurs because managers first provide private investors with asymmetric information
about the company not known by outside investors, enabling the private investor to determine the
true value of the company (Hertzel and Smith 1993). Next, the private investor provides outside
investors a signal of this value by the size of the investment and the discounted or premium
purchase-price per-share paid, relative to the pre-announcement stock price. Considering this
information, Wruck’s (1989) adjusted measure, conventionally used in later EPP studies,
accounts for this asymmetric information release by explicitly considering the private investor’s
share price relative to the pre-announcement public share price. Her measure, although
questioned in recent work by Wu and Wang (2002), still allows for a better measure of the
portion of the announcement return due to factors directly related to the financing and use of
9
acquired funds while mitigating information asymmetry effects. Thereby, her adjusted measure
provides a better opportunity to find support for a desirable liquidity hypothesis with EPPs than
would be expected by examining seasoned public equity offerings.7 This condition may have
contributed to prior studies of public equity offerings not finding any evidence of a desirable
liquidity hypothesis and contributes to the prospect of finding support for the hypothesis when
examining EPPs in this study.
Specification of the dependent variable
A dependent variable is constructed with abnormal returns measured in two ways. The first
measure is the traditional abnormal return for the issuing firm over the period from three days
before the announcement to the day of the announcement, if there is time to trade an announcing
firm’s stock on the announcement date. For firms announcing after the close of trading, the first
trading day after the announcement is treated as day 0. This unadjusted abnormal return measure
is calculated as:
^
^
ARi,t = Ri,t  [  i   i (Rm,t)]
(1)
where ARi,t is the abnormal return for firm i in period t, Ri,t is the total return for firm i in period
^
^
^
t, and [  i   i (Rm,t)] is the market-model predicted return for firm i in period t;  i is the
intercept for security i predicted from the pre-event estimation period from day -200 to day -60;
^
 i is the slope coefficient of security i over this same pre-event estimation period and Rm,t is the
Center for Research in Security Prices (CRSP) value-weighted return of the market during period
7
An unadjusted measure of market responses employed in the empirical tests that follow serves as a test of
10
t. Abnormal returns are measured for selected event windows between days -29 and 10. The
second measure is the adjusted abnormal return employed as the dependent variable in this
study:
ARi,tADJ = [1/(1 -  )][ARi,t
 /(1 -  )][(Pb - P0)/Pb]
(2)
where ARi,tADJ is the adjusted abnormal stock return for firm i in period t,  is the ratio of shares
placed to shares outstanding after the placement for firm i, and ARi,t is the traditional measure of
the abnormal return for firm i in period t from Equation 1. Pb is the market price two days prior
to the event window taken from the CRSP files, and P0 is the placement price. The element (Pb P0)/Pb is the discount received by the private placement purchaser.8
The placement price is taken from the announcement. The estimation period for the
parameters of the model providing the adjusted returns measures is the same as for the
unadjusted measure; similarly, a four-day announcement period adjusted abnormal return is
selected for cross-sectional study from day -3 to day 0.9 10
the robustness of this study’s findings, and at least partially offsets some of Wu and Wang’s (2002) concerns.
8
A negative “discount” represents a premium paid by the purchaser.
9
No set “event window” is favored by all researchers. In the interest of consistency and building on prior
studies of private placements, the four-day window starting three days before the private placement announcement is
used.
10
An unreported supplemental test was conducted to account for potential pre-and post-parameter
estimation bias. There may be a change in the variability of a stock’s returns after the placement announcement,
given the financial leverage decrease associated with the equity infusion from the offering. Pre-event parameter
estimates are biased and miss-specified if the return variability change modifies the covariance of the stock’s return
with the market. To account for this, a second set of parameter estimates are prepared over the period from day 11
to day 151. The results using our reported and this supplemental test are similar, thus the results are robust to this
estimation bias.
11
Specification of the dependent variables
Various theories predict stock price changes based upon a set of descriptive independent
variables. Variables from that set are employed in the tests below and are listed in Table 1.
TABLE 1 ABOUT HERE
Liquidity and change in liquidity factors are used to capture the meaningfulness of the
impact from liquidity on company value changes at the time of the placement announcement.
Earnings/price, new product and working capital variables proxy for the importance of growth
options in describing market responses to private placement announcements. Investor-type
dummy variables (for single or foreign or management buyers) and ownership concentration
measures are employed to discover the significance of changes in the firm’s ownership in
explaining stock price announcement effects. Finally, dummies for financial distress, the
restricted (SEC unregistered) status of the shares issued and the stock’s recent performance – all
shown to be descriptive in prior research - are adopted as control variables. Firm size, ubiquitous
in studies of market responses to corporate news, is also used to control for the portion of the
market’s response attributable to the size of the company.
Data and Descriptive Statistics
Sample selection
The sample of EPPs contains 67 announcements having sufficient information on the
company, issue, and ownership needed to test the various hypotheses potentially explaining EPP
announcement returns. We first drew an initial set of 543 announcements on the Business News
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Wire between 1988 and 1995. This announcement search required the word “private” jointly with
one of the following words: placement(s), offering(s), stock-purchase(s), purchase(s), sales(s)
and stake(s). Only 303 observations have more than a cursory mention of the private financing
that are also equity offerings. Recapitalizations, which are not private equity placements, and
foreign companies, where we do not have access to the required accounting and returns data,
further narrow the sample to 215 observations. The sample of 215 represents the available
sample of equity private placements.11 Data requirements needed from CRSP, Compustat and
Compaq Disclosure and elimination of offerings with other simultaneous information result in a
residual sample of 84 observations. Shown in Table 2, six other conditions potentially
contaminating observations reduced the sample by 17 observations, resulting in the final data set
of 67 EPP announcement observations. The issuing activity is concentrated in the last three years
of the sample period.12
TABLE 2 ABOUT HERE
Sample characteristics
Company, issue and the pre-announcement ownership positions on the final sample are
described in Table 3. Panel A of Table 3 contains the Purchaser Characteristics of the EPPs.
The purchaser information is taken from the text of the private placement announcements in the
Business News Wire. No single group dominates the purchaser descriptions. Sixteen of the
purchasers are single and/or foreign. Twenty-four are institutional or corporate with all of the
11
The text of the private placement announcements varies. Several of the announcements are exhaustive,
providing extensive data on the relative and absolute size of the placements. Data include private investor
characteristics, proposed use of the EPPs proceeds, perceived needs by the firms for the arriving liquidity,
information on the ownership structure changes resulting from the private placement and whether the issues are
registered (unrestricted) or unregistered (restricted). A few of the announcements, however, are brief. The
announcements vary in size from 60 words to several hundred.
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corporate buyers in related businesses. Nine of the purchasers are managers or directors at the
time of the purchase with 11 outside buyers becoming managers or directors with the purchase.
No information on the buyer(s) is given in 26 of the announcements. These characteristics sum
to over 67 as many buyers share multiple features.
TABLE 3 ABOUT HERE
Placements Characteristics are in Panel B of Table 3. The mean size of the primary sample
is $5 million; this small placement size is further highlighted by a median placement size of only
$2.4 million. The largest placement is for $22.5 million. The fraction of shares placed in the
private issues varies from less than 1% to 34.9% of shares outstanding after the placement.
Using outstanding shares as reported in Compaq Disclosure, the average and median fractions
placed are around 12%, with the median slightly less than the mean. Discounts given to the
private placement purchasers by the issuing firms vary, as well. The greatest discount relative to
the firm's publicly traded stock price five days before the announcement is 77.7%. The smallest
"discount" is a premium paid of 16.6% over the firm's stock price. The mean and median
discounts are just over 20%. Sixteen of the issues are of registered shares, 24 of unregistered
shares and 27 of the announcements do not disclose the registered or unregistered status of the
issue.
Firm Characteristics of firms having the placement announcements are in Panel C of Table
3. Market values of equity, based on share prices five days before the issue and most recent
annually reported shares outstanding range from $3.3 to approximately $500 million, with an
average of around $68 million. Before the private issue, inside ownership of the firms varies
12
The by year distribution of observations follows: 4 in 1988, 1989 and 1991; 2 in 1990; 7 in 1992; 13 in
1993; 16 in 1994; and 17 in 1995.
14
from less than 2% to over 82%. The mean and median inside ownership levels are both around a
quarter with the median slightly less than the mean. Averages are increased relative to the
median measures by the larger observation measures.
As of the respective announcement dates, firms’ most recent annually reported asset sizes
in Compustat range from around $0.5 million to over $70 million. Average and median asset
levels of $17.5 million and $10.61 million are reported in Table 3. Book-to-market equity ratios
range from around zero for one firm with marginally negative reported stockholders equity to a
maximum of 1.65. This measure is developed using market prices five days before the issue and
the most recently reported stockholders equity in Compustat. In Table 3, a mean book-to-market
equity ratio of .294 is observed, with a median of .177.
The stated Placement Purposes of the placement proceeds vary and are revealed in Panel D
of Table 3. Purposes are drawn from the text of the announcements. Half (34) of the issues are
for new products. Twenty-three of the placements generate funds for working capital; eight are
for debt payoff. Three provide funds to be used, at least partially, in acquisitions. Fourteen of
the announcements do not reveal the purpose of the private placement proceeds. Announced
fund uses sum to over 67, as many firms report multiple intended uses for their private placement
proceeds.
Sample comparisons with prior studies
Employing information from the three sections of Table 3, we compare our sample
characteristics with the two major studies of EPPs by Wruck (1989) and Hertzel and Smith
(1993) in Table 4. This comparison is needed since we use some of the same variables and
examine some of the same hypotheses covered in their studies. An evaluation of our results with
15
theirs will enable insights on what hypotheses appear to be robust to different time periods and
sample characteristics and what ones appear to be time-period or sample specific.
In Panel A, the purchaser "mix" is materially different, with the Hertzel and Smith (1993)
study dominated by outside buyers. A more favorable response may result for the Hertzel and
Smith sample due to greater potential corporate control benefits arising from the greater
monitoring expected by the addition of large block outside shareholders. Our sample’s purchaser
mix is quite similar to Wruck’s (1989) study.
TABLE 4 ABOUT HERE
Panel B of Table 4 reveals that our sample’s placement characteristics contrast with those
in the other studies. The size of the placements used in this study is smaller than either of the
former works, averaging proceeds from $11 and $32 million in their studies versus $5 million in
this study. The 11.8% average fraction placed in the current study is also less than the average
relative portion of stock issued in the previous private placement samples. Average discounts
granted are similar to the 20.1% discount in the Hertzel and Smith (1993) study, but are far
greater than the average discount of 4.8% that we estimate for the Wruck (1989) study. This
difference between the average fractions placed and discounts given to the purchasers in the
Wruck (1989) and our study is consistent with our sample including smaller firms with poorer
financial health, likely representing a need for external funds to alleviate a liquidity problem.
This belief in furthered by the results in section C of Table 4 where her average issuing firm’s
market value is more than three times larger than in our sample.
In Panel C of Table 4, firms’ average market values of equity is only $68.12 million versus
the average capitalizations of $233.7 million in Wruck (1989) and $94.7 million in Hertzel and
16
Smith's (1993). The ownership concentrations of the firms in the three studies are similar,
however, averaging between 26% and 31% of shares outstanding before the private placement
announcements. Contrasts with these earlier private placement samples show that these are
smaller firms likely followed by fewer analysts and, thereby the market's overall responses will
be more extreme than for the larger firms for whom the announcement would be expected to
release less asymmetric information.
Results
Announcement period returns
Logged announcement period abnormal returns are given in Table 5. Panel A includes the
traditional and unadjusted mean cumulative abnormal returns (CARs) measured using Equation
1. Panel B provides the mean CARs derived using Equation 2. Results reported in Table 5
include event windows adopted by other private placement studies.
TABLE 5 ABOUT HERE
First, the average firm’s lose significant and material wealth prior to the announcement
period of 18.4% with unadjusted returns and 8.6% with adjusted returns. This result is opposite
the effect found with seasoned public equity offerings and is indicative of EPP announcers
having unfavorable conditions to be able to issue equity with a public offering. Second, The
significant positive abnormal returns during the (-9, 0) period for the unadjusted returns and (-3,
0) for unadjusted and adjusted returns reconfirm the positive announcement effect systematically
found in studies of EPPs. During the announcement event window, stock prices reverse the prior
negative stock price performance with or without adjustment; this indicates that outside investors
17
view the announcement as unexpected positive news on the future prospects of the announcing
companies. Third, no abnormal performance is noted in the post-announcement (1, 10) period.
Consistent with a semi-strong form of efficient markets hypothesis, investors re-equilibrate share
prices due to the information revealed in the EPP announcement by the end of trading of day of
the information release.
The adjusted returns measure is intuitively appealing. If the firm privately issues a
significant portion of firm equity, averaging around 12% in this study, at a discount and the
market does not penalize stock price, then a favorable response is implied even if the stock price
change is neutral or moderately negative. The contrast between the positive observed returns in
this study and the negative average market reaction to seasoned equity issues, where no discount
is intended by management, demonstrates the reversal between investors’ response to EPPs and
seasoned public equity offerings. The probable factors affecting the adjusted abnormal returns in
the primary event window are examined in the following section.
Empirical predictions and tests of the desirable liquidity and other hypotheses
OLS regression analysis is used to determine whether or not liquidity additions are viewed
by investors to add value to EPP announcing firms. The independent variables used in the
regression, a summary of the predicted signs of the independent variables’ coefficients, the
regression coefficients and the probability that the coefficients are equal to zero are in the four
columns, respectively, of the cross-sectional test results provided in Table 6. Coefficient signs
and significance levels in the third column are compared to the sign predictions provided in
18
column 2 in providing evidence on the supported and unsupported examined hypotheses.13
TABLE 6 ABOUT HERE
Consideration of value enhancement from desirable liquidity additions
Supporting the desirable liquidity hypothesis, the investors respond more positively to EPPs
with greater levels of liquidity additions in Panel A of Table 6. A significant negative reaction to
the change in liquidity would be expected if an excess free-cash-flow problem were further
exacerbated by higher levels of liquidity. Additionally, derived prior to the liquidity infusion
from the placement proceeds, the liquidity level variable in Table 6 is not significantly affected
by the level of abnormal announcement returns. This result, together with a positive and
significant regression intercepts coefficient of 0.378%, is consistent with investors viewing all
EPPs to be homogeneous with respect to the need to add liquidity or financial slack. Our results
refute the holding of an excess free-cash-flow problem even for the more liquid issuing EPP
companies. In two unreported tests, where the liquidity change variable is excluded, the liquidity
level variable or an interactive factor between liquidity change and liquidity level are positive
and significant. These results continue to support the desirability of liquidity enhancement while
denying the holding of an excess free-cash-flow problem.
Consideration of the impact from growth opportunity differences
The empirical implications of growth options in tests of a liquidity hypothesis are outlined
in Panel B of Table 6. Proxies for growth options, described in Table 1, include an
earnings/price ratio and dummies for new product and working capital investment. First, the
earnings/price factor is negative and marginally significant (p-value equal to .11) in describing
13
Customary tests for model specifications and tests for violations of the standard statistical assumptions
do not temper the primary Table 6 results or those of the unreported supplemental tests.
19
market responses to the announcements in the reported tests, and it is consistently more
significant in unreported tests excluding other explanatory factors. The growing firm, having a
higher P/E (and lower earnings/price ratio), is typically more favorably treated by investors.
Higher pre-announcement growth levels appear to serve as greater certification to outside
investors of a company’s superior investment opportunities. Second, opposite the anticipated
positive response to a new product investment, the new product dummy variable is negative and
significant. Investors appear to see the use of funds to be a negative NPV decision and possibly a
desperation act to revive a failing firm. This condition would be more likely in an EPP
environment where financially weak companies are already excluded from funding the new
product internally, by debt or by public equity issues. Third, the working capital dummy variable
is neither significant nor informative to investors in determining the value impact of an EPP.
Consideration of ownership effects
In a model used by Morck, Shleifer and Vishny (1988), a piecewise linear model is adopted
to test the importance of changes in ownership concentration in explaining market responses to
announced liquidity infusions. Evidence provided in Panel C of Table 6 is consistent with Wruck
(1989) and Morck, Schleifer and Vishny (1988), although we only find a negative-signed and
moderately significant coefficient estimate for the entrenched level of inside ownership from 5 to
25%.14 15 This intermediate level of ownership may allow management control of corporate
assets, without sufficient ownership to discourage misallocations. Fears of increasing costs of
14
Our insignificant and weak significance levels are consistent with Morck, Shleifer and Vishny (1988)
and Wu (2004) where ownership effects are less important with information releases by smaller firms, heavily
represented in our sample; ownership effects are more significant for the more closely monitored and larger firms.
Separate unreported tests employing a single ownership concentration factor are not noteworthy.
15
The small firm sizes and insignificant results in unreported regressions lead to the exclusion of dummy
variables representing the single purchaser, foreign investors or management investors in the Table 6 regression test.
20
entrenchment likely contribute to this negative market response.
Control variables in tests of a desirable liquidity hypothesis
A set of factors used in earlier private placement studies is adopted in Panel D of Table 6 to
control for information releases related to firm size, performance and the nature of the securities
being privately issued. The tests use dummy control variables for financial distress, restricted
shares and prior underperformance, along with the log of firm size.
First, the financial distress factor is insignificant; investors do not differentiate between
EPP issuers based on their financial condition in determining value differences across issuers.
Second, the dummy for the restricted or unregistered stock issue, significant in prior studies, is
not significant in these tests. The Securities and Exchange Commission's (SEC) approval of Rule
144A in 1990 allows financial institutions with more than $100 million invested in securities to
trade unregistered private placed securities freely among themselves. Furthermore, broker-dealers
with at least $10 million in proprietary positions and assets under management may also
participate in such transactions. Hence, Ru1e 144A increases the private placement market
liquidity of unregistered shares and decreases the likelihood of finding economic differences in
the valuation of registered and unregistered shares since the passage of the legislation.
Third, firm size is significantly negatively related to investors’ reaction to EPP
announcements in Table 6. Investors view the EPPs of smaller firms to be more valuable than
that of larger firms. This result could come from three conditions: (1) investors’ view that
liquidity enhancement is needed more for smaller firms, (2) larger firms are more likely
experiencing an excess free-cash-flow problem, and (3) smaller firms have more asymmetric
information released at the announcement than larger firms. Consistent with item (2) and Jensen
21
(1986), the larger firm is assumed, ceteris paribus, to have greater access to liquid assets. It is
then more able and likely to have an excess free-cash-flow problem. Thereby, it receives a less
favorable response to announcements because of an expected excess liquidity infusion from an
EPP. Item (3) holds when an EPP announcements leads to a positive investor response, well
documented in prior studies and Table 5, and smaller firms have greater information asymmetry
than larger firms. Smaller firms are likely to be less able to secure needed liquidity, and the
signal represented by the private investors’ willingness to provide additional liquidity, given their
greater knowledge of inside information, would lead to a more favorable investor response. Risks
of management entrenchment may also be greater with larger firms. Because of the joint holding
of several hypothesis contributing to the size factor, we use this control variable to recognize
alternative hypotheses and we do not assert that the results from size is necessary to support the
holding of a desirable liquidity hypothesis.
Conclusions
Providing one more piece to the equity-issue puzzle, liquidity enhancements contribute to
value enhancement of EPP company announcements. Prior research defining the roles of the
free-cash-flow hypothesis, information theoretic models, and ownership structure theory is
supplemented by our results. The desirable liquidity hypothesis dominates the free-cash-flow
hypothesis with EPPs, which is opposite to the condition found by Pilotte (1992) with companies
announcing public equity offerings. Our results on the value of cash infusions fulfills the
objective of the study to determine if there is support for the position that liquidity enhancement
can be of value.
22
Our tests reveal that an important link exists between market responses to private equity
issues, the amount of liquidity provided by those issues and the size and investment prospects of
the firm. Not observed in prior studies, the excess free-cash-flow hypothesis is supplemented
with a finding that substantial cash inflows are not necessarily associated with unfavorable
market responses for firms issuing equity. The smaller and presumably less diversified firms with
greater growth options experience more positive returns upon announcement than their
counterparts. Results are consistent with the private buyer delivering positive information to the
marketplace with his or her purchase. One question remains unanswered; does the liquidity
enhancement effect at announcement have a positive impact on the long term post performance
and survival of the companies? If this condition holds, an economic rationale exists for investors’
positive reaction to liquidity enhancements by EPPs. If this condition does not hold, a behavioral
finance condition is occurring where naïve investors are falsely overvaluing the benefits of the
liquidity additions, and thereby overvaluing the firm. Given the results of Hertzel et al. (2002),
the later outcome is more likely, although it is possible that liquidity enhancement ameliorates
the post offer equity value declines that they find.
Consistent with Morck, Shleifer and Vishny (1988) and Wu (2004), ownership structure
and the associated importance of monitoring managers is less important for the smaller firms in
this study than for larger firms in similar studies. Nonetheless, changes in ownership
concentration pursuant to the private placement are associated with non-monotonic changes in
firm value. At intermediate levels of ownership concentration between 5 and 25% of outstanding
shares, increasing concentration is associated with negative adjusted abnormal returns. Increases
in concentration above and below this intermediate level reveal insignificant market responses. A
23
proxy for a firm’s growth opportunities is positive and weakly significant and new product
announcements are received unfavorably. Firm size is a robust negative factor in explaining EPP
announcement returns.
A proxy for restricted or unregistered shares is not significant. Recent and more relaxed
SEC guidelines likely contribute to the reduction in the significance of an unregistered private
equity sale, relative to findings of a significant positive response in earlier private placement
studies. Results in this study affirm findings by many authors of the importance of such factors as
firm size and ownership structure in describing market responses to a firm’s information release.
Findings frame the significance of liquidity in describing market responses to these
announcements, and encourage the inclusion of liquidity measures in subsequent studies of
equity issues in general and EPPs in particular.
24
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27
TABLE 1. VARIABLE DEFINITIONS
Liquidity Level &
Change in Liquidity
Earnings/Price
New Product
Working Capital
Single/Foreign
Investor
Management Buyer
Ownership:
Concentration Level 1
Ownership:
Concentration Level 2
Ownership:
Concentration Level 3
Financial Distress
Restricted Shares
Prior
Underperformance
Firm Size
Liquidity Level is liquid assets divided by funds required for preferred
dividends and current operating and debt servicing needs. Change in
Liquidity is the change in the liquidity measure resulting from the private
placement. Current data is defined as from the most recently reported
year prior to the announcement of the private placement. Liquid assets
are the sum of cash plus accounts receivable plus short term marketable
securities.
Measured by the ratio of earnings per share, for the most recently
reported year, to market price five days before the first announcement
of the private placement.
1 if the financial press indicates the private placement will be used to fund
a speculative new product and 0 otherwise.
1 if the private placement proceeds are reported in the financial press as
intended by the firm to be used for working capital and 0 otherwise.
1 if the placement is sold to a single/foreign buyer and 0 otherwise.
1 if a manager or director is the buyer or if the buyer is friendly to or
controlled by management and 0 otherwise.
1 if management ownership after the placement is between 0% and 5%
and 0 otherwise. “Management ownership” includes beneficial control by
management of voting shares and common stock ownership by
shareholders noted as loyal to management in either the private placement
announcement or SEC reports as provided by Compaq Disclosure.
1 if management ownership after the placement is between 5% and 25%
and 0 otherwise. Management ownership is measured in this level in a
manner analogous to that used for Ownership Concentration Level 1.
1 if management ownership after the placement is over 25% and 0
otherwise. Management ownership is measured in this level in a manner
analogous to that used for Ownership Concentration Level 1.
1 if the firm has had 2 consecutive years of negative earnings and 0
otherwise.
1 if the shares to be placed are identified as restricted or unregistered and
0 otherwise. A search is made of the private placement announcement for
the words “restricted” or “unregistered”; if the SEC registration status of
the placement is not noted or is unclear, this variable will take on a 0
value.
1 if the firm’s raw holding period returns over days (-59, -10) are below
the average for the value-weighted index. This variable takes on a 0 value
for all other firms. Returns are calculated using the CRSP daily returns
file.
The log of total assets for the most recent reporting period prior to the
private placement.
28
TABLE 2. PRIMARY PRIVATE PLACEMENT ANNOUNCEMENT SAMPLE REDUCTION
CONDITIONS
Description
Initial Business News Wire keyword announcements
Only cursory mention of private placement
"Recaps” not identifiable as private placements
Foreign companies
Insufficient or unavailable CRSP data
Unavailable required Compustat data
Other simultaneous issue announcements
Insufficient insider ownership data on Compaq Disclosure
Banks and financial institutions
Both shares issued and size of placement not announced
Secondary offering or simultaneous sale by management
Simultaneous change in dividends
Second announcement of earlier issue
Highly influential outliers
Final sample used in initial tests
Number
543
240
34
54
77
20
18
16
7
3
3
1
1
2
Remaining
543
303
269
215
138
118
100
84
77
74
71
70
69
67
67
Notes: The initial sample of 543 observations come from Business News Wire using keyword
searches on the terms "private" jointly found with one of the following words: placement(s),
offering(s), stock purchase(s), purchase(s), sale(s), and stake(s) between January 1, 1988 and
December 31, 1995.
29
TABLE 3. SELECTED CHARACTERISTICS OF PRIVATE PLACEMENT
ANNOUNCEMENTS
Characteristics
Sample Size
Panel A. Purchaser Characteristics
Managers/Directors
Institutions/Corporations
Single/Individual
Test Sample
67
13.4%
35.9%
11.9%
Panel B. Placement Characteristics
Average Proceeds (millions)
Median Proceeds (millions)
Average Fraction Placed
Median Fraction Placed
Maximum Fraction Placed
Minimum Fraction Placed
Maximum Discount
Minimum Discount (premium)
Average Discount
Median Discount
$5.01
$2.40
11.8%
10.8%
34.9%
.2%
77.7%
(16.6%)
20.9%
20.7%
Panel C. Firm Characteristics
Average Market Value of Equity (millions)
Median Market Value of Equity (millions)
Average Ownership Concentration Pre-placement
Median Ownership Concentration Pre-placement
Average Firm Assets (millions)
Median Firm Assets (millions)
Average Market-to-Book Ratio
Median Market-to-Book Ratio
$68.12
$39.47
26.0%
23.1%
$17.50
$10.61
.294
.177
Panel D. Placement Purposes
New Products
34 (51%)
Working Capital
23 (34%)
Debt Payoff
8 (12%)
Acquisitions
3 (4%)
Notes: Each of the announcements meets requirements for available CRSP, Compustat and Compaq
Disclosure data. Announcements take place between January of 1988 and December of 1995.
30
31
TABLE 4. SELECTED CONTRASTS TO EARLIER STUDIES OF EQUITY
PRIVATE PLACEMENTS
Primary
Sample
N = 67
Wruck
(1989)
N = 128
Hertzel &
Smith (1993)
N = 106
Panel A. Purchaser Characteristics
Managers/Directors*
Institutions (Corporate)
Single/Individual
13%
36%
12%
13%
24%
11%
6%
50%
28%
Panel B. Placement Characteristics
Average Proceeds (millions)
Average Discount**
Average Fraction Placed
$5.01
20.9%
11.8%
$31.46
4.8%
19.6%
$11.38
20.1%
16.0%
$68.12
$233.7
$94.68
26%
30.7%
30.3%
Panel C. Firm Characteristics (preplacement)
Average Equity Market Value (millions)
Average Pre-placement Ownership
Concentration
Notes: The observations are contrasted to the data examined in earlier studies of private
placements of equity. Contrasting data are drawn from Wruck (1989) and Hertzel and
Smith (1993).
* Purchasers in the Wruck (1989) study are listed as “management controlled” and in the
Hertzel and Smith (1993) study as “management.” In none of these three studies were the
identities of the private placement purchasers revealed in every examined private
placement announcement.
**A weighted estimate of the average discount to placement purchasers in the Wruck
(1989) study is estimated from the information provided in her study.
32
TABLE 5. CUMULATIVE ANNOUNCEMENT PERIOD ABNORMAL RETURNS
Panel A: Unadjusted Returns
Event Windows
-29, -10
-9, 0
-3, 0
1, 10
Mean CAR
t-statistic
p-value
-18.43
-34.23
.0001
0.6123
1.61
.11
0.4871
2.02
.04
-0.001
-0.002
.99
Event Windows
-29, -10
-9, 0
-3, 0
1, 10
Mean CAR
t-statistic
p-value
-8.606
-15.99
.0001
5.695
14.96
.0001
2.518
10.46
.0001
-0.001
-0.002
.99
Panel B: Adjusted Returns
Notes: Cumulative abnormal returns (CAR) are calculated using the market model and
the value-weighted index. Unadjusted returns are measured using Equation 1.
Parameter estimates are calculated over the period (-200, -60). Adjusted returns are
measured using Equation 2.
33
TABLE 6. CROSS-SECTIONAL REGRESSION OF PRIVATE PLACEMENT
ANNOUNCEMENT PERIOD ABNORMAL RETURNS
Independent Variable
Predicted
Sign
Coefficient
P-Value
+/-
-.062
.193
.343
.002
Panel B. Growth options
Earnings/price
New product
Working capital
+
+
-.294
-.144
-.082
.111
.026
.241
Panel C. Ownership structure
Change in Level 1
Change in Level 2
Change in Level 3
+
+
15.659
-1.948
.663
.168
.093
.119
+/+
+/-
-.006
.067
-.153
-.090
.934
.391
.020
.002
Panel A. Liquidity
Liquidity
Change in liquidity
Panel D. Control variables
Financial distress
Restricted shares
Prior underperformance
Firm size
Intercept
n/a
.378
.008
White’s Spec. Chi-Sq.
n/a
60.56
.492
Adjusted R-squared value
n/a
.474
n/a
Notes: The dependent variable is the adjusted private placement cumulative abnormal
return over the primary event window from three days before until the day of the
announcement. The estimation period (-200, -60) is employed. Coefficient estimates
and p-values are calculated for the 67 announcements.*
p-values are reported where White’s correction improves statistical results. Supplemental
data and a full description of ancillary tests for model specification and variable robustness are available
from the authors.
* Uncorrected
34