Firms’ Choice of Seasoned Equity Issuance Method—Taking Private or Non-private Route

Abstract

The choice of an issuance method for selling subsequent equity is indeed an important corporate financial decision. The recent popularity of private placements over traditional seasoned equity offering (SEO) methods motivates this review on the determinants of firms’ choice between ‘private’ and ‘non-private’ routes for follow-on equity financing. Empirical results are generally consistent with the theoretical propositions. The review suggests further empirical evidence and importance of dynamic models to extensively explain the choice of an equity floatation method by listed companies.

Keywords

Seasoned equity private placement public issue rights offering

Introduction

In spite of the growing corporate finance literature on seasoned equity offerings (SEOs), there is rather limited evidence on the choice of equity refinancing methods by publicly traded companies. Well, it is crucial for a listed company to make an appropriate choice between subsequent equity selling mechanisms. This is because a firm’s choice of a floatation method for follow-on equity financing can have substantial influence on its acquisition of funds, degree of profitability and most importantly, its value. The popular methods of issuing SEOs typically include private placements, public offerings and rights issues. While private placements are issues of a new stock to a select group of small number of well-informed investors, public offerings result in newly issued shares being sold to the public and any other investor at large. In case of rights issue, existing shareholders are given the opportunity to subscribe to new issue of shares via short-lived warrants issued on a pro rata basis. Recently, private placements have emerged as a preferred choice among the publicly traded corporations for raising subsequent equity capital. For instance, studies based in the US (Chen, Dai & Schatzberg, 2010; Floros & Sapp, 2010; Gomes & Phillips, 2012), China (Li-mei & Wei-xi, 2009) and Brazil (Ness & Bordeaux-Rego, 2006) document a recent dramatic shift in the trend for mobilization of funds by listed companies from traditional SEOs to private offerings of equity. This is because unlike traditional SEOs, private placements can be completed in a shorter time frame and can provide the committed capital without going through a lengthy and cumbersome issuance procedure. They are more flexible as placement deals can be tailor-made to suit the requirements of both the issuer and the investor through direct negotiation. Since private placements are made to a few financially sophisticated buyers, who are typically willing to take large risks, they open a financing window for small and risky firms.

This article reviews the existing theoretical and empirical literature on the determinants of firms’ choice between private and non-private routes for selling further equity. It defines ‘private route’ as private placements and confines ‘non-private’ route to public and rights offerings.¹ The review is organized into the following sections: The second section discusses the theoretical framework about a firm’s decision to make private placements of equity. While the third section provides the theoretical under-pinnings on how firms choose between private or non-private equity selling mechanisms, the fourth section gives empirical evidence on the choice between private and non-private issuance methods by listed companies for raising seasoned equity. The fifth and final section concludes the review and provides scope for further research.

Theoretical Foundation on ‘The Decision to Take Private Placement Route’

Hertzel and Smith (1993) show that a firm tends to take private placement route for raising equity when the information asymmetry about its value is greater. In an information-asymmetric world, managers have more information about the value of the firm’s assets and future growth opportunities than outside investors. The presence of information asymmetry creates an adverse selection problem (Akerlof, 1970; Leland & Pyle, 1977).² According to Myers and Majluf (1984), managers of under-valued firms, which have profitable investment opportunities, avoid excessive wealth transfer from existing shareholders to new shareholders when new equity is needed to finance projects. They argue that managers would choose to forgo investment opportunities (projects with positive net present values [NPVs]) by not issuing common shares to the public. Myers and Majluf (1984) call this tendency as the ‘underinvestment problem’. They say that ‘good’ investments would be financed internally or with the less risky type of external financing (i.e., debt), and public equity would be issued only if a manager believes that the firm is overvalued. Lucas and McDonald (1990) too claim that firms tend to time their public equity offerings after the stock price run-up in which stock is experiencing successive rallies or uptrends.

Myers and Majluf (1984) show that underinvestment occurs when equity is undervalued by the market, that is, existing shareholders would have to give up a substantial portion of value of assets in place which is more than the share of NPV they gain by investing in growth opportunity. They assume that the existing shareholders do not subscribe to the issue; it goes to different groups of investors. Therefore, when (P′/P′ + E) (E + S + a + b) < (S + a), underinvestment results. They denote (P′/P′ + E) (E + S + a + b) as the value of the existing shareholders’ claim if a firm issues and invests, where P′ is the market value of their claim conditional on public issue (which is the expected value of assets in place and growth opportunity), a is the true value of assets in place, b is the true value of the NPV of the investment opportunity and E is the issue proceeds required to finance the investment, I, after using financial slack, S, that is, E = (I – S). According to them, financial slack remains in the form of cash or liquid assets. They define (E + S + a + b) as the full information (true/intrinsic) value of a firm, if it issues and invests.

Hertzel and Smith (1993) extend the model of issue-investment decision by Myers and Majluf (1984) and prove that private placement of common shares could lessen the underinvestment problem and thus resolve information asymmetry about firm value. They assume that managers of firms with bright investment prospects can hold negotiations with a small group of big outside investors that their firm is ‘undervalued’. They assert that as it becomes difficult and important to measure a firm’s value carefully, buyers of private placements would have to spend more resources to determine the firm value, and hence would call for greater discounts. Using the same notations as Myers and Majluf, Hertzel and Smith (1993) assume that managers of firms ‘short of’ financial slack (i.e., when S = 0) maximize the value of the existing shareholders’ claim, V^old, with respect to three choices relating to equity issue decision, that is, going for a public issue, making private placement or doing neither. V^old is (P′/P′ + E) (E + a + b) when public equity issue is made; it is (a + b – T) when decision is made to place the equity privately and is equal to (a), when no issue is made. Here, T is compensation to private placement buyers for the costs of assessing firm value. They argue that investors are rewarded for the information costs borne through sizeable discounts on privately placed issues. According to Hertzel and Smith (1993), private placement of equity eliminates underinvestment when (P′/P′ + E) (E + a + b) < (a) < (a + b – T). Here, the first inequality implies Myers and Majluf (1984) condition that underinvestment arises when the wealth transfer to new shareholders exceeds the NPV of the investment opportunity. The second inequality shows that investment project would be financed through private placements as long as the NPV of the investment opportunity is greater than the cost of informing private investors about firm value. They further assert that where there is no underinvestment problem, private placement still results in a gain to the existing shareowners if (a) < (P′/P′ + E) (E + a + b) < (a + b – T). As per Hertzel and Smith (1993), readiness of private placement investors to provide funds for a firm’s project and the management’s decision of not making a public issue give an indication to market that the firm is undervalued. They emphasize that the commitment of funds by well-informed investors could serve as a certification of firm value. They, however, also indicate that the benefit of signalling might induce false signalling by overvalued firms since they could employ private equity placements intentionally to signal undervaluation when it does not actually exist.

Theoretical Insight on ‘The Choice between Private and Non-private Route’

With a view to understanding the pros and cons associated with the mechanisms of subsequent selling of equity, the first part of this section briefly reviews the theory on a firm’s choice between private and public issues, while the second part discusses the theoretical framework regarding the choice between private and rights offerings.

Theory on Private versus Public Issuance Method

Chemmanur and Fulghieri’s (1999) theoretical analysis suggests that the choice between public and private offerings is determined by the level of information asymmetry about the firm value. They point out that since private placements engage quite less number of investors when compared with public offerings, at a given level of information asymmetry, private placements involve lower costs of information production with regard to firm value. Their model implies that firms choose to go public when an adequate amount of information is collected about them in public domain so that costs of measuring the firm value become lesser for outside investors. According to them, when the firm is small, young or is in a ‘complex’ industry (i.e., where the firm’s project is intrinsically more difficult to measure), the cost of duplication in outsiders’ information production dominates the premium demanded by the private financiers. As a result, the firm decides to issue equity privately.³ Subrahmanyam and Titman (1999) posit that public financing is preferred when information is easy to acquire for new investors and serendipitous information⁴ plays a major role. According to them, firms go public when they have already gained visibility, while firms prefer private financing when they plan to implement internal reorganizations. Pagano and Roell (1998) show that a firm would not choose to make private placements to a few large block shareholders for fear of being ‘excessively’ monitored.⁵ They assert that by going public, a firm can ensure that shares are sufficiently dispersed for the right amount of monitoring. They state that a firm’s incentive to go public becomes stronger when a large amount of external funds are required. For this, they reason out that the danger of over-monitoring by private investors increases with the amount of outside finance to be raised. Literature also shows that private placements can cause agency problems through managerial entrenchment (Barclay, Holderness & Sheehan, 2007; Goh et al., 1999).

Maksimovic and Pichler (1999) develop a model that determines how an issuer who wishes to maximize revenue from the sale of the issue should choose between public or private route. They compare three selling strategies that are similar to the institutional practices followed by the US, namely, retail strategy, pool-only strategy and pool–retail strategy. In the retail strategy, the issuer sets a price and sells the issue right away to the financial market without attempting to accumulate information owned by informed investors.⁶ They state that underpricing of the issue is essential to compensate uninformed investors for adverse selection risk and to ensure their participation in the issue market. They explain pool-only strategy as a ‘private offering’ wherein the issuer sells the entire issue to a limited number (pool) of informed investors and incurs the cost of motivating them to bid aggressively. They further indicate that the issuer might have to bear the participation costs demanded by these investors. They argue that the need to encourage pool participants to truthfully reveal their information causes under-ricing by itself in a private placement even though there is no risk of adverse selection. They mention that in the case of pool–retail strategy, issuer allows preferential access to shares to a pool of informed investors in return for the information and also retains the option to sell a fraction of the issue to retail investors. They say that costs of motivation and adverse selection are incurred to a much lesser degree in this practice. Thus, according to Maksimovic and Pichler (1999), the expected difference in under-pricing could act as a significant determinant of choice of issuance mechanism between public and private offerings.

The analysis by Boot, Gopalan and Thakor (2006) provides an alternative explanation for ‘going-private’ decision of the firms which is other than the fear of underpricing by the market due to information asymmetry about firm value. Their model implies that if the potential for disagreement between the manager and outside investors over matters, such as ‘what actions’ maximize firm value, is high, the manager may then consult a private investor whose views would be aligned with his/her own. Jensen and Meckling (1976) and Shleifer and Vishny (1986) also claim that alignment of manager–shareholder interest can bring down agency costs and help in creating a higher firm value. The model by Boot et al. (2006) empirically predicts that the effect of strengthening of corporate governance norms on the going-public decision of firms is positive for less-established firms but is negative for those with reasonably good track records. In line with Chemmanur and Fulghieri (1999), they also find a life cycle effect in the choice of ownership decision, that is, young firms are more likely to go private, while the old firms have a greater tendency to go public.

Vila (2009) studies a public firm’s trade-off regarding the use of private investment in public equities (PIPEs) as opposed to seasoned public issues when new equity capital needs to be raised. He stresses that private placements (PIPEs) involve greater financial flexibility than a public offering. He defines financial flexibility as a firm’s ability to time investment and financing decisions in a manner that maximizes firm value. He models financial flexibility in a two-dimensional way. According to him, quicker mobilization of funds through private placement gives an opportunity to the firm to build up profits expected from investing earlier than its competitors. In other words, delaying the investment is costly. He further states that deciding early on investments prevents the firm from the benefits of having sophisticated investors acquiring more information about the company. This would mean that by delaying the announcement to raise funds and thus investment, sophisticated investors might be able to update beliefs about the firm’s future profitability. This reduces potential dilution costs⁷ due to information asymmetry. He explains that since in the case of PIPEs investment decision is made simultaneously with the decision for obtaining the funds for investment, this flexibility enables the firm to lower the expected dilution costs and to optimally choose the timing of investment. However, at the same time, unlike public equity issues, there are restrictions on reselling the private placement stock. Thus, illiquidity associated with private placements might amplify the dilution costs caused by information asymmetry. He says that a firm continues to prefer PIPEs as long as asymmetries about the firm value are important and illiquidity costs are not too large. He maintains that firms, which are smaller, younger and have limited internal funds, are more likely to make PIPEs.

Theory on Choice between Private Placement and Rights Offering

The key insight of Myers and Majluf (1984) is that under information asymmetry, undervalued firms tend to forgo investment projects because of underpricing of the equity issues by outside investors. The cost of this underinvestment may induce the firm to turn to its own shareholders for additional equity capital. Eckbo and Norli (2004)⁸ generalize Myers and Majluf framework by allowing current shareholder participation in the equity issues via rights offers. They present a model for the choice of seasoned-equity selling mechanism between uninsured rights, rights with standby underwriting⁹ and private placement. They denote k as the fraction of the issue that is taken up by current shareholders and C(k) as total issue costs, which is the sum of direct costs¹⁰ (d) and expected wealth transfer to outside investors. They define the expected profit from issuing and investing to current shareholders as π = b – C(k), which can also be written as π = b – d – I (1 – k) {(a + b + I – d) – P}/P. Here, b and I denote NPV of the project and the investment amount, respectively, which are assumed to be commonly known. True value of assets in place reflected by a is known only to the firm and P is the post-issue secondary market price of the issue. They explain that the firm will issue and invest when the project’s NPV exceeds direct issue costs and there is a (potential) wealth transfer between old and new shareholders on account of adverse selection. The wealth transfer depends on market price P, which in turn is determined by investors’ beliefs about a, assets in place. They state that undervalued firms experience a positive wealth transfer when P < (a + b + I – d). According to Eckbo and Norli (2004), the magnitude of wealth transfer cost gets diluted by shareholder take-up¹¹ which acts like a form of financial slack. When k = 1, π becomes equal to (b – d) as there is no potential for wealth transfer between current and new shareholders, and no scope for adverse selection. When k < 1, that is, the case when some shareholders in the rights offer will sell their rights to outside investors, Eckbo and Norli (2004) argue that adverse selection costs remain positive for undervalued firms even if the rights offer is expected to be fully subscribed in the end. If a firm uses uninsured rights offer and the current shareholders sell all the rights to the outside investors (i.e., k = 0), then potentially large indirect costs might arise in terms of wealth transfer owing to adverse selection. They describe this as a worst-case scenario because there is no quality certification. Thus, their model implies that the issuer would choose that floatation method where the expected total issue costs are lower.

In their model, Eckbo and Norli (2004) assume that standby underwriters and private placement investors inspect the quality of the issue and decide to accept or reject it after a round of bargaining over the offer price. They show that there exists a preference ordering of equity floatation methods which depend on k. High-k firms choose uninsured rights offers (with minimal wealth transfer). Medium-k issuers prefer a standby method, but move on to private placement if underwriter declines the issue. Low-k issuers prefer private placement as they compromise between lower direct costs of private placement issues and greater wealth transfer costs as the current shareholder take-up is small.¹² Low-k firms use standby underwriting if they are turned down by private placement inspection. According to Eckbo and Norli (2004), this issue continues until the firm either chooses uninsured rights (after being rejected by underwriter and private placement investor) or discards the issue.

Armitage and Snell (2002) extend and modify the framework presented by Myers and Majluf (1984) in their theoretical model which predicts the UK issuers’ choice between pure rights offerings and private placements of equity. They assume that the utility of existing shareholders is affected by the issuer’s market price in the short term after the issue. They argue that since private placements provide an opportunity for investigation of the firm value, issuers’ market price post private placement would be higher than it would have been following a Myers–Majluf style issue.¹³ According to them, the higher the utility gained by existing shareholders from change in market price of the shares in the short term subsequent to the issue, the greater the issuer’s probability of choosing a private placement method.

The extant literature on rights offerings relates them to a ownership structure and the behaviour of large (controlling) shareholders. Firms with concentrated ownership, like in European and Pacific Basin countries, prefer rights equity where commitment to subscribe by controlling shareholders goes a long way to minimizing the issuance costs of the rights offers. On the other hand, firms with scattered ownership structures like in the US choose new equity issues (underwritten offers to outside investors) because costs of issuing rights would become exorbitant due to lack of commitment by large shareholders. Again, the risk of adverse selection would emerge if large shareholders renounce their entitled rights. According to Wu and Wang (2007), controlling shareholders’ fear of losing their private benefits of control¹⁴ undoubtedly affects the floatation method choice between rights offerings and new issues to outside investors.¹⁵ As control-diluting new issues substantially reduce block shareholders’ private benefits, they reason out that firms with excessive control benefits would turn to rights issues for making seasoned equity offerings. Slovin, Sushka and Lai (2000), on the other hand, claim that private equity placements have the potential to increase shareholder dispersion. They point out that firms having concentrated ownership structures could use private placements in place of rights offerings to mobilize outside equity and create greater ownership dispersion. They also argue that private placements provide room for monitoring by outsiders and step up the activity for corporate control.

Empirical Review on ‘The Choice between Private and Non-private Route’

Empirical literature on the seasoned equity choice between private and public offerings is briefed in the first part of this section. This is followed by a review on the empirical findings related to the choice of a floatation method between private and rights issues of equity.

Empirical Evidence on Private Placement versus Public Issue

It is observed that relatively little empirical analysis has been conducted on the choice of seasoned equity selling mechanisms. In fact, empirical studies on the choice between private and public issues are mostly based in the US and support the theoretical propositions on major grounds. For instance, Lee and Kocher (2001), Wu (2004), Petrova, Yang and Yildirim (2008) and Gomes and Phillips (2012) find that private placement firms face more information asymmetry than public offering firms. Their findings reveal that firms that go for private placements are smaller and have more growth potential. Private placement issuers are found to be financially distressed (Gomes & Phillips, 2012; Petrova et al., 2008; Wu, 2004) and cash-strapped (Gomes & Phillips, 2012; Lee & Kocher, 2001; Petrova et al., 2008). Lee and Kocher (2001) and Wu (2004) find that firms do not rely on private placements as a monitoring mechanism. Their results are inconsistent with the popular view that private placements are motivated by the demand for better monitoring.

Chen et al. (2010) examine the seasoned equity choice between private placements and public offerings for the US corporations by studying a sample of 2,087 PIPEs and 1,743 SEOs for the period of 1996–2006. The results indicate that firms possessing greater information asymmetry (i.e., smaller size, less analyst coverage and a greater price spread) and displaying a weaker operating performance are more likely to conduct PIPE offerings. Just like Lee and Kocher (2001), they also show that firms are more likely to choose PIPEs when the general market and the firm’s stock are performing poorly, that is, when potential for undervaluation is high. Their analysis suggests that sale of equity privately may be preferred to a public sale in cases where a cost advantage exists.

Besides the US, empirical studies on the choice between public versus private method of equity issuance by a publicly traded firm are also undertaken in the developing markets, such as Brazil and China. Ness and Bordeaux-Rego (2006) study the seasoned equity choice between 528 private placements and 101 public issues of Brazilian companies listed on Sao Paulo Stock Exchange for the period of 1995–2002. Their results show that firms with less liquid stocks, low levels of profitability, greater leverage and smaller issue volumes have a greater probability of using the private placement method of equity issuance. Li-mei and Wei-Xi (2009) examine how companies listed on Shenzhen and Shanghai Stock Exchange decide between private and public placement of equity shares in China. They took a sample of 232 private placements and 44 public offerings from May 2006 to December 2008 to analyze the choice between subsequent equity selling mechanisms. According to them, companies choose private placements when they cannot meet the regulatory requirements of profitability for selling equity issues to public. It is found that the impact of information asymmetry and pressure for demand for funds are important factors in determining firms’ choice of seasoned equity. They explain that small companies reduce the risk of issue failure and also that companies with high debt tend to meet the pressing demand for funds by going in for private equity placements.

Empirical Work on Private Placement versus Rights Issue

There is a surprising lack of empirical evidence on firms’ choice between private placements and rights offerings for follow-on equity financing. It is observed that research papers by Cronqvist and Nilsson (2005), Balachandran, Faff, Theobald, Velayutham and Verwijmeren (2013) and Aziz (2013) are the only ones, till now, which provide an empirical insight on seasoned equity choice between private placements and rights issues. Cronqvist and Nilsson (2005) examine 160 rights issues and 136 private placements made during 1986–1999 by firms listed on Stockholm Stock Exchange to study the choice of equity floatation method in Sweden. Their analysis suggests that firms controlled by families prefer rights offerings to private placements. This is because private placement investors not only dilute families’ control but also monitor firms’ use of issue proceeds which, thereby, threaten families’ extraction of private benefits. Cronqvist and Nilsson (2005) find that firms which establish a new strategic alliance or product market agreement tend to choose private placement of equity to the new business partner. They reason out that block equity ownership aligns interests between business partners and reduces ex-post hold-up problems in the product market relationship. Their results show that firms choose uninsured rights offerings at low levels of asymmetric information about firm value, involve under-writer certification at intermediate levels and choose private placements at high levels of asymmetric information. They find that firms, which are younger and financially distressed, are more likely to choose private placements over rights offerings.

Using a large sample of British public companies listed on London Stock Exchange, Balachandran et al. (2013) analyze seasoned equity choice for the period between 1996 and 2005. They show that firms with low idiosyncratic risk, high liquidity and low information asymmetry (i.e., high-quality firms) are more likely to issue to the existing shareholders through tradable and non-tradable rights offerings. Their results indicate that firms with higher ownership concentration tend to choose non-tradable rights issues. They find that issue proceeds relative to firm size are also significantly higher for firms issuing to current shareholders. They suggest that if a firm decides to issue to non-existing shareholders, firms with high information asymmetry tend to select stand-alone private placements. Their findings reveal that issue discount is higher for issues made to current shareholders. Aziz (2013) examines the issuance choice of rights offerings versus private placements in Malaysia during the period of 2002–2010 and finds that smaller and riskier firms with higher growth opportunities use private placement method rather than rights offerings for raising subsequent equity capital.

Conclusion and Scope for Further Research

Private placements have thrived as a popular and viable route for follow-on equity financing by publicly traded firms in recent times. Evidence shows that privately placed issues have surpassed traditional SEOs, such as public and rights issues in terms of volumes raised and the number of transactions in a big way. This article reviews the extant literature on the factors influencing firms’ choice between private and non-private (public/rights issue) methods for raising further equity capital.

Empirical literature suggests that factors, such as asymmetric information about firm value, growth prospects, profitability, financial slack and stock performance prior to the issue, significantly determine a firm’s choice between private and public route for selling seasoned equity. In line with the theoretical predictions, results show that firms characterized by greater information asymmetry, more growth opportunities, poor profitability, limited financial slack and high potential for undervaluation are more likely to conduct private placements than public offerings.

There is limited empirical evidence on the analysis of seasoned equity choice between private placements and rights issues. Corporate control considerations are found to be important in explaining the choice between private placements and rights issues. Results indicate that firms controlled by families and those with higher ownership concentration prefer rights issues to avoid dilution of control by private placement investors. Consistent with the theory, findings show that private placement firms are associated with more information asymmetry, smaller issue volumes, higher risk and greater financial distress when compared with rights offerings firms.

Further, research focusing on factors, such as issue objectives and investor characteristics, may provide additional insights into managerial choice of equity issuance method. In terms of international comparison, there is immense scope for conducting empirical analysis on the determinants influencing choice of seasoned equity selling mechanisms, especially, in emerging market economies. Although Ness and Bordeaux-Rego (2006) and Li-mei and Wei-Xi (2009) find that firms with greater financial leverage tend to choose private placement method for issuing subsequent equity, it is noticed that a firm’s degree of leverage as a potential determinant of the choice of floatation method has garnered little theoretical attention. It is, therefore, necessary to discern whether this empirical finding is actually backed by a model on seasoned equity choice.

As information and financing needs of a firm change over time, a dynamic model for the choice of equity issuance method seems more suitable. A firm’s risk exposure also changes with time, and is likely to be asymmetric information. Within this context, analyzing floatation method choice could be quite enriching as it would indicate when in the life cycle of a company, one choice dominates the other. Moreover, it is noticed that the existing empirical work focuses on cross-sectional differences between firms in their subsequent equity financing decisions. This approach may lead to problems in controlling for a great deal of heterogeneity across firms. Longitudinal studies might be helpful in this regard for detecting the factors which can potentially affect the choice of seasoned equity selling mechanisms.

Footnotes

Acknowledgements

The author is grateful to the anonymous referees of the journal for their extremely useful suggestions to improve the quality of the paper. Usual disclaimers apply.

Notes

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