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«MICHAEL HERTZEL, MICHAEL LEMMON, JAMES S. LINCK, and LYNN REES* * Hertzel is at Arizona State University, Lemmon is at the University of Utah, Linck ...»

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Long-run Performance Following Private Placements of Equity




Hertzel is at Arizona State University, Lemmon is at the University of Utah, Linck is at the University of Georgia,

and Rees is at Texas A&M University. We thank Kent Daniel, Steve Foerster, Ludger Hentschel, Sherry Jarrell,

Srini Kamma, Ed Kane, Ajay Khorana, S.P. Kothari, Wayne Mikkelson, Jim Nelson, Cliff Smith, two anonymous referees, Rick Green and René Stulz (the editors), and seminar participants at the American Graduate School of International Management, the University of Arizona, Arizona State University, Georgia Tech, the University of Miami, the University of Rochester, Texas A&M University, the University of Western Ontario, the 1997 Financial Management Association Meetings, and the 1998 Southern Finance Association meetings for helpful comments.

Greg Durham, Lalitha Naveen, and Jerry Chen provided valuable research assistance. Hertzel acknowledges financial support from the Dean’s Council of 100 Faculty Summer Grant Program and the Jack B. Furst Private Equity Research Program. Any errors or omissions are the responsibility of the authors.


Public firms that place equity privately experience positive announcements effects, with negative post-announcement stock-price performance. This finding is inconsistent with the underreaction hypothesis. Instead, it suggests that investors are overoptimistic about the prospects of firms issuing equity, regardless of the method of issuance. Further, in contrast to public offerings, private issues follow periods of relatively poor operating performance. Thus, investor overoptimism at the time of private issues is not due to the behavioral tendency to overweight recent experience at the expense of long-term averages.

It is well established that the stock market reacts negatively to announcements of seasoned equity issues.1 Recently, Spiess and Affleck-Graves (1995) and Loughran and Ritter (1997) document that, in addition to the negative announcement period returns, issuing firms experience abnormally low stock returns over the five years following the issue announcement. One explanation of these findings is that managers time equity issues to take advantage of “windows of opportunity” to issue overvalued equity. This explanation requires not only that investors are overly optimistic about the issuing firms’ prospects at the time of the issue announcement, but also that investors underreact to information conveyed by the announcement. While Fama (1998) argues that the results reflect normal random variations that occur in efficient markets, the long-run post-announcement abnormal stock-price performance is widely viewed as presenting an important challenge to the traditional paradigm of market efficiency.

Providing an additional challenge to the traditional framework are behavioral theories that have been advanced to explain: (i) investor overoptimism at the time of the issue announcement and (ii) investor underreaction to information conveyed by the announcement.

For example, Loughran and Ritter (1997) argue that investor overoptimism at the time of the issue may reflect the behavioral tendency, as observed in psychology studies, for humans to overweight recent experience at the expense of long-term averages.2 They show that operating performance peaks at the time of the equity issue, and suggest that the post-announcement stockprice decline reflects overextrapolation by investors of the pre-issue trend in operating performance. Daniel, Hirshleifer, and Subrahmanyam (1998) formalize the underreaction hypothesis in a model where investors are overconfident and have biased self-attribution. Given these behavioral attributes, they show that the valuation effects of public news events will not be fully incorporated at the announcement, and that subsequent abnormal performance will continue

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In this study, we provide further evidence on investor behavior and expectations around equity issues by investigating the stock-price and operating performance of a sample of publicly traded firms conducting private equity issues. In contrast to public equity issues, which are underwritten, registered with the Securities and Exchange Commission, and sold to a large number of investors, private equity issues are typically negotiated directly with a single or small group of investors without SEC oversight. Our study is motivated, in part, by evidence that announcements of public and private equity issues are associated with opposite stock-price effects: While public issues, on average, are associated with negative stock-price effects, private issues are associated with positive stock-price effects. The positive stock-price response to the announcement of private equity issues sets the stage for an interesting experiment, since the underreaction hypothesis predicts continued positive stock-price performance following the announcement, whereas investor overoptimism associated with the "windows of opportunity" framework predicts long-run post-announcement underperformance.

For a sample of 619 publicly traded firms announcing private placements of equity during the 1980 to 1996 period, we find that positive announcement period returns are followed by abnormally low post-announcement stock-price performance. In our sample, the mean raw buy-and-hold return for the three-year period following private equity issue announcements is only 0.2 percent. Relative to a size-and-book-to-market matched sample of control firms, the mean three-year buy-and-hold abnormal return is -23.8 percent. This level of underperformance is similar to that found for initial public offerings (e.g., Ritter (1991) and Loughran and Ritter (1995)) and seasoned equity offerings (e.g., Spiess and Affleck-Graves (1995) and Loughran and Ritter (1995, 1997)), and suggests that investors are overoptimistic about the prospects of firms

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the underreaction hypothesis. Instead, our evidence suggests that the direction of the average announcement effect is incorrect. We discuss the implications of this for earlier studies by Wruck (1989) and Hertzel and Smith (1993) that offer explanations for the positive stock-price reaction to private placement announcements.

Given the evidence of investor overoptimism, we next investigate whether the behavioral explanation of investor overoptimism around public equity issues holds in the case of private equity issues. In sharp contrast to evidence that public equity issues tend to follow periods of above average operating performance, we find that private equity issues tend to follow periods of relatively poor operating performance. Thus, the behavioral tendency for humans to overweight recent experience cannot explain investor overoptimism around the time of private issue announcements. In fact, our results suggest that, if anything, investors put insufficient weight on recent performance; i.e., investors appear to be overly optimistic that the poor current operating performance will improve in the future. Consistent with this, we find high market-to-book ratios and significant stock-price run-ups prior to private equity issues.

To further investigate the nature of investor overoptimism at the time of private issue announcements, we examine the pattern of capital and R&D expenditures in the periods surrounding the private issues in our sample. Loughran and Ritter (1997) find that firms that issue publicly tend to have above average capital expenditures both before and after the issue and view this as evidence that investors and managers may be too optimistic about the prospects of these new investments. We document a similar pattern for firms that issue equity privately, and suggest that investors may similarly be overoptimistic about the future growth opportunities of firms that issue equity privately.

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feature of private equity issues is that they are typically sold to investors at substantial discounts from current market value (16 percent, on average, for our sample). Prior literature suggests the discounts reflect compensation to private placement investors for expected monitoring services and expert advice (Wruck (1989)), illiquidity (Silber (1991)), and information production (Hertzel and Smith (1993)). Our findings suggest another potential explanation; i.e., the negative post-issue stock-price performance suggests that private placement discounts may reflect private investors’ assessments of true (lower) firm value.4 The remainder of our paper is organized as follows. In Section I, we describe our data and research methods. In Section II, we provide evidence on post-announcement stock-price performance and tests of the underreaction hypothesis. Section III examines the operating performance and capital expenditures of our sample firms and explores sources of overoptimism at the time of the issue. Section IV discusses the implications of our findings for prior studies that have been advanced to explain positive announcement effects and the sizable discounts at which shares are issued to private placement investors. Section V concludes.

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A. Sample Description Through Dow Jones News Retrieval Service (DJNR) searches, we identify 952 announcements of equity private placements from the 1980 to 1996 period by firms that existed on the Center for Research in Security Prices (CRSP) NYSE/AMEX/Nasdaq monthly stock files at the year-end prior to the private placement announcement.5 To avoid potential problems with low-price stocks (Ball, Kothari, and Shanken (1995)), we exclude 209 firms with a price less

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firms that had completed a private placement within the preceding three years (the firm’s first private placement is included in the sample), leaving us a final sample of 619 equity private placements.

The private placements in our sample are most heavily concentrated in the periods 1985 to 1987 and 1991 to 1993. Firms traded on Nasdaq comprise 79 percent of the sample. By comparison, 50 percent of the public offerings in the Spiess and Affleck-Graves (1995) sample are Nasdaq firms. Aggregate proceeds raised from the private placements in our sample is $9.1 billion (in 1996 dollars), $5.6 billion of which is raised by Nasdaq firms.

Panel A of Table I shows that the sample spans a large number of industries. However, some clustering is evident, with just under 55 percent of the sample belonging to six industry groups (chemicals and allied products, electric and electronic equipment, holding and other investment offices, instruments and related products, industrial machinery and equipment, and business services). To address this issue, we control for industry effects in our empirical analysis. Panel B indicates that the average proceeds raised from the private placements in our sample is $12.7 million, and that the mean number of new shares issued as a percent of total shares outstanding after the issue is 21.2 percent. In contrast, Krishnamurthy, et al. (1999) report, over a similar time period, average proceeds of $48.8 million for public issues, representing 17.4 percent of total shares outstanding after the issue. Thus, although private placements are of significantly smaller dollar value, the fraction of shares sold is slightly larger than that in a typical seasoned public issue. The mean (median) market value of equity of our sample firms is $188.6 ($31.9) million. The mean (median) book-to-market ratio is 0.43 (0.26).6 Thus, the sample is skewed towards small, low book-to-market firms. We control for size and

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The private placements in our sample are sold at a mean (median) discount of 16.5 percent (13.4 percent), measured relative to the share price at the end of the month prior to the announcement date.7 The table also reports that the mean four-day {-3,0} announcement period return is 2.4 percent, significant at the one percent level.8 This translates to a four-day discountadjusted abnormal return of 15.2 percent, significant at the one percent level.9 These findings are consistent with previous studies of private placements, which also find that private placements are associated with positive announcement period returns and are issued at substantial discounts.

B. Measurement of Long-run Abnormal Stock-Price Performance We adopt two basic approaches to measure long-run abnormal stock-price performance following private placements of equity. First, we follow the approach of Barber and Lyon (1997) and benchmark performance by using an appropriately selected single control firm for each sample firm (buy-and-hold abnormal return method). However, as pointed out by Fama (1998) and Mitchell and Stafford (2000), this methodology may be problematic because it does not adequately account for potential cross-sectional dependence in returns. To address this possibility, we also estimate abnormal returns using the calendar-time portfolio approach used by Mitchell and Stafford. The calendar-time portfolio approach was first used by Jaffe (1974) and Mandelker (1974). We describe our methodology in more detail below.

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where BHRi,a:b is the buy-and-hold return of the sample firm and BHRcompi,a:b is the buy-andhold return of the control firm over the same time period. We compute buy-and-hold abnormal returns for our sample firms beginning the month after the private placement announcement through the end of the three-year period following the announcement or until either the sample

or control firm delists, whichever is sooner.10 The average buy-and-hold abnormal return is:

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where n is the number of firms in the sample.

In calculating the buy-and-hold abnormal returns, we consider three benchmarks of postannouncement performance: (1) a size-matched sample, (2) an industry and size-matched sample, and (3) a book-to-market and size-matched sample. To assess the statistical significance of the abnormal returns calculated with this method, we utilize a bootstrapping procedure as suggested in Kothari and Warner (1997). Additional details of our method for selecting control firms and of the bootstrapping procedure are provided in the Appendix.

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