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E-MailThe following post comes to us from E. Han Kim and Amiyatosh Purnanandam, both of the Department of Finance at the University of Michigan.
In our paper, Seasoned Equity Offerings, Corporate Governance, and Investments, forthcoming in the Review of Finance, we assess how the strength of governance affects investor confidence about management’s intended uses of the proceeds from SEOs. Our primary tests are conducted using difference-in-differences approaches using the staggered enactments of business combination statutes (BCS) as an exogenous shock weakening external pressure for good governance from the market for corporate control.
These tests are supplemented by two additional analyses, one relying on shareholder-value-reducing acquisitions as an ex post proxy for weak governance; the other relying on top management’s firm-related wealth sensitivity to shareholder value as a proxy for the strength of internal governance. These empirical analyses cover different sample periods spanning 1982 through 2006. Investor reaction to SEOs is positively and significantly related to the strength of governance regardless of which empirical strategy we use and which time period we examine.
The economic magnitudes of governance impacts are surprisingly large, explaining much of the negative stock price reactions to the announcement of SEOs. Absent secondary offerings, investors’ main concern with SEOs is whether management will use the proceeds productively or wastefully. Good governance enhances investor confidence, helping firms raise external equity at lower costs.
These results challenge the notion that the general stock price reaction to SEOs is negative. We identify important subsets of SEOs that receive positive or clearly non-negative investor reaction: SEOs followed by increases in capital expenditures by firms unaffected by the enactment of BCS, and pure primary offerings by issuers with management incentives closely aligned to shareholder value. These empirical regularities cannot be explained by information-based explanations usually invoked to explain negative market reactions to SEO announcements. Instead, they highlight the important role governance plays in altering investor perception of seemingly identical managerial decisions.
Our results have several normative implications for firms in need of external equity financing. These firms can avoid negative investor reaction and lower costs of external equity by (1) more closely aligning managerial incentives to shareholder value; (2) avoiding value reducing acquisitions prior to SEOs; and (3) excluding secondary offerings from SEOs. The benefits of these shareholder-friendly actions may require reduction in private benefits for those in control. As such, our study underscores the benefit side of the trade-off facing firms in need of external equity financing.
The full paper is available for download here.
