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E-MailPhilip Bond is Professor of Finance and Business Economics at the University of Washington. This post is based on an article authored by Professor Bond and Hongda Zhong, Assistant Professor of Finance at London School of Economics.
A widely documented empirical finding is that share prices fall in response to a firm’s announcement of a seasoned equity offering (SEO). The standard explanation for this empirical regularity is that a firm has information that investors lack, and a SEO reveals to investors that the firm’s information is negative (see, in particular, Myers and Majluf 1984). In equilibrium, firms with negative information issue equity and accept the negative share price response because the SEO provides funding for a profitable investment. In contrast, firms with positive information prefer to pass up the investment rather than issue equity at a low price.
But if a firm really does have superior information relative to its investors, a firm’s decision problem is more complicated than simply deciding whether or not to undertake an SEO. In particular, a firm with positive information potentially has the incentive to repurchase shares, both to (A) directly profit from the repurchase transaction, and also to (B) communicate positive information to investors, and thereby improve the terms of a subsequent SEO. However, most existing SEO models are static, which eliminates both incentives. For motive (A), this follows from the no-trade theorem (Milgrom and Stokey 1982): investors can infer that a repurchase offer comes from a currently undervalued firm, and hence they prefer to retain their shares. Motive (B) is inherently dynamic, in that it requires at least two rounds of equity transactions to implement. Yet motive (A) figures prominently in managerial survey responses, while Billett and Xue (2007) provide empirical evidence for (B).
In our article, Buying High and Selling Low: Stock Repurchases and Persistent Asymmetric Information, recently featured in the Review of Financial Studies, we analyze a dynamic version of the standard SEO model. Our main result is that repurchases motivated by both (A) and (B) indeed arise in equilibrium. Moreover, these repurchases interact with SEOs. In particular, we show that the possibility of repurchases reduces the likelihood that a firm undertakes an SEO. The equilibrium outcome of the static game, in which bad firms issue and good firms do nothing, is fragile, in the sense that in the dynamic setting this outcome fails a standard refinement of game theory.
Our results suggest that the standard explanation of the negative price-reaction to SEO announcements is incomplete, in the sense that the equilibrium that underpins the explanation must also feature repurchases, a point that is absent in the standard explanation. Nonetheless, our analysis still delivers the negative price reaction to SEO announcements (this is the “selling low” of the title), because in equilibrium an SEO is a negative signal relative to both the alternatives of repurchasing and doing nothing. The primary empirical implications of our analysis are that (1) some firms repurchase and then subsequently engage in an SEO, (2) in such cases, the dollar value of the SEO exceeds the dollar value of the repurchase, (3) the cumulative share price response to a repurchase announcement and then subsequent SEO announcement is more favorable than the cumulative response to an SEO announcement made without a prior repurchase. All three predictions are consistent with the empirical findings of Billett and Xue (2007). Additional empirical implications are that (4) some firms repurchase in order to profit from the repurchase transaction, and (5) repurchasing firms have good investment opportunities and are credit constrained. As noted, (4) is consistent with survey responses, while (5) has some support in existing empirical studies.
The intuition for our result that an equilibrium must feature repurchases is as follows. On the one hand, if investor beliefs following a repurchase offer are that a firm is bad, then good firms certainly profit from repurchases, since the price they pay is low. On the other hand, if investor beliefs following a repurchase offer are good, then any firm interested in undertaking an SEO can benefit by first repurchasing, so as to improve investor beliefs. So in either case, repurchases arise in equilibrium.
The full article is available for download here.
