Do Firms Issue More Equity When Markets Become More Liquid?

Rogier Hanselaar is a Data Scientist at Aegon N.V.; René M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics at the Fisher College of Business at The Ohio State University; and Mathijs A. van Dijk is Professor of Finance at the Rotterdam School of Management at Erasmus University Rotterdam. This post is based on their recent article, forthcoming in the Journal of Financial Economics.

In our paper Do firms issue more equity when markets become more liquid?, we investigate whether variation in stock market liquidity helps to explain variation in corporate equity issuance over time.

It is well-known that the volume of both initial public offerings (IPOs) and seasoned equity offerings (SEOs) fluctuates considerably over time, but the underlying causes of these fluctuations are not well understood. Prior research has pointed at economic conditions (such as GDP growth) as well as capital market conditions (such as volatility) as potential determinants. It has also been documented that equity issuance tends to be high after the stock market has gone up and when aggregate stock market valuation (as measured by, for example, the aggregate price-earnings ratio) is high, which is often interpreted as evidence that firms successfully “time” the market when raising new equity.

We argue that stock market liquidity (broadly defined as the ability to trade shares easily with little impact on the price) may also be an important determinant of equity issuance. After all, as a firm’s shares trade in a less liquid market, investors have to be given more of a discount to absorb these shares. We would therefore expect that equity issuance is more costly for existing shareholders when a firm’s stock is less liquid because an increase in the supply of shares has a greater price impact. As issuance becomes more costly, firms are expected to issue less equity, everything else equal. We investigate this hypothesis using a large sample of countries over a 20-year period. We find strong support for the hypothesis that equity issuance increases following improvements in stock market liquidity.

Our analyses are based on a large sample of more than 10,000 IPOs and 35,000 SEOs in stock markets in 37 countries around the world from 1995 to 2014. Our main variable of interest is the total number of equity issues (IPOs + SEOs) in a country per quarter, although we also analyze IPOs and SEOs separately, as well as the aggregate proceeds instead of the number of equity issues.

Our main finding is that recent changes in stock market liquidity (over the past one to four quarters) are a powerful predictor of changes in equity issuance. In particular, we find that equity issuance around the world tends to go up following improvements in market liquidity. We provide evidence that this relation between liquidity changes and equity issuance changes cannot be attributed to liquidity serving as a proxy for the general state of capital markets, aggregate economic activity, asymmetric information, sentiment or market timing. It is also not plausible that the relation could be due to reverse-causation, since equity issuance typically represents a small fraction of outstanding equity at the country level. Remarkably, changes in market liquidity are as powerful in explaining variation in equity issuance as are popular proxies for market timing. Furthermore, we show that accounting for variation in liquidity not only improves explanatory power for issuance in-sample, but also enhances out-of-sample predictive power.

We then turn to tests that focus more directly on the nature of the mechanism that explains the relation between liquidity and equity issuance. For firms, an equity issuance has costs and benefits. Firms in good financial condition can more easily postpone an equity issue if they believe that it will be less costly in the future compared to firms that might be unable to pay their bills without new funding. We find that the relation between issuance and liquidity is weaker for loss making firms, which suggests that in circumstances where issuing equity is a matter of greater urgency, liquidity considerations play a smaller role.

We also explore whether the relation between changes in equity issuance and changes in liquidity differs across countries and across time. Countries differ in the ease with which firms can issue equity. We show that issuance is more strongly related to liquidity in more financially developed countries, consistent with the view that firms are able to issue equity more rapidly in these countries to exploit favorable liquidity conditions. An obvious concern is that our results could be driven by the financial crisis. When we remove the 2008-2011 period from our sample, a period that includes the peak of the European sovereign crisis as well as what is often referred to as the credit crisis, our results are similar.

Overall, we interpret our findings to be supportive of the view that stock market liquidity affects the cost of equity issuance and that firms take stock market liquidity into account when deciding whether and when to issue equity. This interpretation suggests that the role of market liquidity extends beyond the boundaries of financial markets and that it has a pervasive impact on corporate financial policies.

The complete paper is available for download here.

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