Are Seasoned Equity Offerings bad news?

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Aarhus School of Business and Social Sciences Aarhus University May 2015

Are Seasoned Equity Offerings bad news?

A research on European Seasoned Equity Offerings and the disclosed use of issue proceeds

from 2000 to 2010

MSc Finance & International Business Master thesis Authors: Jesper Dissing (403148) Kristian Rasmussen (522165) Academic advisor: Jan Bartholdy Characters: 196.900 (excl. blanks)

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Abstract

This thesis examines the effect of seasoned equity offerings, specifically the abnormal stock returns around the announcement, change in operating performance subsequent to the issue and actual use of issue proceeds. The thesis contributes to the existing literature by combining the short- and long-term view in a European setting and taking into account the announced use of issue proceeds. We use a sample of 342 seasoned equity offerings conducted between 2000 and 2010 from 15 European countries, divided into three subsamples based on their announced intended use of issue proceeds as well as two comparative benchmark samples. We use the event study methodology based on abnormal stock returns in a three, seven and 21-day event-window for the short-term analysis, Difference-In-Difference (DID) regression in a three years ex-ante and ex-post event-window and OLS regressions on our study on actual use of issue proceeds.

We find that, in general, firms that issue seasoned equity experience significant abnormal negative stock returns around the announcement and experience a significant decline in operating performance relative to peers. We do not find any abnormal stock returns or any significant change in operating performance relative to peers for the 81 firms that issue equity with the purpose of repaying debt. For the 107 firms who intend to use the issue proceeds for general corporate purpose we find significant abnormal negative stock returns around the announcement, but do not find a significant decline in operating performance relative to peers. Lastly, we find significant negative abnormal stock returns around the announcement and a significant decline in operating performance relative to peers, for the 154 firms who announce specific investments as the intended purpose.

Our analysis on use of issue proceeds indicates that the firms in fact use the issue proceeds as announced. Most noticeable are the strong results for debt repayment, by firms who announce this as their primary purpose.

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Table of appendices

APPENDIX A - OVERVIEW OF PREVIOUS FINDINGS ... 96

APPENDIX B-SAMPLE COLLECTION PROCEDURE... 97

APPENDIX C - MATCH COMPARISON PLOT ... 98

APPENDIX D - DESCRIPTION OF NACE CODES ... 99

APPENDIX E - SHORT TERM: SHAPIRO-WILK TEST FOR NORMALITY ... 99

APPENDIX F - LONG TERM: SHAPIRO-WILK TEST FOR NORMALITY ... 99

APPENDIX G - QUANTILE REGRESSIONS ... 100

Table of figures

FIGURE 1 - ESTIMATION PERIOD AND EVENT WINDOW (THREE-DAY EVENT WINDOW) ... 28

FIGURE 2-SAMPLE OVERVIEW ... 51

FIGURE 3 - CUMULATIVE ABNORMAL RETURNS [-10;+10] ... 55

Table of tables

TABLE 1 - DIFFERENCE-IN-DIFFERENCE TABLE ... 36

TABLE 2 - OFFER SIZE & OFFER SIZE SCALED BY ASSETS... 52

TABLE 3-SEO’S DIVIDED BY COUNTRY AND INDUSTRY ... 53

TABLE 4 - DESCRIPTIVE STATISTICS ... 54

TABLE 5 - SHORT-TERM TEST STATISTICS: FULL SAMPLE ... 56

TABLE 6-SHORT-TERM TEST STATISTICS:DEBT REPAYMENT ... 57

TABLE 7 - SHORT-TERM TEST STATISTICS: GENERAL CORPORATE PURPOSE ... 58

TABLE 8 - SHORT-TERM TEST STATISTICS: INVESTMENT ... 58

TABLE 9-DIFFERENCE BETWEEN SUBSAMPLES ... 59

TABLE 10 - PAIRWISE DIFFERENCE BETWEEN SUBSAMPLES ... 60

TABLE 11 - SHORT-TERM CROSS-SECTIONAL REGRESSION ... 62

TABLE 12 - DESCRIPTIVE STATISTICS ... 65

TABLE 13 - DID TABLE: PRE-SEO CHARACTERISTICS ... 66

TABLE 14 - DID TABLE: POST-SEO CHARACTERISTICS AND DID ESTIMATOR... 69

TABLE 15 - LONG-TERM DID REGRESSION: FULL SAMPLE ... 72

TABLE 16- LONG-TERM DID REGRESSION:DEBT REPAYMENT ... 74

TABLE 17 - LONG-TERM DID REGRESSION: GENERAL CORPORATE PURPOSE ... 76

TABLE 18 - LONG-TERM DID REGRESSION: INVESTMENT ... 77

TABLE 19-PAIRWISE COMPARISON BETWEEN SUBSAMPLES ... 79

TABLE 20 - ACTUAL USE OF ISSUE PROCEEDS: GENERAL CORPORATE PURPOSE ... 83

TABLE 21 - ACTUAL USE OF ISSUE PROCEEDS: DEBT REPAYMENT ... 84

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List of abbreviations

ABT - Arbitrage Pricing Theory AIM - Alternative Investment Market C&STI - Cash & Short-term investments CA - Current Assets

CAPM - Capital Asset Pricing Model CAR - Cumulative abnormal return CFIA - Cash flow from investing activities CL - Current Liabilities

D - Debt

DEB - A firm that states that the issue proceeds will be used for repaying debt DID - Difference-In-Difference

EBIT - Operating income before interest and tax

EBITDA - Operating income before interest, taxes, depreciation and amortization Eq - Equity

EUR - Euro

FCF - Free cash flow

GEN - A firm that does not precisely state what the issue proceeds will be used for INV - A firm that states that the issue proceeds will be used for investment purposes LN - Natural log

M&A - Mergers & Acquisitions NPV - Net Present Value OLS - Ordinary Least Square OROA - Operating return on assets OROS - Operating return on sales PP&E - Property, plant & equipment R&D - Research & Development SEO - Seasoned equity offering TA - Total Assets

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1 Introduction

A so-called “investment expert” on a worldwide TV-station recently made a bold statement that, “this logic of seeing a seasoned equity offering as bad news, is an old fashioned way of viewing the market” (Website 1: CNBC, 2015). Could this non-academic “investment expert”

really be right? Empirically, everything speaks against this statement, as the extensive research by academics seems to agree that a seasoned equity offering is in fact bad news. The general consensus on the subject is that the offering entails a negative market reaction, in the shape of a significant decline in stock prices, and a subsequent decline in operating performance in the years following. However, the “investment expert” might still have a point,

as he suggests that the ultimate use of the issue proceeds might actually be beneficial for the shareholders. Thus, it could potentially depend on the use of issue proceeds whether a seasoned equity offering is bad news. The academics have already turned their attention to this subject, however all research seems to heavily focus on the market reaction while almost completely ignoring subsequent operating performance. Especially in terms of operating performance, the findings seem to be inconclusive, which leaves the question very open.

Previous studies have primarily focused their researched on either the market response or operating performance, but there seems to be a lack of research linking the market reaction to the subsequent operating performance. Furthermore, most studies are quite outdated and/or based on US firms. Thus, there is a gap in the literature both in terms of EU firms and whether the market reaction actually corresponds to the future operating performance of firms issuing seasoned equity.

The question then remains whether a seasoned equity offering is always bad news or whether this depends on the intended and actual use of issue proceeds. This thesis therefore examines this subject, which leads to the following research question.

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1.1 Research question

The aim of this study is to investigate the market response, any change in operational performance and the use of issue proceeds of firms issuing seasoned equity. This leads to the following main research question:

- What are the implications of a seasoned equity offering on firm performance and how is this moderated by intended use of issue proceeds?

To answer the main research question, the following three sub-questions are put forth: - What are the implications of a seasoned equity offering on stock price and how is this

moderated by intended use of issue proceeds?

- What are the implications of a seasoned equity offering on operating performance and how is this moderated by intended use of issue proceeds?

- Are the issue proceeds used in accordance with the proclaimed purpose?

1.2 Thesis approach

This thesis seeks to further explore the literature of seasoned equity offerings. This will be done through three methodological approaches. First, a short-term event study will be conducted to measure the immediate effect the SEO1_{announcement has on the issuers’ stock} price. Secondly a long-term performance study on the basis of accounting measures will be conducted, to examine any changes in operational performance. At last we seek to explore if the firms actually use the issue proceeds in alignment with the SEO prospectus. These three methodological approaches will all be assessed on the basis of the intended use of issue proceeds, stated by the firms in their SEO prospectus. By combining these three approaches we enhance the robustness of our conclusions compared to previous literature, which primarily focus on the short- or long-term stock return or long-term operational performance. Moreover this paper will take its origin in European data, thereby contributing to the modest evidence on seasoned equity offerings in Europe, since most of the previous literature is based on US data.

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This paper is built up upon previous research and empirical evidence. The theoretical framework of Walker & Yost (2008) and Autore, Bray & Peterson (2009) has been used to define the motive behind the SEO, by the intended use of issue proceeds. Also the framework of MacKinlay (1997) and Barber & Lyon (1996) have contributed to the methodology for the research design as well as the execution of the short-term event study and the long-term performance study. Furthermore the relatively new model developed by Kim & Weisbach (2008) has been applied to assess the use of issue proceeds.

In order to answer the above problem statement the approach to this thesis will be based on an analytical approach, which means the thesis will be approached on the basis of a positivistic paradigm. The assumption behind this paradigm is that we try to see the reality as objective as possible, where we only focus on the facts and causality. Therefore this paper should be independent from its writer, which means that another writer should draw about the same conclusions as we do in this paper.

1.3 Delimitation

Most of the delimitations are outlined throughout the thesis. However a few fundamental delimitations are laid down in this section. The geographical boundary of this thesis is limited to the following European countries: Austria, Belgium, Denmark, Finland, France, Germany, Great Britain, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden and Switzerland.2

This thesis will apply a variety of theories as described in section 2.2, in order to explain the market reaction and subsequent firm performance after a SEO. The applied theories will not be tested empirically, nor will the previous research be applied to test if the theories hold in practice. Instead the theories are assumed to be well specified and tested, which is why they will only be applied in order to describe the market reaction and operating performance after a SEO.

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This thesis is mainly limited by availability of data. Due to requirements of sufficient ex-ante and ex-post data, focus is therefore exclusively on seasoned equity offerings conducted in the period from 2000 to 2010, both years included.

We exclude companies in the financial and utility sector in our analysis. These companies operate under strict regulations that are fundamental different from the remainder of companies. This is common practice in researches on seasoned equity offerings.

1.4 Data sources

The literature in this thesis will be based on primary sources, which are well known published articles. These articles have been published in respected international journals, which include a mixture of previous research on seasoned equity offerings as well as more theoretical models. The primary reason for choosing peer-reviewed articles is the validity.

Besides articles from well-respected journals, this thesis relies heavily on stock as well as accounting data. As a primary source for the stock data, Datastream has been used. For the accounting data and additional firm information Bloomberg has been used, combined with robustness checks of the data through Orbis, as well as the annual reports of the firms. The data sources are considered reliable, and furthermore due to the robustness check of the accounting data, our data is suggested to be of good quality. Nevertheless the data should still be observed from a critical point of view. All data can be found on the enclosed CD.

1.5 Thesis structure

The remainder of the thesis is structured as follows. Section 2 provides an overview of the relevant theory of seasoned equity offering. Following, an overview of previous empirical findings regarding the market reaction as well as operational performance of issuing firms is presented. On the basis of the theoretical foundation and empirical findings the thesis hypotheses are presented in section 3. In section 4 we present the research methodology for the short-term study, operational performance study and study on actual use of issue proceeds. Section 5 presents the data as well as any considerations taken in the process of collecting the data. On the basis of the theory, previous empirical findings, research methodology and data, section 6 presents the empirical results divided into short-term, long-term and actual use of issue proceeds. We conclude the thesis with a conclusion in section 7

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and a critical discussion in section 8. A bibliography of applied literature and appendices are available at the back of the thesis.

2 Theory overview and empirical findings

In the following section a brief introduction to SEO’s in general and the possible reasons for conducting a SEO will be provided. The section also provides an overview of relevant theory in relation to market reaction and operational performance as well as previous empirical findings on the subject. The presented theory and empirical findings will form the basis of the

thesis’ hypothesis and serve as reference in the analysis.

2.1 Seasoned equity offerings

A seasoned equity offering is a way for a firm to gain outside capital through the financial markets. A SEO is defined as a new stock/equity issue, by a firm that currently is traded on a stock exchange. This means that the firm is publicly listed by previous having gone through an equity issuance through an Initial Public Offering (IPO), where the original stock was offered for the first time. When firms conduct a SEO, they are able to do so by offering two types of shares. First off they are able to offer primary shares, which are newly issued shares that are offered to public investors for the first time. The other way is through the use of secondary shares, which refer to existing shares that are being sold from existing shareholders to new shareholders, so basically the already traded shares shift hands. The main differences between these two types of offerings is that primary share offering raises new capital to the firm, whereas secondary shares do not raise new capital. Furthermore a secondary share offering is non-dilutive3_{, since no new shares are issued. In a primary share offering current} ownership will be diluted, because a number of new shares are issued. This thesis will only be

looking at SEO’s where the offering contains an amount of primary shares4_.

There are several reasons why a firm might offer new equity. Generally this is described in the prospectus following the offering and is known as the Use of proceeds. This could include specific investment in R&D, funding of continuous operations, merger and acquisitions,

3_{Stock dilution refers to the reduction in the ownership percentage, due to a SEO}

4_{Most offerings contain a mixture of primary- and secondary shares, however often with an clear overload of} primary shares.

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recapitalizing, repaying debt and so on. The work of Walker & Yost (2008) and Autore, Bray & Peterson (2009) have grouped the many reasons into three different categories, based on the stated use of issue proceeds. The first group is the firms that offer new equity in order to recapitalize, by repaying some of its current outstanding debt, which would result in a change of leverage5_{(DEB). The second group is the firms that issue new equity in order to use it for} general corporate purposes. This group does seldom reveal any specifics about the use of proceeds, which basically means that the issue proceeds will either be added to the firms’

working capital, and serve as a liquidity buffer for continuous operations or that it is too costly for the firm to reveal any specifics in terms of competitive advantages (GEN). The third group is the firms that issue equity with a clear intention to fund investments through the issue proceeds, be it for M&A activities or R&D (INV). We will in this thesis follow the same classifications as Walker & Yost (2008) and Autore, Bray & Peterson (2009), in order to detect if the stated intended use of issue proceeds have an effect on the short- and long-term performance of the SEO firms. The different motives in relation to this thesis will be described further in section 5.2.

2.2 Theory overview

As a theoretical framework to answer our research question a number of theories have been included. The main subjects of the theories are capital structure, adverse selection, signaling and principal-agents problems. The theories do in many ways overlap and are therefore not mutually exclusive. However, they each take its roots in different aspects of the corporate finance theories.

2.2.1 Capital structure

The first to define a relation between the optimal capital structure and firm value where Modigliani & Miller (1958), who argued that a company does not increase or lower its value by changing its capital structure, assumed that there are no taxes, bankruptcy costs, agency costs or information asymmetry. The reason for that argument is that when a company changes its leverage by increasing its level of debt, the equity holders will require a higher return due to the increase in risk, thereby offsetting the effect the capital structure has on company value and vice versa (Modigliani & Miller, 1958). Since all firms in practice face

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taxes, this thesis finds it more relevant to look at the corrected model by Modigliani & Miller (1963), where they include corporate taxes. In the corrected model they argue that there is an advantage of holding debt over equity, because debt entails a tax shield, due to the tax deductibility on the interest payments. Thus the market value of a levered firm will always be higher than an unlevered firm (Modigliani & Miller, 1963). All things equal, the market will perceive an equity issue negative since an increase in equity per se decreases leverage. If the

issue proceeds will be used to repay some of the firm’s outstanding debt, leverage decreases even more, which would result in a larger drop in stock price for this SEO motive. The reason is that when firms lower their leverage, they do not exploit their tax shield favorably, which leads to declining firm performance and firm value.

Brennan & Schwartz (1978) have elaborated further on the model developed by Modigliani & Miller (1963), by including bankruptcy costs. They argue that with a rising amount of debt, a firm faces an increased probability of bankruptcy, which increases the cost of financial distress. Basically this means that the marginal benefit of the increase in firm value declines with rising debt levels, whereas the marginal bankruptcy cost increase. Therefore an optimal capital structure exists, which result in a trade-off between the amount of debt and equity a firm should hold in order to maximize firm value. A firm should therefore increase debt until the advantage of the higher tax shield is offset by the increase in bankruptcy costs, as higher leverage beyond this point would reduce firm value (Brennan & Schwartz, 1978). This theory is further supported by DeAngelo & Masulis (1980) who propose a similar optimal capital structure model (DeAngelo & Masulis, 1980). Assuming that an optimal capital structure exists, a SEO would always be perceived as something positive by the market, regardless of what the issue proceeds will be used for. The reason is that a SEO per se changes firm

leverage, and assumed that managers’ act in the best interest of shareholders, the change in leverage is to the better i.e. towards the optimal capital structure. However should a firm issue new debt in combination with equity, thereby having no effect on the leverage ratio, the market value of the firm should be unaffected. The market should therefore be neutral to this action, which should not lead to any change in stock prices. This type of combination is mostly seen when firms need cash to finance investments. In the long-term, the improvements in capital structure should be reflected positively in earnings and performance in general.

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2.2.2 Adverse selection

It is said that the financial markets work provided that buyers and sellers have the same full information at the same time. However, in practice this is rarely the case, as asymmetric information does exist within the financial markets. On the basis of asymmetric information Akerlof (1970) specified the term adverse selection, which defines a process in which buyers and sellers do not have the same level of information. In his paper “Market for lemons”, he

exemplifies the adverse selection problem with the used car market, where the adverse selection results in owners of good cars not wanting to put their cars on the market (Akerlof, 1970). The idea behind the theory is that only the sellers know the true quality of the used cars and buyers are not able to distinguish the good ones from the bad ones. This drives prices down, as buyers are only willing to pay for the average quality car, which results in good-quality cars being undervalued. As good-quality car owners are not willing to sell at undervalued prices, they take their cars out of the market, resulting in adverse selection. This theory is quite fundamental for many financing theories.

The pecking order model of Myers & Majluf (1984) elaborates further on the adverse selection dilemma in a financing context. The basic idea behind the pecking order theory is that firms prioritize their way of financing investment projects, through a clear hierarchy. First, they will use internal financing such as internal generated cash, then they will use debt and as a last resort the firm will issue equity as a financing source. Myers & Majluf assumes

that firm managers’ act in the interest of current shareholders, that managers know the true value of the firm’s assets and that only positive NPV-projects exist. When firms finance internally there are no costs of information asymmetry, as outside financing is not needed. However when outside financing is needed firms pass some information to the public, which leads the market to revise the value of the firm and its shares. As with the “Lemon”problem outsiders do not know the true value of the firm, and their best guess of the firm is that it is of average quality. Since this is the public’s best guess, managers of a good quality firms, refuse to issue equity, because the true value of the assets in place are higher than the market perceives. This causes the investors to revise their best guess about the quality of the firm downwards, entailing information asymmetry costs, because undervalued firms with good projects will not issue equity. This would in general mean that when the equity is underpriced, managers would rather foresee NPV-positive projects, rather than having to

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issue equity. On the other hand managers would issue equity if their securities were overpriced i.e. if managers expectations of future performance were lower than the markets expectations. Overall the pecking order model predicts that a SEO would lead the market to revise their expectations of the firm value and future performance downwards.

Cooney & Kalay (1993) have taken a slightly different view on the pecking order. Opposite Myers & Majluf (1984), they state that not all projects are NPV positive; arguing that the market has the expectation that the investments a firm can undertake both can be good or bad. They therefore argue that if firms do not undertake an investment, it may simply be because the project has negative NPV. Furthermore Cooney & Kalay assume that the market expects the future projects to be of average quality. This means that the announcement of an equity financing for a project could entail a positive market reaction if the project is better than the market expected and thus predicts better performance (Cooney, Jr. & Kalay, 1993).

One of the ways to mitigate this adverse selection dilemma is by minimizing the asymmetric information between managers and investors. Managers are able to do so by being as informative about the use of the issue proceeds through the SEO prospects. In general firms that do not state what the issue proceeds will be used for, will experience a significant drop in stock price, since they do not minimize the information asymmetry between managers and investors. Since investors do not know what the issue proceeds will be used for, they are not able to distinguish between good or bad projects; hence they still face the adverse selection dilemma. Thus if firms do have good projects they would be interested in differentiating

themselves, in order to avoid themselves from being “pooled” with the average firm. This

means that firms with good projects would be as specific to the public as possible in the SEO prospectus. This would lead the stock market reaction to be less negative, because of the ability to positively distinguish themselves from the average firm. However not all firms with good projects may be able to be specific, for example if the costs of letting competitors in on project details are too big. These firms are therefore forced to be pooled with the average projects when issuing new equity. On the other hand firms with bad projects will never be specific about the use of issue proceeds, as informing the public about a bad project will result

in a more negative reaction than if they were “pooled” with the average project. Firms with

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Firms issuing equity in order to repay current outstanding debt do not face the adverse selection dilemma. As they merely adjust their capital structure they should be free for the signal of bad projects, hence the market response for these firms should be less negative and performance should be unaffected (Myers & Majluf, 1984).

Also Krasker (1986) has made an extension to Myers & Majluf (1984). He argues that there is a relationship between the issue size and stock price reaction. Opposite Myers & Majluf this model suggests that managers are able to decide the amount of equity raised through an issue. This means that more overvalued firms tend to issue more equity and keep the excess cash as financial slack. Therefore there is a negative correlation between stock price and issue size, which is why investors use issue size as a proxy for overvaluation and insider asymmetric information (Krasker, 1986).

There are some shortcomings to the pecking order hypothesis, because in order for firms to follow the pecking order, they must have access to all financing sources. Relatively small and young companies might not have access to sufficient internal funds, nor external funds in terms of debt, since lenders might not have gained confidence in the firm. Young and small firms are therefore often forced to finance through equity issues. One might therefore suggests that the pecking order hypothesis only holds for older and larger firms, because smaller and younger companies are more likely to be financed with equity ( (Frank & Goyal, 2003) & (Diamond, 1989)). Furthermore the pecking order theory disregards the effect of taxes, agency costs, financial distress and the issuance cost of securities.

2.2.3 Signaling

The pecking order hypothesis above assumes that financial slack is fixed and always inadequate for undertaking the project, thus requiring external financing. However, other theories adopt another point of view and assume that external financing only is needed when internal cash flows are insufficient. The basic idea is therefore that managers have inside information on future performance and profitability and that a financing decision therefore is a signal to the market of the firm’s future cash flows.

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One signaling model developed by Miller & Rock (1985), suggests that the net financing policy can be used as a signal of firm quality. They argue that when a firm pays out dividends to its investors it sends a strong positive signal of future cash flows. This model therefore suggests, the higher the pay-out ratio the stronger the signal. The opposite of giving its investors’

money, is asking them for money through an equity issue, the effect is therefore merely the effect of paying dividends, though with opposite sign. A SEO is therefore a negative signal of future earnings. Even though the firm state that the issue proceeds will be used for specific investments, the market should react negatively, as they argue that the firm is not able to generate enough internal funds to finance the optimal level of investment. As also argued by Krasker (1986), this statement would mean that a larger issue size indicate a larger need of cash. Again this indicates a negative association between issue size and stock price. If firms issue equity in order to repay debt, the firms should be free from the signaling effect of lack of liquidity and future declining performance as this just changes capital structure (Miller & Rock, 1985).

Ross (1977) has developed another signaling theory, where he suggests that debt can be used as a signal of firm quality. He argues that the higher the amount of debt, the higher the quality of the firm. He assumes that high quality firms earn high profits, which means they easier can bear a larger amount of debt and the entailed interest payments, compared to firms of lower quality. Therefore high leverage firms can signal the level of firm quality to investors (Ross, 1977). Basically this means that if a firm issues equity and uses the proceeds to repay some of its debt, this has a negative signaling effect, which according to Ross (1977), should indicate declining profits. Firms that intend to use the issue proceeds for investments or do not state the intended use of issue proceeds, should not see a negative market reaction to the SEO announcement, or at least only a slight negative reaction since they should have used debt over equity as a financing source.

Leland & Pyle’s (1977) signaling theory is based on management’s willingness to own and

invest in the firm and any new projects. The argument is that managers are able to minimize the information asymmetry by increasing their own ownership in the firm. They base their theory on the adverse selection problem, and thus a higher level of management ownership signals good firm quality. In general this theory states that a SEO is seen as a negative signal of

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future performance, since a SEO dilutes manager ownership in the firm. If managers therefore instead would take up larger equity positions when issuing equity, some of the asymmetric information between managers and investors would diminish, which would send a strong signal of the quality of the firm. In turn management can include secondary shares in the offering, which would indicate lack of confidence to future performance. Thus an inclusion of secondary shares would send a negative signal to the market in terms of future performance (Leland & Pyle, 1977).

2.2.4 Agency theory

Within corporate finance, agency problems are a widespread phenomenon and in relation to equity financing the theories are well applied. In short, the agency theories explain the conflicts between principals6_{and agents}7_{, where problems arise due to the fact that the} agents not always act in the best interest of the principals. The problem herein lies that it is difficult for the principals to control if the agents spend excessive money on perquisites or engage in excessive risky investment etc.. Therefore the agency costs rise, due to this information gap (Brealey, et al., 2009).

Jensen & Meckling (1976) combined the agency theories with financing theories and developed a theory on the ownership structure of the firm. Their theory explains how the cost associated with the conflicts between managers and shareholders reduce the market value of the firm. The costs are defined as the costs associated with monitoring the manager as well as loss in firm. These costs originate from the assumption that when management ownership level decreases, the manager tends to be more inclined to fulfill his or her own needs in form of perquisites and opportunistic behavior instead of maximizing firm value, which basically leads to a lower firm value. In order to compensate for this, shareholders monitor the manager in various ways, which are associated with costs. Therefore from the shareholders perspective an equity issue will always be seen as something negative since it increases the resources available to the managers, which leads to higher cost associated with monitoring and open for more investments in value decreasing activities.

6_{Investors, Shareholders, lenders etc.} 7_{Managers, firm executives etc.}

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Jensen (1986) has extended the version of Jensen & Meckling (1976), to include the availability of free cash flow. He states that if a firm has sufficient free cash flow it should use these funds as a source of financing, instead of external financing. His definition of free cash flow is cash flows in excess of that required to fund all positive NPV projects of a firm. If there is free cash flow available this should be paid out to the shareholders in order to maximize value for the shareholders. Available free cash flow entails an increase in agency costs of equity and reduces firm value. He therefore suggests that if excess free cash flow is available and a firm announces a SEO, the market would react negatively since a SEO further increases the cash availability for managers and lead to value decreasing investments (Jensen, 1986). However if a firm has no excess free cash flow to invest in a project the firms has to approach the capital markets. In this case it is up to the investors and analysts to assess the project and to value if the issue proceeds are spent in their best interest, which might lead to a non-negative market reaction around announcement.

Jensen (1986) argues that one way of reducing the agency conflict between managers and investors is through the use of debt. By using debt over equity managers are forced to payout future cash flows, which reduces resources available to the managers, which in turn reduces the consumption of perquisites and opportunistic behavior of the managers. Shareholders on the other hand cannot force managers to pay out dividends or repurchase stocks8_{. Therefore} if a firm issues equity with the purpose of paying back outstanding debt, this would opposite Myers & Majluf (1984) be perceived as more negative by the market, as managers are no longer obliged to pay out future cash flows, which enhances the resources available to managers and thereby increases the agency conflict.

2.2.5 Summary

Basically all the theories suggest that a SEO in general entails a negative market reaction and a subsequent decline in performance. If equity issues are split into the SEO motives the theories are a bit ambiguous, though they all agree that when a firm states general corporate purpose the stock price will be revised downwards due to expected lower performance ex-post. If we look at firms stating investment as their intended use of issue proceeds, the theories argue that the market reaction could be both negative as well as positive.

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Nevertheless most of the theories point in the direction of a negative market reaction and subsequent decrease in operating performance. When the issue proceeds are used for debt repayment, the theories comes with contradictory arguments on how the market reacts as well has how performance develops ex-post. The preponderance of theories though suggests that a SEO should not impact the stock price or operating performance ex-post. To give a better indication of the effect of a SEO or lack thereof, we review the previous research and report the findings in the next section.

2.3 Literature review

A reasonable amount of research has been conducted to investigate the implications of SEO’s, i.e. the short-term market reaction to a SEO and the operating performance in the years after. As will be described in this section, the main findings of these researches are most often an immediate negative reaction in the stock price around the SEO announcement. Most of the studies on the stock price reaction have been carried out on the US market, whereas only a few studies have focused on European countries. A number of researchers have extended the stock performance research to focus on the long-term, which basically measures the stock price development over a longer period than the short-term market reaction. The long-term stock performance is however out of the scope of this thesis. Furthermore, researchers have put some attention to the long-term operational performance of seasoned equity issuers. The long-term operational performance studies primarily focus on the changes in the income statement, balance sheet items and performance measures thereof. Only a few, though, have coupled the announced use of issue proceeds to the short-term market reaction and long-term operational performance, as we will in this thesis.

2.3.1 Studies on market reaction

One of the earliest studies on the stock price reaction to the announcement of a SEO is by Asquith & Mullins, done in 1986 (Asquith & Mullins Jr., 1986). In their study on 266 US listed industrial firms issuing equity, they find that, on average, the announcement is associated with a significant abnormal negative return of 2,7%. This negative reaction is observed in 80% of their sample. The reduction in price and thereby total drop in firm value actually showed to equal about 78% of the proceeds from the SEO. They also found that issuing firms’

stock on average outperformed the market two years prior to the SEO and underperform the market two years ex-post, with 33% and -6% respectively. Asquith and Mullins’ (1986)

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findings are consistent with the hypothesis stating that a SEO in general is a negative signal about a firm’s current performance and future potential. Furthermore, their pre-issue stock performance findings support Myers & Majluf’s (1984) pecking order theory, indicating an overvalued firm at the time of the SEO.

Another study on the US market, conducted by Kim & Purnanandam (2006), also finds negative market reactions to SEO announcements. The magnitude of the reaction they find is a bit lower, -1,34%, but still significant. By looking into the combination of primary and secondary shares they also find support for the signaling theory by Leland and Pyle (1977). Thus, when a SEO contains an amount of secondary shares, meaning that an insider or a large shareholder is selling its shares through the issue, the market reacts more negative than is the case in a pure primary share offering (Kim & Purnanandam, 2006).

Korajcyk et al. (1990) also detect an abnormal drop in stock returns of 2,9% around the announcement. Their sample is composed of 1.480 SEO’s in the US between 1974 and 1983.

However, contrary to Kim & Purnanandam (2006), the reaction to offerings that include secondary shares is roughly the same as pure primary offerings (Korajczyk, et al., 1990). Cox and Aryal, who studied 77 non-financial US firms between 1997 and 2004, found that both rights and underwritten offerings experienced negative returns upon the announcement (Cox & Aryal, 2007).

These above researches are, however, conducted on the US market, a market that has been studied extensively. The few available studies of the European market are not as conclusive. A

study on the Norwegian stock market on 188 SEO’s between 1980 and 1993 by Bøhren et al. (1997), shows a significant positive reaction of 0,47%. Compared to Asquith & Mullins (1986) 80%, only 51% of the announcements are followed by a negative market reaction (Bøhren, et al., 1997). On the Finnish market, Do (2009) finds a significant drop in stock price of 3,6% for the 93 announcements during 1996 and 2003. Similar to Asquith & Mullins (1986) findings, around 80% of Do’s observations experienced negative returns around the announcement (Do, 2009).

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2.3.2 Studies on market reaction with use of issue proceeds

The above-mentioned studies all take a general perspective to the announcement effect of

SEO’s, while the focus of this thesis is to assess the effect the announced use of issue proceeds have on the market reaction and firm performance. One of the first studies to examine this topic was carried out by Masulis & Korwar in 1986. They examined 1.406 offerings from 1963 to 1980, of which 690 was by industrial firms. Masulis & Korwar divided their sample in three categories of intended use of issue proceeds based on the information available in the prospectuses; Debt reduction, capital expenditures and mixed uses. The debt reduction firms intended to repay outstanding debt, the capital expenditure firms intended to invest in specific projects and mixed uses firms were those who listed multiple purposes. For the

combined sample of SEO’s they found a significant negative two-day return of 3,25%. In the divided samples, they did not find any significant differences between the stated uses of issue proceeds on the announcement effect. With twoday returns of 3,84% for debt reduction, -3,75% for capital expenditures and -2,52% for mixed uses, all announcements were received negatively by the market (Masulis & Korwar, 1986).

Hull & Moellenberndt (1994) specifically studied US equity offerings intended for reducing debt in the years 1970 to 1988. Their research is based on the premise that an increase in debt is a positive signal, and thus a decrease in debt would be a negative signal. Within a three-day event window the 496 sample firms that issued equity with the intention of paying off debt, on average experienced a significant drop in stock price of 2,82%. In an extended window of 11-days, the reduction was 3,05% and still significant (Hull & Moellenberndt, 1994). Their findings are therefore in line with the agency theories, Ross’ signaling theory and M&M’s (1963) tax shield model.

Johnson et al. (1996) took another view and studied the market reaction for 141 SEO’s in the US who only stated investment as the use of issue proceeds. They used a sample of SEO’s that

stated anything else than investment as a benchmark, and found that the market did not react significantly different to SEO’s announcing specific investment purposes. The announcement day reaction was -2,07% and -2,17% for the investment sample and non-investment sample respectively. A separation of the full investment sample into general capital expenditures and acquisitions did not result in any significant differences either (Johnson, et al., 1996).

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Gajewski & Ginglinger (2002) study on the French market during 1986-1996 showed a slightly different result. They found that when issuers state that proceeds were intended for either M&A or other investments, the market reaction was still negative, but around 1% more positive than when stating debt repayment or general corporate purpose (Gajewski & Ginglinger, 2002). Gajewski & Ginglinger (2002) assigned the difference to be due to reduced information asymmetry and reduced moral hazard. This is consistent with the agency theories, where debt repayment and general corporate purpose increases free cash flow at disposal to managers.

Hull et al. (2009) combined the previous studies and investigated SEO’s where the stated use of issue proceeds was either investment related purposes or debt reduction. They removed

SEO’s where none of this was the case, thus excluding all observations where the intended use of issue proceeds were more general. Like most studies, they also studied US listed stocks, but within a newer period, from 1999 to 2005. For their sample of investments purposes and debt reduction purposes, SEO’s the mean three-day market reaction was negative for both groups with 2,73% and 1,72% respectively. Furthermore, they found evidence that the difference in market reaction was significantly different between the two samples (Hull, et al., 2009). This supports the adverse selection theory of Myers & Majluf (1984) and the signaling model of Miller & Rock (1985), that the market receives debt reduction purposes less negative. However, the different reactions to investment and debt reduction purpose SEO’s is

contradictory to the findings of Gajewski & Ginglinger (2002),

A more in depth study of the market reaction of announced intended use of issue proceeds is by Walker & Yost (2008). They divided their sample of 328 US SEO’s into investment, general

corporate purpose and debt repayment based on the intended use of issue proceeds described in the prospectuses. Walker & Yost’s results are in line with the general effect of SEO announcements, as they observed an overall two-day abnormal return of -2,76%. For the divided sample, the observed abnormal returns were -2,18%, -3,2% and -3,26% for the INV, GEN and DEB sample respectively. The smaller reaction for the investment sample were however not significantly different from the other two samples, and thus does not support the findings of Hull et al. (2009). In general, they concluded that being specific about the use of

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issue proceeds matters. Walker & Yost’s categorization of the SEO’s is very similar to the one of this thesis and thus their results are highly comparable to ours. Furthermore, Walker & Yost also covered long-term operational performance, so we will return to their study later (Walker & Yost, 2008).

2.3.3 Studies on operational performance

The focus of this thesis is not only the announcement effect of SEO’s, but also any implications

the equity issue may have on the long-term operational performance. This focus area is however not so extensively studied as the short-term announcement effect, but not completely overlooked either. Whereas the short-term studies predominantly use abnormal stock returns, the long-term studies have employed a number of different methods and performance measures. This makes the results of the previous long-term findings more difficult to compare.

Some of the first to focus on the implications of SEO’s on the operational performance were Healy & Palepu (1990) in their study on 93 industrial firms during 1966 to 1981 in the US. They measured the earnings per share ex-ante and ex-post and found no decline in earnings per share ex-post for issuers compared to industry averages. However, they found increased volatility in earnings in the ex-post years (Healy & Palepu, 1990). A concurrent study of SEO’s

between 1975 and 1982 by Hansen & Crutchley (1990) however got dissimilar results. Hansen & Crutchely argue that earnings per share may be diluted following a SEO, and that ROA (return on assets) therefore is a better measure for operational performance. Compared to a weighted market average, the 109 issuers in their sample experienced a significant downturn in ROA in the three years ex-post (Hansen & Crutchley, 1990). Both studies ascribe

their findings to signaling theories of management’s knowledge of future earnings and ROA.

These fairly early studies where quite basic in terms of how to illustrate the effect of a SEO, by merely looking at one performance measure. Later on Loughran & Ritter (1997) applied a number of ratios in their study to expose any operational performance implications. Their sample consisted of 1.338 SEO’s between 1979 and 1989, excluding firms in the financial and

utility industries. Besides ROA, they measured changes in profit margin, EBITDA scaled by sales and scaled by assets as well as investments and R&D scaled by assets. Methodological

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they matched their sample to non-issuers of same industry and size with the closest EBITDA/Assets and measured performance differences between SEO firms and non-issuing firms from four years ex-ante to four years ex-post. In the four years past the SEO, Loughran & Ritter documented a significant deterioration on all ratios for issuers compared to non-issuers. Their result holds for both median and mean ratios, and after having winsorized their data. Contradictory to the pecking order theory Loughran & Ritter did not find any evidence for increases in debt ratios prior to the SEO, implying that the sample firms were not constrained by their debt capacity (Loughran & Ritter, 1997).

In a contemporaneous study, McLaughlin et al. (1996) used the free cash flow as a

performance measure for their sample of 1.296 SEO’s in the US from 1980 to 1991. Similar to Loughran & Ritter (1997), they found a significant decline of 1,7% in the industry-adjusted FCF from one year prior to three years ex-post. However, McLaughlin et al.’s results showed that the sample firms in general performed better, by having higher industry-adjusted FCF ratios than their industry peers throughout the seven years of their analysis. Furthermore, regression results of the determinants of the performance change showed that the ratios of FCF to assets in t-1 were significantly negative related to the change in post-SEO performance.

Thus their results follow Jensen’s FCF theory, that larger ex-ante FCF’s is followed by greater

performance deterioration. Their regression results also indicated that the investments take time to become productive, as the coefficients for investments in fixed assets (change in PP&E) increased and became more significant throughout the years. This also indicated that SEO firms that invested, performed better than non-investing SEO firms. McLaughlin et al. (1996) extended their research and found two variables that stood out as being significant determinants for the SEO decision. They found that firms with high growth opportunities, as

proxied by Tobin’s Q9_{, and high leverage had a higher tendency to perform a SEO} (McLaughlin, et al., 1996). This indicates that firms with high leverage seek to reduce or avoid higher bankruptcy costs and adjust towards a target leverage ratio, as the trade-off theories suggest.

9_{McLaughlin et al. (1996)}_{proxy Tobin’s q as market value of equity plus book value of debt to book value of} asset.

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Heron and Lie (2004) also observed performance declines in their sample of 2.038 primary share offerings in the US from 1980 to 1998. The decline was measured with operating income scaled by sales and assets as well as FCF scaled by assets. Like McLaughlin et al. (1996), Heron & Lie also found evidence for the significant negative effect of pre-SEO performance to the change in performance. With regards to firm characteristics they found, that issuers in general did not have low cash holdings, i.e. were not in need of equity/liquidity, or had high leverage in comparison to industry medians (Heron & Lie, 2004). Cox and Aryal (2007) on the other hand found no significant changes in ROA, ROE or operating income scaled by sales (Cox & Aryal, 2007). Having said that, Cox & Aryal only looked at a three-year period from one-year prior to one-year post and they did not compare their sample to any benchmark samples. Thus their results should be looked upon with caution.

As was the case with studies on the announcement effect of SEO’s, a large proportion of the

studies on long-term operational performance study the US listed firms. The study by

Andrikopoulos (2009) on UK SEO’s is one of the few non-US studies. He examined 1.542 issues on the London Stock Exchange, AIM market excluded, in the period from 1988 to 1998. He used a benchmark sample of non-issuers matched by industry and size and found a significant decline in both ROA and net profit margin compared to both benchmarks, for up to three years after the SEO. This is while issuers on average experienced a growth in turnover above benchmark firms in the same three years. Furthermore, he observed significant larger investments in assets for the sample firms in comparison to the benchmarks. Andrikopoulos linked his findings with the agency theories and free cash flow theories that excess funds/cash flows are invested in negative NPV projects, and thus that the firms are subject to empire building managers (Andrikopoulos, 2009).

Bayless et al. (2005) studied 1.752 SEO’s by industrial firms in the US during 1974 to 1999 and found similar declining operational performance for issuing firms ex-post. Overall they reported a significant decline in sales growth, operating income growth, asset growth, growth in cash to total assets as well as capital expenditures. On the other hand they found that growth in debt and growth in free cash flow increased significantly (Bayless, et al., 2005). Their findings were however not compared to any industry benchmarks, and thus it is

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difficult to assess whether their findings can be assessed to the SEO offerings or other macro-economic effects.

2.3.4 Studies on operational performance with use of issue proceeds

A common feature of the previous studies are the generalization of the SEO’s, where the researchers have disregarded the announced intended use of issue proceeds. As mentioned by Cox and Aryal (2007), the proceeds may have been used to pay back costly debt and therefore may or may not have had a positive or negative effect on ROA (Cox & Aryal, 2007). Segregation between the intended uses of issue proceeds might therefore show another picture or at least a differentiated picture in regards to operational performance of SEO firms. Only a few studies though are available with this segregation.

As mentioned earlier the study by Walker & Yost (2008) also covers the long-term operational performance, split into three subsamples based on the announced use of issue proceeds. Recall they divided their US sample into firms who use the funds for investment (INV), debt repayment (DEB) and general corporate purpose (GEN). The operational performance of the sample firms were studied from the year prior the SEO to two years after. To determine the use of SEO proceeds they measured changes in total assets, capital expenditures plus R&D cost, the level of long-term debt and working capital in relation to the year prior to the SEO. They found that firms that intended to invest in fact increased their total assets more than the GEN and DEB subsamples. However, both INV and GEN firms increased their assets significantly more than DEB firms did. In comparison to this, they found that the working capital ratio for all three groups only proved to be significant for the GEN and DEB samples. An absolute increase in capital expenditures plus R&D were also found for all groups, with INV and GEN firms showing a significant higher increase compared to DEB firms. With regards to the level of long-term debt, they found that firms that intended to repay debt generally had larger amounts of debt prior to the SEO compared to the industry median. Even though DEB firms had a higher level of long-term debt, Walker & Yost found that these firms only decreased their leverage significantly in the SEO year, before increasing it to the same pre-SEO level in the following two years. Neither the INV, DEB nor GEN subsample had a significant different leverage in the second year after a SEO, which indicated that the debt

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firms rather are replacing its debt instead of repaying it. With regards to performance, Walker & Yost found that all three groups saw a significant decline in operating income to total assets, with GEN firms showing a significant decline. However, when they adjusted for industry, both the INV and DEB subsample actually saw an increase in comparison to industry peers. As with the short-term findings, they concluded that firms that announce general corporate purpose, as intended use of issue proceeds appeared to invest in less profitable projects compared to INV and DEB firms.

A similar study by Autore et al. (2009) also examined the post operational performance taking into account the announced use of issue proceeds, with same categorization as Walker & Yost

(2008). Autore et al.’s sample consists of 880 SEO firms listed in the US during 1997 to 2003, excluding firms in the financial and utility industries. Autore et al. (2009) focused on the change in operating income scaled by sales and scaled by total assets. Both performance measures were industry and performance adjusted, and in both cases, they used OLS and quantile regressions to validate their results. For the entire sample, they found a significant decline in both performance measures when adjusting for industry and performance. However, when separating the sample into the three subsamples the decline was only significant for the DEB and GEN sample, while the performance for the INV subsample remains unchanged. Their regression results validated these results and furthermore indicated that the size of the SEO in terms of issue proceeds relative to firm size, does not have a significantly effect on the change in operational performance. These findings are partly consistent with the findings of Walker & Yost (2008). Autore et al. (2009) linked their findings to the fact that the INV subsample most often has a specific investment opportunity and thus are less likely to take advantage of a possible overvaluation.

2.3.5 How are the issue proceeds used

While the before mentioned studies focus on the overall performance changes of SEO firms, the following study tries to link the direct effect of SEO proceeds to changes in key ratios. Kim & Weisbach (2008) studied as much as 13.142 SEO’s from 38 different countries across continents between 1990 and 2003, among these 1.820 from continental Europe and 1.651 from the UK (Kim & Weisbach, 2008). They employed quite a different method than previous studies, and looked into the effect of SEO proceeds on seven accounting variables; change in

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total assets, inventory, cash holdings, capital expenditures, R&D, acquisitions and the reduction in long-term debt. The variables were looked upon from the year-end of the SEO year to three years ex-post. More precisely they ran a regression on these variables with the proceeds from the SEO and other sources of funds as explanatory variables. “Other sources” of

funds covered funds from divestitures of fixed assets, long-term debt issuances and funds from operations. By doing so, they argued that the model were able to explain which funds were used for which purpose, and thus give insight into how SEO proceeds are being used in comparison to internal generated funds. On all dependent variables, besides long-term debt reduction, they found that SEO proceeds had a significant positive effect. Furthermore, they found that the issue proceeds mainly were held as cash and invested in R&D, while internal generated funds mainly were used for reductions in long-term debt. Kim & Weisbach’s (2008)

model also gave the possibility of examining the dollar change in the accounting variables by a dollar change in either SEO proceeds or funds from other sources. The results showed that for a dollar increase in issue proceeds, approximately 50 cent were held as cash the first year after and then decreasing to 30 cent in the third year after the SEO. In terms of R&D they found that a dollar increase in issue proceeds raised R&D expenses by about 19 cent in the first year and increased to about 65 cents in the second year after. This indicated that the issue proceeds initially were held as cash and then spend on R&D investments over time rather than invested all at once. Kim & Weisbach (2008) thus concluded that SEO proceeds were used to finance investments and that the SEO had been conducted to take advantage of a high market valuation.

2.3.6 Conclusion based on previous research

Based on the previous literature, it seems that the SEO announcement generally entails an immediate negative reaction, with only the Norwegian serving as an exception. Furthermore, the studies show that a SEO announcement is received negatively by the market regardless of the intended use of issue proceeds. However the previous findings are inconclusive to whether the market reaction is differentiated by the announced use of issue proceeds. Based on the previous proposed theory one would expect debt repayment SEO’s not to experience

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The operational performance studies all indicate the same overall change in performance subsequent to a SEO. Aside from one study, all others observe negative ex-post performance compared to ex-ante performance. The few studies that divide their sample based on the intended use of issue proceeds do not show any conclusive results. Only the results for firms stating general corporate purposes are consistently indicating a negative performance change ex-post. The previous findings on firms who are stating specific investments or debt repayment indicate that it is still uncertain if and how a SEO affect these firms performance. For an overview of previous findings in respect to the market reaction, as well as subsequent performance see Appendix A.

3 Hypotheses

The previous sections have outlined the relevant theories regarding seasoned equity offerings, as well as previous empirical findings related to the topic. Based on this and in continuation of the research question the specific hypotheses of the thesis are presented below. The hypotheses are formulated as our predictions given the theory and empirical findings. The hypotheses are arranged in the same context as the analysis.

The following hypotheses are related to the short-term implications:

H1: Firms offering seasoned equity experience significant negative abnormal stock returns

around the announcement.

H1A: Firms offering seasoned equity intended for “debt repayment” do not experience

significant abnormal stock returns around the announcement.

H1B: Firms offering seasoned equity intended for “general corporate purpose” experience

significant negative abnormal stock returns around the announcement.

H1C: Firms offering seasoned equity intended for “investment” experience significant

negative abnormal stock returns around the announcement.

H1D: Significant difference in the abnormal stock returns around the announcement between the “use of issue proceeds” subsamples.

H1E: Offer size, Inclusion of secondary shares, Firm age, Pre-SEO Free cash flow and Leverage

Are Seasoned Equity Offerings bad news?