Journal of Corporate Finance

What motivates exchangeable debt offerings?

Anna N. Danielova

_{, Scott B. Smart}

⁎

_{, John Boquist}

Dept of Finance, DeGroote School of Business, McMaster University, 1280 Main Street, Hamilton, ON, Canada L8S 4M4 b

Dept of Finance, Kelley School of Business, Indiana University, 1309 E. 10th St. Bloomington, IN 47405-1701, United States

a r t i c l e i n f o

a b s t r a c t

Article history:

Received 7 November 2006

Received in revised form 18 September 2009 Accepted 21 September 2009

Available online 26 September 2009

Debt that is convertible into shares of a company other than the issuer is called exchangeable debt. Mostfirms that issue exchangeable debt hold large blocks of shares in several companies, and in this paper we study factors that influence the selection of a particular block to serve as the underlying asset for an exchangeable debt issue. Comparisons between issuers' holdings in differentfirms shed light on issuers' performance as monitors as well as their ability to engage in market timing. Holdings attached to these issues display superior past operating performance, but after the offer, both operating performance and stock returns decline. In contrast, we do notfind similar systematic performance patters for the“other holdings”of exchangeable debt issuers.

© 2009 Elsevier B.V. All rights reserved. JEL classifications:

G12 G14 G32 Keywords: Exchangeable debt Market timing Operating performance Convertible debt 1. Introduction

Unlike convertible debt, a security with payoffs linked to the performance of the issuer's common stock, exchangeable debt (ED) generates payoffs that depend upon the stock of a separatefirm. Afirm that issues exchangeable debt gives bondholders the option (or sometimes requires bondholders) to exchange their bonds for shares of anotherfirm (hereafter the underlyingfirm) in which the issuingfirm has a stake. For example, in 2001, Liberty Media issued $550 million in 30-year bonds exchangeable into shares of Motorola, one of 11 different companies in which Liberty held a large stake. Each $1000 par value bond was exchangeable into 36.8189 Motorola shares after January 15, 2006. In this paper we exploit the tendency offirms issuing ED to hold large equity stakes in several underlyingfirms to determine which of these blocksfirms select as the underlying security in an ED offer. If systematic differences exist between the blocks of stock chosen as the underlying asset for an ED offer and other blocks not selected, then those differences may yield new insights as to the underlying motive for the ED offer.

We are particularly interested in two issues. First, do ED issuers possess information that allows them to dispose of their holdings before they decline in value? Recent work byBaker and Wurgler (2000)and others suggests thatfirms issue equity when subsequent returns are low, and they issue debt when subsequent equity returns are high. Thus, managers appear to have timing ability with regard to their own stock. By comparing the returns of the holdings that ED issuers select as the underlying asset for an offering to the returns of holdings not selected, we may learn about the ability of insiders to time offerings based on information they possess as large shareholders.

⁎Corresponding author. Tel.: +1 812 855 8568.

E-mail addresses:adaniel@mcmaster.ca(A.N. Danielova),ssmart@indiana.edu(S.B. Smart),boquist@indiana.edu(J. Boquist). 1

Tel.: +1 905 505 9140x26193. 2

Tel.: +1 812 855 3366.

0929-1199/$–see front matter © 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.jcorpfin.2009.09.004

Contents lists available atScienceDirect

Journal of Corporate Finance

Second, if the stocks' underlying ED offerings exhibit poor post-issue performance, does that reflect insiders' market timing ability or reduced monitoring by the issuer? Again, because ED issuers are usually large investors in severalfirms, when they divest holdings in onefirm, presumably they have greater resources to monitor their remaining holdings. Furthermore, the increase in the issuer's incremental resources for monitoring should be greater when the issuer has fewer holdings remaining after an ED issue. That is, if afirm holds large blocks in_five different_firms and cuts that to four via an ED issue, the incremental increase in monitoring resources is smaller than it would be for afirm that holds blocks in just two companies and reduces that to one. Thus, we test to see if the operating and stock performance of the holdings that remain after an ED offering change, and if that change is linked to the number of the issuer's holdings. We analyze 107 issues of exchangeable debt by 80 corporate issuers between 1981 and 2005. Wefind that prior to conducting an exchangeable debt offering, an overwhelming majority of exchangeable debt issuers had several (6 on average) equity holdings in variousfirms, and our hypothesis tests focus on whether there are performance differences (accounting performance and stock returns) between thefirms selected for ED issues and those not selected. We document several striking patterns in the operating performance of the underlyingfirms and other holdings. Underlyingfirms tend to be more profitable than otherfirms that ED issuers hold. Prior to an ED offering, underlyingfirms also achieve operating performance equal to or better than performance of comparablefirms in its industry. However, over the three-year horizon following the offer, performance of the underlyingfirm declines to or below the industry average. We do not observe this pattern in the operating performance of issuers' holdings not chosen for an ED offering. These“other” firms trail their industry peers before and after the ED offering, but there is no tendency for performance to deteriorate over time.

Turning from accounting-based performance measures to stock returns, wefind that thefirms underlying ED issues exhibit positive abnormal stock returns of roughly 1% per month over one-, two-, and three-year pre-event horizons, although this result holds only for equally-weighted portfolios. Thefirms not chosen in the ED issue exhibit no pre-event abnormal returns. After the ED issue occurs, underlyingfirms earn negative abnormal returns, though the significance of this result varies depending on the portfolio weighting method and the post-event horizon. Again, wefind no evidence of abnormal returns at any horizon in the sample of“other”firms. Collectively, the evidence regarding operating performance and stock performance suggests that ED issuers choose underlyingfirms based on positive past performance, but that performance deteriorates after the issue.

Next, to explore the possibility that reduced monitoring rather than market timing might explain these results, we split our ED transactions into two groups based on the number of stakes held by issuers prior to their ED offering. The incremental resources available to monitor the issuer's remaining holdings is greater the fewer the number of these holdings. In fact, the number of investments held by the issuer does not appear to influence the relative performance differences that we observe over time. As a result, we do notfind any evidence suggesting that reduced monitoring explains ourfindings.

Finally, we estimate a logistic model to study the determinants of the issuer's choice of which position to include in the ED offering. Wefind thatfirms with larger performance declines are more likely to be chosen as the underlying asset, as arefirms in which the issuer holds a larger stake.

The remainder of the paper is organized as follows.Section 2reviews the previous literature on ED issues.Section 3describes the data collection process and presents sample characteristics of the data.Section 4 presents evidence on the operating performance of both the underlyingfirms and other holdings.Section 5investigates long-term patterns in their performance.

Section 6explores the determinants of the choice of the underlying stock for exchangeable debt offerings.Section 7concludes.

2. Prior research on ED issues

Prior research on ED offerings examines both the valuation effects associated with ED announcements and the economic motivation for ED issues.3_{In terms of short-term valuation effects, these papers generallyfind insignificant announcement returns for}

the issuer and negative announcement effects for the underlyingfirm.4_{Research has also provided insight as to the motivation for ED}

offers, in part by interpreting the event study evidence and in part by conducting additional tests.Barber (1993), for example, observes that investment bankers pitched ED offers as a way that clients wanting to divest a large block of stock could do so in a tax efficient manner. The tax savings come in two forms—deferral of capital gains on the underlying shares, and tax exclusion for the dividends paid by the underlying shares. Barber rejects the hypothesis that ED offers provided substantial tax benefits relative to other means of divesting shares. He observes that if tax savings were the primary motivation behind ED offers, then issuers should realize a positive announcement return, a prediction which the data do not support. He also notes that in many ED offerings, the issuer faces a capital loss on the underlying shares rather than a capital gain, and in other cases the underlying shares pay no dividends. He tentatively concludes that ED issuers save on underwriting fees relative to what they would pay to issue a block of shares in a seasoned equity offering.

Ghosh et al. (1990)emphasize the positive effects of asset restructuring for ED issuers. Citing the extensive literature on negative announcement effects forfirms issuing equity-linked securities, Ghosh et al. argue that the insignificant announcement returns for ED issuers (i.e., the absence of a negative announcement return as found in most equity-linked offerings) provide indirect evidence of a positive asset restructuring benefit associated with ED offers. In addition, they attribute the negative abnormal announcement return on the underlyingfirm's shares to reduce concentration in thatfirm's ownership structure.

3

See for example,Ghosh et al. (1990), Barber (1993), and Gentry and Schizer (2002). 4

Insignificant abnormal returns documented at the announcement of exchangeable debt issues may reflect the presence of two counterbalancing effects: the negative effect of equity-linked security offering and the positive effects of asset divestiture. Prior research documents positive CARs for parentfirms for asset restructurings through spin-offs (Miles and Rosenfeld, 1983; Schipper and Smith, 1983; Hite and Owers, 1983), asset sell-offs (Alexander et al., 1984; Jain, 1985; Hite et al., 1987; Lang et al., 1995), and carve-outs (Schipper and Smith, 1986; Anslinger et al., 1997; Vijh, 2002). Conversely, equity-relatedfinancing transactions that are associated with negative CARs are: IPOs (Ritter, 1991; Jain and Kini, 1994; Teoh et al., 1998), SEOs (Asquith and Mullins, 1986; Masulis and Korwar, 1986; Schipper and Smith, 1986), and convertible debt issues (Mikkelson, 1981; Dann and Mikkelson, 1984; Eckbo, 1986).

In recent years, a growing body of literature examines whether insiders possess superior information which allows them to sell overvalued securities to investors. For example,Baker and Wurgler (2000)find that when the equity share of aggregate new security issues is high (low), subsequent stock returns are unusually low (high).Lee (1997)shows that when corporate insiders sell their own shares prior to a seasoned equity offering of secondary shares, the shares subsequently underperform benchmarks.

Jenter (2005)reports that insiders of low-valuation_firms trade as if they believe their_firms' shares are undervalued, while insiders of high-valuationfirms do just the opposite.

It is in the spirit of this recent literature that we reexamine the motivation for exchangeable debt offerings. BothBarber (1993) and Ghosh et al. (1990)essentially take as given afirm's decision to divest a block of stock via an ED offer. In this paper, we depart from their work by studyingfirms with large investments in several underlying companies. Firms elect to divest some, but not all of these investments through ED offers. By studying the choice of which block of stock forms the underlying asset in an ED offer, we shed additional light on the motivation for these transactions.

3. Data and sample characteristics

We hand collected our sample of exchangeable debt offerings from various sources. The original list of transactions comes from the Security Data Company's Corporate New Issues database (SDC Platinum) from 1981 through 2005. We began with all U.S. new issues and specified a very broad list for the security type code including exchangeable bonds and notes, mandatory exchangeable notes, and many other categories. This generated a potential sample of 378 transactions. Starting with this list, we searched LexisNexis, Dow Jones News Retrieval, and the Edgar database of SECfilings to retrieve news stories and prospectuses pertaining to these offerings and to verify the details of each deal. We eliminated 100 deals due to missing information (e.g., missing information on Compustat or CRSP). We dropped another 50 deals issued by investment banks because these transactions appeared to be motivated by the banks' desire to hedge another position. An additional 163firms were eliminated because they did not meet the definition of exchangeable debt (e.g., the payoff on the debt did not depend on the equity of afirm other than the issuer, the issuer had no prior ownership stake in the underlyingfirm, or the debt was issued as payment to the underlyingfirm in a merger). This list was cross checked and augmented by the exchangeable transactions provided by Salomon Smith Barney and JP Morgan Convertible Research Groups. We identified 42 additional ED transactions from these sources and from a general search conducted using LexisNexis, Dow Jones Interactive, SECfilings, and search engines on the Internet. The accuracy of data was verified by comparing it to SECfilings and public announcements of exchangeable offerings in the Wall Street Journaland news wires. Applying these criteria resulted in a sample of 80 issuers and 107 ED offerings between 1981 and 2005.

Some exchangeable debt issues, like the Liberty Media example cited in the introduction, give the bondholder the option to exchange their bond for shares in an underlyingfirm. Other issues, known as mandatory exchangeable debt, require bondholders to convert. For example, in 1998 Tribune Co. issued 3-year bonds that required conversion into shares of the Learning Company. These bonds had a face value of $27.94 and paid a coupon rate of 6.5%. At maturity, bondholders would receive $27.94 worth of Learning Tree shares as long as the stock price was between $27.94 and $33.25. At lower prices, bondholders would simply receive one share of stock, and at prices above $33.25, they would receive 0.83 Learning Tree shares. Thus, investors who purchased the mandatory exchangeable bonds received periodic coupon payments, faced downside exposure to Learning Tree stock, and enjoyed some upside exposure as well. Table 1

Inflation-adjusted (2005 dollars) distribution and proceeds of announcements of exchangeable debt offerings.

Year announced Number of ED offerings Gross principal amount raised ($ millions)

1981 4 913 1982 2 403 1983 6 1282 1984 2 523 1985 6 985 1986 7 1354 1987 2 478 1988 3 5067 1989 3 625 1990 2 3498 1991 3 601 1992 5 2400 1993 5 2898 1994 4 1816 1995 12 3079 1996 11 2683 1997 5 6416 1998 4 5910 1999 11 9615 2000 4 3545 2001 3 2662 2003 1 1869 2005 2 784 Total 107 59,407

Table 1presents the distribution over time of the number of ED transactions as well as the inflation-adjusted dollar volume of transactions. Roughly twice as many ED offerings took place in the 1990s as compared to the 1980s. Much of the increase in ED activity occurred in the second half of the 1990s. The samples constructed by Barber and Ghosh et al. in their prior work on ED offerings contained fewer than 40 deals, so we have more than twice as many issues to study.

All exchangeable debt offerings have in common that the payoff to bondholders is linked to the equity value of a company in which the ED issuer holds a stake. These“underlying”equity positions are acquired by ED issuers in several different ways. In our sample of 107 transactions, about 20% of the underlying equity positions were created as part of an equity carve-out. Another 20% resulted from a direct investment in the underlyingfirm, and still another 20% came from an exchange offer or strategic alliance. In just over 5% of our sample,firms acquired the original equity stake as part of an aborted takeover attempt or merger. On average, about 4 years elapses between the time that the ED issuer acquires their equity stake in the underlyingfirm and the time that the ED issue takes place.

Similarly, issuers' stated motives for ED offerings vary. The most common reason (20% of our sample) given for an ED issue is to monetize the underlying equity position and to diversify the issuer's investment portfolio. About 10% of ED issuers say that the transaction is part of a decision to increase corporate focus on a few strategic business units. But in the vast majority of cases,firms offer only a generic explanation for the transaction, typically saying that it is part of a corporate restructuring program. Likewise, mostfirms either do not specify how they will use the ED proceeds, or they provide a vague explanation such as“general corporate purposes.”

We further explored whether the issuers in the original sample have more than one large equity holding. To do this we searched annual reports and periodic SEC_filings such as forms 10K, 10Q, and 8K, general statements of acquisition of bene_ficial ownership (forms 13D, 13G), tender offer statements (form 14D-1), and proxy statements (form DEF14A) using LexisNexis, Edgar, and Thomson Research. From these sources we gathered information on the details of each block of stock held by an ED issuer. On average, ED issuers hold large stakes in 6 companies. For the company chosen as the underlying stock for the ED offering, the issuer's average stake is 25%, whereas the issuer's average holding in companies not chosen as the underlying asset is 29%. Because issuers' holdings in underlying and“other”firms are very similar, it does not appear that the size of the issuer's stake is the primary determinant of which equity holding serves as the underlying asset for the ED offering. Whenfirms issue ED securities, they reduce but typically do not eliminate their position in the underlyingfirm. Assuming that investors who buy exchangeable bonds ultimately convert into the underlying stock, the average issuer will continue to hold about 9.9% of the underlyingfirm.

Table 2

Selected mean and median values for issuers, underlyingfirms, and other investments and corresponding industry means and medians. Corporate issuers

(mean/median)

Underlying firms (mean/median)

Other invested firms (mean/median)

Underlying—other

Issuer Industry Dif Underlying Industry Dif Other Industry Dif

MVE ($ billion) 10.08 2.26 ⁎⁎⁎ 12.22 2.46 ⁎⁎⁎ 11.09 2.12 ⁎⁎⁎ 2.92 0.41 ⁎⁎⁎ 2.73 0.30 ⁎⁎⁎ 0.74 0.26 ⁎⁎⁎ ⁎⁎⁎ V ($ billion) 19.29 3.73 ⁎⁎⁎ 16.72 3.39 ⁎⁎⁎ 13.72 2.96 ⁎⁎⁎ 4.41 0.67 ⁎⁎⁎ 3.19 0.48 ⁎⁎⁎ 0.85 0.44 ⁎⁎⁎ ⁎⁎⁎ TobQ 1.05 1.75 ⁎⁎⁎ 2.43 1.95 2.75 4.14 ⁎⁎ 0.90 1.12 ⁎ 1.41 1.23 ⁎⁎ 1.15 1.33 Levb 0.29 0.34 0.23 0.32 ⁎⁎⁎ 0.24 0.38 ⁎⁎⁎ 0.29 0.25 0.20 0.24 0.19 0.22 Cash/TA 0.07 0.12 ⁎⁎⁎ 0.11 0.14 ⁎ 0.18 0.16 ⁎⁎⁎ 0.03 0.07 ⁎⁎⁎ 0.05 0.08 0.07 0.11 E/P 0.07 0.05 0.03 0.04 −0.18 0.02 ⁎⁎ ⁎⁎ 0.06 0.05 0.05 0.04 0.02 0.02 ⁎⁎⁎ R&D/sales 0.01 0.01 0.03 0.02 0.04 0.03 ⁎ 0.00 0.00 ⁎⁎⁎ 0.00 0.01 ⁎⁎⁎ 0.00 0.01 ⁎⁎⁎ ⁎ ROA 0.10 0.12 0.14 0.14 0.02 0.11 ⁎⁎⁎ ⁎⁎⁎ 0.11 0.13 0.17 0.14 ⁎ 0.09 0.11 ⁎⁎⁎ TDebt ($ billion) 8.70 1.37 ⁎⁎ 3.73 0.78 ⁎⁎⁎ 2.03 0.64 ⁎⁎⁎ 1.18 0.14 ⁎⁎⁎ 0.38 0.07 ⁎⁎⁎ 0.12 0.10 ⁎⁎⁎ ⁎⁎⁎ V/sales 2.87 2.31 5.27 2.38 7.50 2.92 ⁎ ⁎ 1.40 1.56 2.44 1.69 ⁎ 2.44 2.05 D/E 0.90 0.74 0.43 0.57 0.75 0.40 ⁎⁎ 0.40 0.31 ⁎⁎ 0.16 0.29 ⁎⁎ 0.18 0.24 ⁎

All data are reported atfiscal year-end prior to the exchangeable debt announcement. Equity market values are calculated three months before the announcements. Market capitalization is the total number of shares outstanding times thefiscal year-end closing price. Firm value equals to the sum of market value of equity, book value of liabilities and of preferred stock. Tobin's Q is proxied by the market-to-book ratio, where market-to-book ratio is the book value of liabilities and preferred stock plus the market value of common stock divided by the book value of assets. Book leverage is the ratio of long-term debt plus current debt-to-total assets. Cash and marketable securities holdings is calculated as the ratio of cash to total assets. Return on assets is computed as income before extraordinary items plus interest expense plus tax plus depreciation, all divided by total assets. R&D to sales ratio is the ratio of research and development expense to sales. Earnings price ratio is earnings per share divided by price per share. Value to sales is the ratio of thefirm's market value to sales. Debt-to-equity ratio is total liabilities divided by the market value of equity. Corresponding industry mean and median values are computed over 4-digit SIC industries if at least 5 companies are available or otherwise over 3-digit SIC industries. All data are winsorized at the 1 and 99 percentiles prior to calculations. Statistical significance between samples and corresponding industries and between underlying and other holdings is marked for 10% (⁎), 5% (**), and 1% (⁎⁎⁎) levels. Wilcoxon–Mann– Whitney test is used for medians.

Table 2contains summary statistics for ED issuers, the underlying_firms, and the other holdings along with industry means and medians for each group. We calculate these statistics using year-end data just prior to the ED announcement. Perhaps surprisingly, ED issuers, underlyingfirms, and the otherfirms in which issuers hold a stake are all much larger than their industry peers. Even more surprising is that ED issuers are no larger than the firms in which they invest, at least in terms of average market capitalization. Similarly, there is only mixed evidence that underlyingfirms are larger than thefirms not selected for the ED issues (e.g., only difference in medians is significant).

Relative to their industry peers, ED issuers have lower Tobin's Q ratios and lower cash holdings. Underlyingfirms have higher Tobin's Q values than their industry peers, less leverage, and lower cash holdings. Firms that the issuer holds but does not include in the ED offer have lower Tobin's Q ratios and less leverage relative tofirms in the same industry.

Comparing underlying and otherfirms further, wefind that underlyingfirms have higher earnings-to-price ratios and higher profitability. These two groups offirms do not differ in terms of Tobin's Q or leverage. On other dimensions, the evidence is mixed in that either the difference in medians or the difference in means is significant, but not both. We now turn to an analysis of the operating performance of underlying and otherfirms both before and after the ED issue.

4. Operating performance

To investigate the possibility that insiders of ED issuers choose which stock serves as the underlying asset based on market timing considerations, wefirst look at the operating performance of all holdings 3 years before and after the ED announcement year.

The most striking characteristic offirms chosen to be underlying for ED offerings is the trend in their profitability as shown in

Table 3. Both mean and median return on assets (ROA)5_{of underlyingfirms peak at thefiscal year-end prior to the announcement}

of exchangeable debt. Underlyingfirms are consistently more profitable than their industry peers and the otherfirms held by the issuer. Firms not selected as part of the ED offer earn lower profits than their industry peers. However, for this group performance improves after the ED issue occurs. Mean (median) ROA for otherfirms rises from 5.4% (9.6%) in the year of the ED issue to 8.5% (10.0%) 3 years after. Note that this group's performance improves relative to the industry benchmark as well.

InTable 4we split our ED issuers into two groups based on the number of_firms in which they hold large stakes at the time of the offer. We do this to explore a possible corporate governance explanation for the performance patterns that we observe. To be specific, when an issuer divests its holdings in a company through an ED offer, its incentives to monitor the underlying company are weakened, so the underlyingfirm's performance may fall. Similarly, because they dramatically reduce their holdings of the underlyingfirm, the issuer may deploy additional resources toward monitoring their other investments, so thesefirms may show improved performance. However, the incremental resources available to monitor the issuer's other holdings should be greater when the issuer held fewer investments to start with. Therefore, we divide our sample into two groups, issuers with large stakes in more than 4 companies at the time of the ED offer and issuers with 4 or fewer stakes.

In Panel A ofTable 4, we examine performance trends for issuers with relatively few holdings. As was the case inTable 3, underlyingfirms consistently outperform their industry peers and the issuer's other holdings. Also as inTable 3, the operating performance of underlyingfirms deteriorates after the issue. However, in this case, the performance of the issuer's other holdings Table 3

Return on assets for underlyingfirms and other holdings.

ROA −3 −2 −1 Year 0 + 1 + 2 + 3 Underlying Mean 0.141 0.142 0.154 0.153 0.139 0.142 0.135 Median 0.154 0.132 0.166 0.157 0.150 0.160 0.140 Industry Mean 0.135 0.136 0.136 0.130 0.125 0.124 0.119 Median 0.134 0.139 0.141 0.137 0.130 0.116 0.122 Other investments Mean 0.045 0.058 0.071 0.054 0.068 0.074 0.085 Median 0.085 0.083 0.095 0.096 0.116 0.110 0.100 Industry Mean 0.113 0.105 0.109 0.102 0.101 0.108 0.113 Median 0.122 0.119 0.110 0.110 0.110 0.113 0.119 Underlying—other Mean ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ Median ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎

For eachfirm mean (median) return on assets (ROA) is calculated as income before extraordinary items plus interest expense, tax, and depreciation, divided by total assets and trimmed at the 5 and 95 percentiles prior to calculations. Data are aligned so that year 0 is the year of exchangeable debt issue. Statistical significance between underlying and other holdings is marked for 10% (⁎), 5% (⁎⁎), and 1% (⁎⁎⁎) levels. Wilcoxon–Mann–Whitney test is used for medians.

5

Table 4 Return on assets.

ROA −3 −2 −1 Year 0 + 1 + 2 + 3

Panel A: For underlyingfirms and other holdings for issuers with less than or equal to 4 holdings. Underlying Mean 0.134 0.143 0.149 0.150 0.142 0.137 0.137 Median 0.150 0.127 0.163 0.151 0.150 0.151 0.143 Industry Mean 0.139 0.140 0.141 0.142 0.139 0.137 0.133 Median 0.134 0.143 0.151 0.151 0.147 0.136 0.140 Other investments Mean 0.079 0.092 0.087 0.090 0.035 0.019 0.058 Median 0.073 0.093 0.079 0.099 0.054 0.089 0.075 Industry Mean 0.098 0.125 0.118 0.133 0.117 0.096 0.114 Median 0.114 0.123 0.119 0.118 0.100 0.078 0.105 Underlying—other Mean ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎ ⁎⁎⁎ Median ⁎⁎ ⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎

Panel B: For underlyingfirms and other holdings for issuers with more than 4 holdings. Underlying Mean 0.152 0.149 0.161 0.156 0.140 0.152 0.134 Median 0.169 0.167 0.181 0.177 0.170 0.171 0.140 Industry Mean 0.130 0.132 0.125 0.110 0.106 0.107 0.100 Median 0.134 0.139 0.130 0.122 0.110 0.102 0.107 Other investments Mean 0.044 0.056 0.069 0.054 0.062 0.084 0.090 Median 0.094 0.083 0.097 0.095 0.119 0.113 0.109 Industry Mean 0.116 0.102 0.107 0.097 0.098 0.109 0.113 Median 0.123 0.119 0.110 0.109 0.110 0.113 0.119 Underlying—other Mean ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎ Median ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎⁎⁎ ⁎ ⁎⁎ Table 5

Comparative changes in return on assets for underlyingfirms and other holdings, 1981–2005.

ROA Year+ 1–year0 Year+ 2–year0 Year+ 3–year0

Underlying unadjusted Mean −0.015 −0.011 −0.018 Median −0.008 0.003 −0.017 Industry Mean −0.004 −0.005 −0.010 Median −0.007 −0.021 −0.015 Other investments Mean 0.014 0.020 0.031 Median 0.020 0.013 0.004 Industry Mean 0.000 0.007 0.012 Median 0.000 0.003 0.009 Underlying—other Mean ⁎⁎ ⁎⁎ ⁎⁎⁎ Median ⁎⁎ ⁎

Underlying industry adjusted

Mean −0.010 −0.006 −0.008

Median −0.001 0.024 −0.003

Other industry adjusted

Mean 0.014 0.013 0.020

Median 0.020 0.010 −0.006

Underlying—other industry adjusted

Mean ⁎ ⁎

Median

For eachfirm mean (median) return on assets (ROA) is calculated as income before extraordinary items plus interest expense, tax, and depreciation, all divided by total assets and trimmed at the 5 and 95 percentiles prior to calculations. Data are aligned so that year 0 is the year of exchangeable debt issue. Unadjusted rows reportΔROAWe(calculated as ROA for year + 1 minus ROA for year 0). Industry-adjusted rows reportΔROAi,adjwhich isΔROAWeminus the change in ROA seen in a sample of controlfirms. The control sample is matched on the combination of 4-digit SIC code (where at least 5 observations are available, followed by 3-digit if less than 5 observations present, and then by 2-digit if less than 5 observations present). Statistical significance is marked for 10% (⁎), 5% (⁎⁎), and 1% (⁎⁎⁎) levels.

also decline, both in absolute and relative (to industry) terms. This is counter to the pattern that we would expect to see if issuers free up resources to monitor their other holdings after the ED offering takes place.

In Panel B we see the same patterns for underlyingfirms once again. Performance falls after the ED issue. But the performance of otherfirms rises. Given that issuers in Panel B hold large positions in 4 or more companies, it seems unlikely that the improved operating performance that we see inTable 4could be explained by improved monitoring since monitoring resources would be spread over morefirms than was in the case in Panel A.

Table 5provides an overview of comparative changes in ROA for underlyingfirms and other holdings. Thefirst two rows in each subsection show unadjusted changes in ROA, whereΔROAtis the ROA for yeartminus the ROA for year 0. Year 0 is the year of the exchangeable debt announcement. In the second two rowsΔROAt,adjis calculated asΔROAtfor the underlying or otherfirm minus mean (median)ΔROAtfor a portfolio of controlfirms matched on the basis of four-digit SIC codes.6

The unadjustedΔROAtshows that underlyingfirms exhibit deteriorating performance after the ED issue, while the issuer's other holdings show performance improvement. On an industry-adjusted basis, underlyingfirms show below-average performance changes in the years after the ED offer, while the issuer's other holdings show either no performance change or improving performance depending on the horizon. Asterisks indicate that the differences in unadjusted performance changes between underlying and other firms are generally significant, and differences in industry-adjusted performance changes are sometimes significant. In contrast, none of our estimates lead toward the conclusion that underlyingfirms improve their performance relative to otherfirms after the offering.7

In summary, wefind decreasing operating performance following the ED announcement for the underlyingfirms. This suggests that future operating characteristics offirms (as well as their corresponding industries) play an important role in the choice of the underlyingfirm for ED offerings. However, all could be anticipated by the market and reflected in security prices. Do ED issuers have better information than investors have about the subsequent performance of assets underlying ED offers? The next section provides stock market evidence on this question.

6_{If the number offirms in the control portfolio is less thanfive, we use a three-digit SIC match, followed by a two-digit match.} 7

In unreported tables we repeat the analysis ofTable 5after breaking the sample into subgroups based on whether the ED issuer had more than 4 other holdings or 4 or fewer holdings at the time of the offer. Our results mirror those inTable 4. Specifically, for issuers with few holdings at the time of the ED offer, the performance of underlyingfirms deteriorates after the offer, but the performance of otherfirms declines even more. Forfirms with more than 4 holdings, underlyingfirm performance deteriorates after the offer, while the performance of otherfirms improves. For both subgroups, the post-issue performance differences are significant about half the time.

Table 6

Pre-announcement calendar-time Fama and French three-factor model portfolio regressions. Pre-announcement horizon

1 year 2 years 3 years

a Adjusteda a Adjusteda a Adjusteda

Equal weighting Issuer −0.007 −0.006 0.003 0.003 0.002 0.003 96 [−1.39] [−1.17] [0.90] [1.22] [0.68] [1.14] Underlying 0.009 0.010 0.008 0.011 0.009 0.009 101 [1.74]⁎ [1.81]⁎ [2.81]⁎⁎⁎ [3.63]⁎⁎⁎ [4.15]⁎⁎⁎ [3.89]⁎⁎⁎ Other holdings 0.006 0.005 0.001 0.000 0.001 0.000 172 [0.89] [0.77] [0.13] [0.03] [0.17] [0.02] Underlying—other ⁎ ⁎ ⁎ Value weighting Issuer 0.001 0.000 0.001 0.001 −0.002 −0.002 96 [0.11] [−0.00] [0.29] [0.30] [−0.73] [−0.74] Underlying −0.000 −0.001 −0.000 0.001 0.002 −0.000 101 [−0.07] [−0.14] [−0.04] [0.31] [0.66] [−0.02] Other holdings 0.007 0.005 0.006 0.005 0.005 0.003 172 [1.33] [0.98] [1.57] [1.22] [1.50] [0.83] Underlying—other

For the period 1981–2005, equally-weighted adjusted Fama–French intercepts are estimated for the one-, two-, and three-year pre-announcement horizons for the exchangeable debt issuers and their holdings (underlying and otherfirms). Equally-weighted calendar-time portfolio returns are calculated each month for the samplefirms that experienced exchangeable debt announcements during the previous 12, 24, and 36 months. The estimated intercept comes from the regression of controlfirm calendar-time portfolios' (rebalanced monthly to drop all the companies that reach the end of their 1-,2-, and 3- year period and to add all companies that just executed a transaction) excess returns on the three Fama–French factors. Theadjustedintercept is the difference between the estimated and the expected intercepts, where the expected intercept is equal to the average intercept from 1000 calendar-time portfolio regressions for random portfolios in the same size and book-to-market quintiles as the eventfirms. Thet-statistics, using a 2-tail test, are shown in brackets under each parameter.⁎,⁎⁎, and⁎⁎⁎denote statistical significance at the 10%, 5%, and 1% levels, respectively. Statistical difference between underlying and other holdings is noted for 10% (⁎), 5% (⁎⁎), and 1% (⁎⁎⁎) levels.

5. Long-term stock market performance

We use the calendar-time portfolio approach to measure abnormal long-run performance before and after the exchangeable debt issues. We choose the calendar-time approach as opposed to traditional event-time methodology for two reasons. First,

Fama (1998)warns against the buy-and-hold methodology because of the inherent bad model problem. Second,Mitchell and Stafford (2000)show that the calendar-time methodology reduces the problem of cross-sectional dependence among event firms.8

For each month from January 1981 to December 2005, we form equally-weighted (EW) or value-weighted (VW) portfolios of all samplefirms (separately for issuers, underlying, and otherfirms) involved in exchangeable debt offers within the previous 3 years (we repeat this analysis for one and two-year windows). We exclude events on the same issuingfirm that occur within 1 year of an ED announcement, and we drop the top and bottom 1% of returns to ensure that results are not driven by outliers. Portfolios are rebalanced monthly to drop all companies that reach the end of their three-year period and to add companies making new exchangeable debt offers. The portfolio excess returns are regressed on the three Fama and French (1993)

factors:

Rp;t−Rf;t=ap+bpðRm;t−Rf;tÞ+spSMBt+hpHMLt+ep;t′; ð1Þ whereRp,tis the simple return of the EW (or VW) portfolio in montht,Rf,tis the return on three-month Treasury bills in montht,

Rm,tis the return on the value-weighted market index in montht, SMBtis the difference between the returns of small stocks and big stocks portfolios in montht, and HMLtis the difference between the returns of portfolios of high book-to-market stocks and low book-to-market stocks in montht. Within this framework, under a correctly specified model, the interceptapmeasures the average monthly abnormal return of the portfolio of eventfirms. Under the null hypothesis, the mean monthly excess return of the calendar-time portfolio is zero. However,Fama and French (1993) and Mitchell and Stafford (2000)show that the Fama–French three-factor model is unable to completely explain the cross-section of stock returns. To control for this potential bias, we follow

Mitchell and Stafford (2000)and estimate anadjustedintercept by calculating the difference between the estimated and the expected intercepts. The expected intercept is equal to the average intercept from a bootstrapped sample of 1000 calendar-time

8_{Other recent papers which use this methodology includeHertzel et al. (2002), Byun and Rozeff (2003), andBoehme and Sorescu (2002). Of course we must} acknowledge that the profession has not universally embraced any single approach for measuring long-term abnormal returns and that estimates obtained from alternative methods sometimes reach different conclusions.

Table 7

Post-announcement calendar-time Fama and French three-factor model portfolio regressions. Post-announcement horizon

1 year 2 years 3 years

a Adjusteda a Adjusteda a Adjusteda

Equal weighting Issuer −0.004 −0.004 0.001 0.003 0.002 0.004 [−1.07] [−1.02] [0.35] [1.14] [0.90] [1.63] Underlying −0.008 −0.009 −0.006 −0.006 −0.005 −0.004 [−1.43] [−1.58] [−1.90]⁎ [−1.74]⁎ [−1.87]⁎ [−1.74]⁎ Other holdings 0.004 0.004 0.005 0.004 0.003 0.001 [0.73] [0.64] [0.94] [0.76] [0.70] [0.22] Underlying—other Value weighting Issuer −0.002 −0.006 0.001 0.002 −0.001 −0.001 [−0.34] [−0.96] [0.42] [0.56] [−0.44] [−0.47] Underlying −0.009 −0.009 −0.003 −0.004 −0.003 −0.004 [−1.75]* [−1.69]* [−0.76] [−1.07] [−0.98] [−1.47] Other holdings 0.003 0.007 0.005 0.005 −0.006 −0.007 [0.58] [1.09] [0.82] [0.79] [−1.36] [−1.61] Underlying—other

For the period 1981–2005, equally-weighted adjusted Fama–French intercepts are estimated for the one-, two-, and three-year post-announcement horizons for the exchangeable debt issuers and their holdings (underlying and otherfirms). Equally-weighted calendar-time portfolio returns are calculated each month for the samplefirms that experienced exchangeable debt announcements during the previous 12, 24, and 36 months. The estimated intercept comes from the regression of controlfirm calendar-time portfolios' (rebalanced monthly to drop all the companies that reach the end of their 1-,2-, and 3- year period and to add all companies that just executed a transaction) excess returns on the three Fama–French factors. Theadjustedintercept is the difference between the estimated and the expected intercepts, where the expected intercept is equal to the average intercept from 1000 calendar-time portfolio regressions for random portfolios in the same size and book-to-market quintiles as the eventfirms. Thet-statistics, using a 2-tail test, are shown in brackets under each parameter.⁎,⁎⁎, and⁎⁎⁎denote statistical significance at the 10%, 5%, and 1% levels, respectively. Statistical difference between underlying and other holdings is noted for 10% (⁎), 5% (⁎⁎), and 1% (⁎⁎⁎) levels.

portfolio regressions. The bootstrapped sample is a random sample offirms in the same size and book-to-market quintiles as the eventfirms. The test statistic is then given by,

t= ⌢a−Eð⌢aÞ

se ; ð2Þ

where se is the standard error from the original regression (Eq. (1)).

Table 6summarizes the results for the one-, two-, and three-year pre-announcement horizons, for both EW and VW portfolios. This is done separately for the issuers, underlying, and otherfirms. For the EW portfolios, wefind insignificant intercept terms for issuers and other holdings at all horizons, but for the underlyingfirms we observe positive, significant intercepts at all horizons. The underlyingfirms earn positive abnormal returns of roughly 100 basis points per month. However, when we estimate the regression using VW portfolios, no such pattern emerges. Thus, wefind mixed evidence that the assets that ED issuers ultimately choose as the underlying asset for an ED offering exhibit positive abnormal performance leading up to the offer.

InTable 7we examine the post-offer performance of issuers, underlyingfirms, and the issuer's other holdings. Once again we see no tendency for issuers or other holdings to exhibit abnormal stock performance, but there is some evidence that underlying assets underperform. Estimates of the underlying firms' underperformance range from−30 to−90 basis points per month. Though all of the intercept terms for the underlying portfolio are negative, the significance of intercept term depends on both the portfolio weighting scheme being used and the post-event time horizon.

Combined with the prior evidence on operating performance, the results thus far suggest that ED issuers choose underlyingfirms based on strong past performance and expected weak performance. This evidence is consistent with the hypothesis that ED issuers have private information about thefirms in which they invest and that the market does not fully incorporate this information when ED issues are announced.

6. Predictability of the underlying stock choice for the exchangeable debt offering

In this section, we further investigate the motivation behind exchangeable debt offerings. In particular, we test whether the extent of adverse information about the prospects of the particular asset holding determine whether this holding will be the one chosen to package with the ED offering.

Table 8

Logistic regression of the choice of the underlying stock.

1 2 3 4 5

Panel A: UsingΔ(mean)ROA1,adj

Intercept −0.458 −0.770 −0.407 −0.277 −0.535 [0.152]⁎⁎⁎ [0.218]⁎⁎⁎ [0.165]** [0.243] [0.280]* ΔROA1,adj −3.867 −4.057 −3.887 −3.434 −3.761 [1.857]⁎⁎ [1.881]⁎⁎ [1.851]** [1.871]* [1.903]** Stake before 0.013 0.018 [0.007]⁎⁎ [0.009]** Sizeholding −0.000 −0.000 [0.000] [0.000] B/Mholding −0.120 −0.196 [0.213] [0.222] % concordant 57.1 61.3 58.2 56.1 61.2

Panel B: UsingΔ(median )ROA1,adj

Intercept −0.475 −0.776 −0.418 −0.277 −0.535 [0.154]⁎⁎⁎ [0.220]⁎⁎⁎ [0.167]⁎⁎ [0.245] [0.281]* ΔROA1,adj −5.264 −5.356 −5.104 −4.2553 −4.476 [2.061]⁎⁎ [2.075]⁎⁎⁎ [2.080]⁎⁎ [2.092]⁎⁎ [2.120]** Stake before 0.013 0.018 [0.007]⁎ [0.008]** Sizeholding −0.000 −0.000 [0.000] [0.000] B/Mholding −0.128 −0.205 [0.2134] [0.223] % concordant 61.5 63.6 61.9 59.2 62.1

The table presents the results of logistic regression analysis of the choice of underlying equity to package with ED. The dependent variable is 1 for the underlying firm and 0 for all other holdings.ΔROA1,adjis the difference in ROA of the holding in year 1 minus year 0 minus the corresponding difference in the matching sample of controlfirms. The control sample is matched on the combination of 4-digit SIC code (where at least 5 observations are available, followed by 3-digit if fewer than 5 observations present, and then by 2-digit if fewer than 5 observations present) and similar size. Size is measured as the book value of the assets and satisfies the requirement SizeControl/Sizeholding∈[0.5, 2].ΔROA1,adjhas been trimmed at the 2.5 and 97.5 percentiles due to the influence of outlying observations. Size and book-to-market for holdingfirms are reported at thefiscal year-end prior to the announcement of exchangeable debt issues. Size is the book value of total assets, and B/M is the ratio of book value to market value, calculated as the sum of market value of equity, long-term debt, current debt, and preferred stock.“Stake before”is the pre-offer issuer's percent ownership in investedfirms.

Our foregoing results show that, for underlyingfirms, post-ED operating performance declines on average from the pre-ED levels; whereas, the operating performance of other holdings improves in the years following the ED offerings. The long-run performance study displays a similar pattern: the average underlyingfirm significantly underperforms during the period following an exchangeable debt announcement, while other holdings show no signs of underperformance. An alternative method of testing the timing hypothesis is to test for a systematic relationship between future operating performance and the probability of choosing a particular holding as the underlying.

To do this we conduct a logistic regression identifying factors influencing the likelihood of choosing a particular holding to package with ED. The dependent variable is 1 for the underlyingfirm and 0 for all other holdings. As we have mentioned above, we

useΔROA1,adjas our measure of operating performance, whereΔROA1,adjis defined as the difference in ROA of the holding in year

1 minus year 0 minus the corresponding difference in the matching sample of controlfirms. We use both mean and median values of ROA obtained for the matched sample as a robustness check in our logistic analysis. The control sample was matched based on the four-digit SIC code wherever at leastfive matches were available. Otherwise, the sample was matched on the three-digit or two-digit code. The control sample was also limited tofirms of a size comparable to that of the holdingfirm, where size is measured as the book value of the assets and satisfies the requirement SizeControl/Sizeholding∈[0.5, 2].ΔROA1,adjhas been trimmed at the 2.5 and 97.5 percentiles to eliminate the influence of outlying observations.

Other independent variables include size and book-to-market ratio for eachfirm held by an ED issuer. The larger the size of the potential underlyingfirm, the larger can be the exchangeable debt issue tied to that holding.Chan and Chen (1991)propose that low stock prices and high book-to-market ratios are signals for_firms that the market judges as having poor prospects.Fama and French (1992)suggest that book-to-market captures cross-sectional variation in average returns that is related to relative distress. Companies with higher book-to-market levels could be judged by the market as having poor current investment outlooks. We also control for the issuer's pre-offer ownership percentage in potential underlyingfirms.

Table 8reports the results. Panel A uses mean values of the ROA for the matched sample. Panel B displays the results using median values of ROA. Consistent with the timing hypothesis, there is a highly significant negative relationship between afirm's future operating performance and the probability of it being chosen for an ED issue. These results are consistent across all regression specifications and for both mean and median adjusted measures of ROA. The results support the existence of a timing motivation for ED issues: large declines in operating performance follow after the holding becomes underlying for the ED issue. Issuers have a greater tendency to choose the particular underlyingfirm when they own a greater pre-issue stake in it. Thefinal two control variables, size and book-to-market of holdings, are not significant in all regression specifications.

In summary, when several equity investments are available, the choice of which holding to package with an ED issue is tied to firm performance. The decision is driven by the desire to divest the holding that has expected deterioration in future operating performance.

7. Conclusion

This study contributes to an understanding of the motivation for exchangeable debt offerings. Our innovation is recognizing that most ED issuers have several stocks which could be chosen as the underlying asset for the offering and testing for differences between assets that are chosen vs. not chosen as the underlying security. With this analysis, the paper proposes an additional rationale for ED offerings similar to recent work on capital structure decisions byBaker and Wurgler (2000)suggesting that managers choose which security type to offer based on expected future performance.

Our results indicate that issuers choose the underlying asset based on superior past performance and expected poor performance. Wefind similar results for both operating performance measures and stock returns. In contrast, we do notfind similar systematic performance patterns for the“other holdings”of ED issuers.

Our research contributes to the growing literature on the market timing ability of managers and the role that ability plays in determining capital structure as well as to the literature on the role of large investors as corporate monitors. Our results generally affirm that insiders have access to information which allows them to time security offerings opportunistically. Furthermore, that information extends not to just thefirm in which insiders are employed, but also tofirms in which their employer holds a large stake. We certainly do not reject the notion that large shareholders can serve as effective monitors, but our results suggest that they also may gain an information advantage that they can exploit to the benefit of their own shareholders. At times, the gains from selling at the right time may outweigh the potential benefits from attempting to exercise an influence through monitoring.

Acknowledgements

A. Danielova appreciates funding provided by the Social Sciences & Humanities Research Council (SSHRC) of Canada and the Arts Research Board of McMaster University.

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