Literature review_1 Why do firms use private placements (vis-à-vis public offerings )?

1. Uncertainty Timing, Information Risk, and Private Placements of EquityJi-Chai Lin Louisiana State UniversityYiLin WuNational Taiwan UniversityHui-Nien Hung National Chiao Tung UniversityComments welcome

2. Literature review_1Why do firms use private placements (vis-à-vis public offerings)? • High information asymmetry is the main reason that firms use • private placements (vis-à-vis public offerings) • to raise equity capital. • Hertzel and Smith (1993) • Wu (2004) • Cronqvist and Nilsson (2005) • Krishnamurthy, Spindt, Subramaniam, and Woidtke (2005), and • Gomes and Phillips (2010)

3. Literature review_2pre-placement performance • Significant pre-placement stock price run-up, • in spite of poor operating performancebefore equity private placements • Hertzel, Lemmon, Linck, and Rees (2002) • Chaplinskyand Haushalter (2010).

4. Literature review_3announcement effect • Despite that large discounts are offered to private investors, • the market tends to react positively to EPP announcements. • Wruck (1989) • Hertzel and Smith (1993)

5. Literature review_4post-issue performance • In contrast to the positive market reactions at announcements, • the stocks tend to perform poorly over the long run after EPPs. • Hertzelet al. (2002), • Brophy, Ouimet, and Sialm (2009), and • Chaplinskyand Haushalter (2010)).

6. A behavioral explanation for the pre- and post-placement stock price patterns • Hertzelet al. (2002) suggest: • public investors are overoptimistic about the prospects of issuing firms and • the market corrects the behavioral bias over time, • resulting in post-announcement stock-price underperformance.

7. The purpose of our study • offer an alternative, rational explanation for the pre- and post-placement stock price patterns.

8. Characteristics of EPP issuers • EPP sample tends to have higher capital and R&D expenditures than those of the corresponding industry median firms in the years surrounding the private placements. • Hertzel et al. (2002) • More R&D could raise the level of uncertainty about future profitability.

9. Determinants of firm valuation (ME/BE) • Pastor and Veronesi (2003) learning theory (or Bayesian learning) • A convex relation between the growth rate and future book equity value at time T. • The M/B ratio is increasing in : • (1) expected profitability and • (2) the uncertainty about average profitability

10. Taking advantages of uncertain profitability in raising equity capital • Pastor and Veronesi (2003) conjecture that • since uncertainty increases valuation, • entrepreneurs would have incentives to start new firms with uncertain profitability • even when expected profitability is low. • Indeed, Pástor and Veronesi (2005) show that • firms time their IPOs • when market conditions are good and also • when uncertainty about their future profitability is high.

11. We extend Pástor and Veronesi’s (2003) learning theory to EPPs • to help understand when firms use private placements to raise equity and why their returns behave as documentd.

12. The problem with high uncertainty • High uncertainty makes it difficult for private investors to evaluate issuing firms. • Hertzel and Smith (1993) suggest that • issuing firms use offering price discounts • to induce private investors to produce information and do due diligence.

13. Double-sided information production • Buy-side: Private investors have strong incentives to produce information • to assess firm value and decide whether to participate in the deals. • Sell-side: A firm undertaking a private placement usually engages • the services of an investment bank to serve as its agent • making introductions to potential investors. • conducting a fairly extensive pre-placement due diligence investigation, • providing post-placement information production services by analyst research coverage.

14. Who also benefits from the double-sided information production? • Issuing firms could benefit from information production for and by private investors. • Private investors’ informed decisions (finance the firm or not) • allow firms to better pinpoint where their future prospects are likely to be, • which could lead to better corporate investment decisions. • General investors could also learn and benefit from information production for and by private investors.

15. Information risks • The risk of losing to better informed traders. • Easley, Hvidkjaer, and O’Hara (2002 and 2010) and Easley and O’Hara (2004) argue that • investors demanding a higher return to hold stocks with greater PIN. • Duarte and Young (2009) decompose PIN into two parts: • one related to asymmetric information (AdjPIN), and the other related to illiquidity.

16. Learning and information risk • Pástor and Veronesi (2003) • treat the effect of learning on firm valuation as idiosyncratic, and • suggest that it has no effect on the required rate of return. • However, in our study, • since most private placement firms are relatively small with high uncertainty and hence have high information asymmetry, • we argue that • learning and the resolution of uncertainty • would lead to lower information risk faced by general investors.

17. Our hypothesis for high valuation at issuance • firms have incentives to time equity private placements • when uncertainty about their earnings growth has reached a high point, • allowing them to sell equity at high valuation • (since compounding is a convex function).

18. Our hypothesis for low post-issue stock returns • Information production for and by private investors, • along with their informed decisions to finance the firms amid high uncertainty, • facilitate learning and hasten the resolution of uncertainty, • resulting in a decline in information risk faced by general investors.

19. Main predictions from our hypothesis • 1. Pre-placement firm valuation would increasewith the uncertainty about earnings growth. • 2. Issuing firms with higher pre-placement uncertainty have stronger incentives to hire investment bankers to assist private investors.

20. Main predictions_2 • 3. Post-placement firm valuation would decline as uncertainty declines • due to double-sided information productions that facilitate learning and speed up the resolution of uncertainty. • 4. information risk would decline as well following the EPPs, which would lead to lower expected stock returns in the post-issue period.

21. Our EPP sample • 2,515 private placement agreements • 1993-2006 • Companies filing with the SEC must file private placement exhibits that report the original agreements.

22. Matched non-issuers • Match each issuing firm with a non-issuing firm • size (equity market capitalization), • return momentum, • book-to-market equity ratio, and • pre-issue AdjPIN

23. The pattern of M/B

24. The pattern of M/B for EPPs with and without placement agents

25. Proxy for uncertainty about earnings growthIrvine and Pontiff (2009) i) control for persistence and seasonality in ROE growthii) pooled cross-sectional time-series regression for each of the Fama-French 48 industries from 1990 to 2009

26. The pattern of IdioROEVol

27. The pattern of IdioROEVolfor EPPs with and without placement agents

28. The pattern of IdioCFVol

29. The pattern of IdioCFVol for EPPs with and without placement agents

30. The patterns of AdjPIN

31. Evidence of uncertainty timing: Regression results of pre-contract quarterly changes in log of M/B

32. Evidence of uncertainty timing: Regression results of pre-contract quarterly changes in log of M/B

33. Evidence of uncertainty timing: Regression results of pre-contract quarterly changes in log of M/B

34. Evidence of uncertainty timing: Regression results of post-placement quarterly changes in log of M/B

35. Evidence of uncertainty timing: Regression results of post-placement quarterly changes in log of M/B

36. Evidence of uncertainty timing: Regression results of post-placement quarterly changes in log of M/B

37. The results are consistent with our uncertainty timing hypothesis • 1. Firms have incentives to time equity private placements when uncertainty about their earnings growth has reached a high point, allowing them to sell equity at high valuation. • 2. Double-sided information productions facilitate learning and speed up the resolution of uncertainty, resulting in a decline in uncertainty and information risk faced by general investors.

38. Information risk and long-run post-issue stock returns • 1. The time-series regression approach • 2. The calendar-time portfolio approach • 3. Ibbotson’s (1975) RATS regression analysis

39. Construction of information risk factor (AdjPINF) • We sort all NYSE, Amex, and Nasdaq stocks into 10 deciles • by market capitalization at the end of the prior year. • Within each size decile, we sort firms into three equal-sized groups based on AdjPIN from the prior year. • Within each size decile, we forma zero-investment portfolio: long high-AdjPINand short low-AdjPIN stocks. • AdjPINF, is defined as the (equally weighted) average of the 10 zero-investment portfolios.

40. Table 8. Summary statistics and correlations of the pricing factors

41. The time-series regression approach

42. EPP firms

43. EPP firms

44. Matched non-issuers

45. The calendar-time portfolio approach

46. The calendar-time portfolio approach

47. The calendar-time portfolio approach

48. The calendar-time portfolio approach

49. Ibbotson’s (1975) RATS regression analysis

50. Shift in information risk surrounding EPPs