Market Discounts and Shareholder Gains for Placing Equity Privately

Abstract

Despite selling at substantial discounts, private placements of equity are associated with positive abnormal returns. We find evidence that discounts reflect information costs borne by private investors and abnormal returns reflect favorable information about firm value. Results are consistent with the role of private placements as a solution to the Myers and Majluf underinvestment problem and with the use of private placements to signal undervaluation. We also find some evidence of anticipated monitoring benefits from private sales of equity. For the smaller firms that comprise our sample, information eflects appear to be relatively more important than ownership effects.EQUITY PRIVATE PLACEMENT IS among the least-studied methods of corporate capital raising. The few studies that have been published raise provocative questions. An early study by the SEC (1971) reports average discounts of about 30 percent for private placements of unregistered shares. A few small scale studies in the tax-accounting literature find discounts on unregistered shares can exceed 50 percent (Arneson (1981a, 1981b), Friedlob (1983), and Johnson and Racette (1981). In more recent studies, Wruck (1989) reports smaller but still substantial average discounts and Silber (1991) reports discounts on restricted stock averaging 34 percent. Although the illiquidity associated with unregistered stock provides a partial explanation, it is not clear why investors require, and firms are willing to accept, such sizeable discounts. Nor is it clear why registered shares often are privately placed at substantial discounts. The stock price reaction to private placement announcements is also puzzling. Wruck, for example, finds positive announcement period abnormal returns averaging 4.4 percent.^ The positive reaction contrasts with the negative market reaction to public equity issue announce-

Financing Under Extreme Uncertainty: Evidence from Private Investments in Public Equities

“…The type of PIPE investments we study differs from the private placements studied by, among others, Wruck, (1989), Hertzel and Smith (1993), Barclay, Holderness, and Sheehan (2003) and Krishnamurthy, Spindt, Subramaniam, and Woidtke (2005) on several dimensions. First, although private placements usually include restricted shares that prevent investors from selling their shares in the public market for a year or longer, the equity issued via a PIPE offering can be publicly traded once it is 2 registered, typically within a few months after the PIPE transaction.…”

“…In previous studies, the announcement date price reactions to private placements of equity have been attributed to information effects (Hertzel and Smith (1993)), greater monitoring due to increased ownership concentration (Wruck (1989)), and liquidity costs due to the resale restrictions on the shares (Silber (1991)) and entrenchment (Barclay, et al (2003)). Hertzel and Smith (1993) argue that the extended discussions and negotiations between a firm and private investors during a private placement can allow private investors to resolve some of the asymmetric information about a firm's value. PIPE transactions are particularly well suited for testing this "information hypothesis."…”

“…For example, a number of studies find that firms making follow-on equity offerings experience average stock price increases of 30 percent or more in the months leading up to the issue and that earnings are positive and growing ahead of the offer. 2 Hertzel and Smith (1993) find that 80 percent of firms making private placements of equity experience positive earnings over the two years prior to issue. Similarly, as shown in Chaplinsky and Hansen (1993) and Denis and Mihov (2003), public and private debt issuers are generally profitable firms in the years prior to issue.…”

“…For example, the average proceeds from a PIPE represents approximately 16 percent of the issuer's equity compared to 17 percent of shares outstanding in Barclay, et. al (2003) and 16 percent of the value of equity in Hertzel and Smith (1993). Coupling the large stakes with the fact that PIPE investors can begin selling their shares shortly after making the investment, the liquidity of the issuer's stock will be a more important concern of PIPE investors than it is for traditional private placement investors.…”

“…At this point it is reasonable to ask how PIPEs differ from traditional private placements, such as those studied by Wruck (1989), Hertzel and Smith (1993), Barclay, et al (2003), andKrishnamurthy, et al (2005). 8 Among these studies, the earliest sample dates from 1979, prior to the adoption of Reg S, and the latest ends in 1997, before the large growth in the PIPE market.…”