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Abstract:
We study the issuance of tracking stocks, a form of corporate restructuring that has recently become very popular, and compare it with spin-offs and equity carve-outs. We find that parents and subsidiaries of tracking stock firms are more related than those that undertake the other two forms of corporate restructuring, that there is a positive announcement effect (similar in magnitude to that of spin-off announcements) and that the number of analysts following the firm increases following the issuance of tracking stock. At the same time, we find a decline in the operating performance of firms subsequent to the issuance of tracking stock. We also find that firms issuing tracking stock underperform in the long-run relative to a portfolio of industry-matched firms and the market index. The long-term performance of tracking stocks is similar to that of equity carve-outs, but significantly worse than that of spin-offs. Our findings suggest that the main motivation for the issuance of tracking stock is the preservation of synergies between the business units involved and the control benefits accruing to firm management, while reaping the benefits of the better reflection of "hidden value" in the combined firm's equity market valuation.

corporate governance, tracking stock, equity carve-outs, spin-offs, financial structure, corporate restructuring

Abstract:
We develop a theoretical analysis of an entrepreneur's choice between venture capital (VC) and angel financing at various stages in a private firm's life, and characterize the dynamic evolution of the firm's contract with its financier (VC or angel). In our model, an entrepreneur has information superior to a potential financier about his own firm; however, this information advantage diminishes as the financier interacts with the firm over time. Venture capitalists and angels differ in two ways. First, venture capitalists can add value to the firm by exerting effort, which, together with the entrepreneur's effort, increases the chance of project success; the angel is unable to add significant value. Second, venture capital financing is scarce relative to angel financing. The equilibrium VC contract maximizes value-addition by ensuring that both the entrepreneur and the VC exert optimal effort. We develop the following results in the above setting. First, we characterize the optimal financing path of the firm: depending on firm characteristics, a firm may use angel financing in its early stages and switch to VC financing in later stages, or vice versa. Second, VC financing contracts resemble convertible debt, while angel financing contracts may resemble a variety of financial securities, including equity. Third, for firms which use venture financing in earlier as well as later rounds, earlier round financing contracts will have more of a fixed income component and less of a warrant ("upside") component compared to later round financing contracts. Fourth, later round financing contracts between an entrepreneur and a VC who financed it in an earlier round will have a greater warrant component compared to such a contract between a VC and a previously angel-financed firm. Fifth, we characterize how the structure of VC financing contracts relate to: (i) the experience and productivity of the VC; (ii) the nature of the firm's industry; and (iii) the scarcity of VC financing. Finally, we develop predictions for the relationship between the financing path of a firm and the probability of its having a successful exit (IPO or acquisition), and for differences in the compositions of VCs' and angels' investment portfolios.

Angels, Venture Capital, Contract Dynamics

Abstract:
We develop a theoretical analysis of the choice of firms between fixed-price offerings and uniform-price auctions for selling shares in IPOs and privatizations. We consider a setting in which a firm goes public by selling a fraction of its equity in an IPO market where insiders have private information about intrinsic firm value. Outsiders can, however, produce information at a cost about the firm before bidding for shares. Firm insiders care about the extent of information production by outsiders, since this information will be reflected in the secondary market price, giving a higher secondary market price for higher intrinsic-value firms. We show that auctions and fixed-price offerings have different properties in terms of inducing information production. Thus, in many situations, firms prefer to go public using fixed-price offerings rather than IPO auctions in equilibrium. We relate the equilibrium choice between fixed-price offerings and IPO auctions to various characteristics of the firm going public. Unlike the existing literature, our model is able to explain not only the widely-documented empirical finding that underpricing is lower in IPO auctions than in fixed-price offerings (e.g., Derrien and Womack (2000)), but also the fact that, despite this, auctions are losing market share around the world. Our model thus suggests a resolution to the above "IPO auction puzzle," and indicates how current IPO auction mechanisms can be reformed to become more competitive with fixed-price offerings. Our results also provide various other hypotheses for further empirical research.

Abstract:
We empirically distinguish between three possible roles of venture backing in IPOs: certification, where venture-backed IPOs are priced closer to intrinsic firm value than non-venture backed IPOs due to venture capitalists' concern for their reputation; screening and monitoring, where VCs are able to either select better quality firms to back (screening), or help create such higher quality firms by adding value to them (monitoring) in the pre-IPO stage; and market power, where venture capitalists attract a greater number and higher quality of market participants such as underwriters, institutional investors, and analysts to an IPO, thus obtaining a higher valuation for the IPOs of firms backed by them. We argue that IPO underpricing is not the most appropriate measure to evaluate the role of venture backing in IPOs. Instead, we compare four sets of more direct measures between VC backed and non-VC backed (and between high-reputation VC backed and low-reputation VC backed) IPOs. The evidence strongly rejects the certification hypothesis, while finding considerable support for the market power hypothesis and some support for the screening and monitoring hypothesis. We find that venture capitalists attract higher quality market participants to the IPOs of firms backed by them, thus increasing the heterogeneity in investor beliefs about these firms, resulting in higher valuations for the equity of these firms (both in the IPO and in the secondary market immediately following the IPO).

venture capital, certification, screening, monitoring, market power

Abstract:
At what point in a firm’s life should it go public? How do a firm’s ex ante product market characteristics relate to its going public decision? Further, what are the implications of a firm going public on its post-IPO operating and product market performance? In this paper, we answer the above questions by conducting the first large sample study of the going public decisions of U.S. firms in the literature. We use the Longitudinal Research Database (LRD) of the U.S. Census Bureau, which covers the entire universe of private and public U.S. manufacturing firms. Our findings can be summarized as follows. First, a private firm’s product market characteristics (total factor productivity (TFP), size, sales growth, market share, industry competitiveness, capital intensity, and cash flow riskiness) significantly affect its likelihood of going public after controlling for its access to private financing (venture capital or bank loans). Second, private firms facing less information asymmetry and those with projects that are cheaper for outsiders to evaluate are more likely to go public. Third, as more firms in an industry go public, the concentration of that industry increases in subsequent years. The above results are robust to controlling for the interactions between various product market and firm specific variables. Fourth, IPOs of firms occur at the peak of their productivity cycle: the dynamics of TFP and sales growth exhibit an inverted U-shaped pattern, both in our univariate analysis and in our multivariate analysis using firms that remained private throughout as a benchmark. Finally, sales, capital expenditures, and other performance variables exhibit a consistently increasing pattern over the years before and after the IPO. The last two findings are consistent with the view that the widely documented post-IPO operating underperformance of firms is due to the real investment effects of going public rather than being due to earnings management immediately prior to the IPO.

Going public decision, product market

Abstract:
Do institutional investors possess private information about SEOs? If they do, do they use this private information to trade in a direction opposite to this information (consistent with a "manipulative trading" role) or in the same direction as this information (consistent with a direct "information production" role)? In this paper, we make use of a large sample of transaction-level institutional trading data to study institutional trading before, during, and after an SEO, and thus distinguish between the above two roles of institutional investors in SEOs. Our data allow us to explicitly identify institutional SEO share allocations for the first time in the literature. We analyze the consequences of the private information possessed by institutional investors for: SEO share allocation; institutional trading before and after the SEO and realized trading profitability; and the SEO discount. Our results can be summarized as follows. First, institutions are able to identify and obtain more allocations in SEOs with better long-term returns. Second, more pre-offer net buying of the SEO firm's equity by institutional investors is associated with more institutional SEO share allocations, and also more post-offer net buying. Third, institutions flip only a very small fraction of their SEO share allocations: 3.20 percent during the first two days post-SEO. However, this lack of flipping does not appear to be costly to institutional investors, since there is no significant difference between the extent of SEO underpricing and the realized profitability of institutional SEO share allocation sales. Fourth, institutional investors' post-SEO trading significantly outperforms a naive buy-and-hold trading strategy in SEOs. Further, the profitability of post-offer trading in SEOs where institutions obtained allocations is higher than that of trading in SEOs where they did not obtain allocations. Finally, more pre-offer institutional net buying and larger institutional SEO share allocations are associated with a smaller SEO discount. Overall, our results are consistent with institutions possessing private information about SEOs, and with an information production rather than a manipulative trading role for institutional investors in SEOs.

Seasoned Equity Offerings, Institutional investors, Manipulative trading, Information production, SEO discount, Underpricing

Abstract:
Mandatory convertibles, which are equity-linked hybrid securities that automatically convert to equity on a pre-specified date, have become an increasingly popular means of raising capital in recent years (about $20 billion worth issued in 2001 alone). This paper presents the first theoretical and empirical analysis of mandatory convertibles in the literature. We consider a firm facing a financial market characterized by asymmetric information, and significant costs in the event of financial distress. The firm can raise capital either by issuing mandatory convertibles, or by issuing more conventional securities like straight debt, ordinary convertibles, or equity. We show that, in equilibrium, the firm issues straight debt or ordinary convertibles if the extent of asymmetric information facing it is large, but the probability of being in financial distress is relatively small; it issues mandatory convertibles if it faces a smaller extent of asymmetric information but a greater probability of financial distress. Our model provides a rationale for the three commonly observed features of mandatory convertibles: mandatory conversion, capped (or limited) capital appreciation, and a higher dividend yield compared to common stock. We also characterize the equilibrium design of mandatory convertibles. We test the implications of our theory regarding a firm's choice between mandatory and ordinary convertibles and find supporting evidence.

mandatory convertibles, ordinary convertibles, financial innovation

Abstract:
We develop a new rationale for the performance and value improvements of firms following corporate spin-offs. We consider a situation of a firm with multiple divisions, where incumbent management may have differing abilities for managing various divisions. Giving up control to a rival with better ability in managing the firm, while it benefits equity holders (including incumbent management) by increasing the firm's equity market value, also involves losing the incumbent's benefits from control. Due to this trade-off, the incumbent, while willing to relinquish control to extremely high ability rivals, may not wish to do so for rivals who have only moderately higher management ability relative to him. Spin-offs increase the chance of loss of control to potential rivals in two ways: First, it reduces the ability of the incumbent to use firm size strategically against the rival in a control contest (after the spin-off, the rival can invest to the full extent of his wealth in the equity of the firm more vulnerable to a takeover). Second, it increases the probability that passive investors will vote with the rival in a contest for control for at least one division (in a joint firm, the superior management ability of any rival with respect to one division may be neutralized by inferior ability with respect to another one). This increased chance of loss of control following a spin-off, in turn, motivates the incumbent to work harder (despite his disutility for effort) in equilibrium in an attempt to maintain control. Thus, the increase in equity market value of the firm upon spin-off announcements arises not only from market participants incorporating in their valuations the increased probability of a takeover by a more able rival for control, but also from their anticipating the increase in managerial efficiency arising from the disciplining effect of the spin-off on firm management. Our analysis predicts that, in addition to positive announcement effects, the equity of a sample of spun-off firms will also exhibit long-term positive abnormal returns under certain conditions. Our model also explains a wide variety of other recently documented empirical regularities, and provides hypotheses for further empirical work.

spin-offs, corporate control

Abstract:
We analyze a firm's choice between dual class and single class share structures, either at IPO or subsequently, prior to an SEO. We consider an entrepreneur ("incumbent") who obtains both security benefits and private benefits of control, and who wishes to sell equity to outsiders to raise financing to implement his firm's project. The incumbent may be either talented (lower cost of effort, comparative advantage in implementing projects) or untalented: the incumbent's ability is private information, with outsiders observing only a prior probability that he is talented (his "reputation"). The firm's project may be either long-term (intrinsically more valuable, but showing less signs of success in the short run) or short-term (faster resolution of uncertainty). Thus, under a single class share structure, an incumbent (not holding a majority equity stake in the firm) has a greater chance of losing control to potential rivals if he adopts the long-term project, since outside equity holders may vote for the rival if they believe that the project is not progressing well. A dual class share structure allows the incumbent to have enough votes to prevail, but may be misused by untalented incumbents to dissipate value by not exerting effort. In equilibrium, the incumbent simultaneously chooses the IPO share structure (dual class or single class), project type (long-term or short-term), and how much effort to exert. Our results help to explain firm's choices between dual class and single class IPOs and the relative post-IPO operating performance of dual class versus single class IPO firms. We also characterize the situations under which a firm will undergo a share unification or a dual class recapitalization, the announcement effect of these events on the firm's equity, and their effect on its subsequent operating performance.

Dual Class Shares, Voting Structure, Antitakeover Provisions, Recapitalizations

Abstract:
We analyze a firm's choice between dual class and single class share structures, either at IPO or subsequently, prior to an SEO. We consider an entrepreneur (incumbent) who obtains both security benefits and private benefits of control, and who wishes to sell equity to outsiders to raise financing to implement his firm's project. The incumbent may be either talented (lower cost of effort, comparative advantage in implementing projects) or untalented: the incumbent's ability is private information, with outsiders observing only a prior probability that he is talented (his reputation). The firm's project may be either long-term (intrinsically more valuable, but showing less signs of success in the short run) or short-term (faster resolution of uncertainty). Thus, under a single class share structure, an incumbent has a greater chance of losing control to potential rivals if he undertakes the long-term project, since outside equity holders may vote for the rival if they believe that the project is not progressing well. A dual class share structure allows the incumbent to have enough votes to prevail against any rival, but may be misused by untalented incumbents to dissipate value by not exerting effort. In equilibrium, the incumbent simultaneously chooses the IPO share structure (dual class or single class), project type (long-term or shortterm), and how much effort to exert. Our results help to explain firms' choices between dual class and single class IPOs and the relative post-IPO operating performance of dual class versus single class IPO firms. We also characterize the situations under which a firm will undergo a share unification or a dual class recapitalization, the announcement effect of these events on the firm's equity, and their effect on its subsequent operating performance. Finally, our model provides testable predictions for the conditions under which firms will include stronger antitakeover provisions in their corporate charters and the relationship between the prevalence of such provisions in a firm's charter and its post-IPO operating performance.

Dual Class Shares, Voting Structure, Antitakeover Provisions, Recapitalizations, Unifications

Abstract:
We analyze firms' choice between exchanges to list their equity (including multiple listings), and exchanges' choice of listing standards for firms which apply for listing, in an environment of competition and co-operation among exchanges. We model an equity market characterized by asymmetric information, where outsiders can reduce their informational disadvantage relative to insiders by producing (noisy) information about firms at a cost. Exchanges are populated by two kinds of investors: sophisticated investors, with a cost advantage in producing information (low-cost investors), and ordinary investors, without such a cost-advantage (high-cost investors); the proportions of these two kinds of investors vary across exchanges. While firms are short-lived agents, exchanges are long-lived, value-maximizing agents, whose stringency in their listing and disclosure standards evolve over time. Exchanges also use their listing standards as a tool in competing with other exchanges for listings by firms. However, outsiders can partially infer the rigor of an exchange's listing policy by studying the subsequent performance of firms which have obtained listing there. The listing standards chosen by an exchange therefore affects its reputation. The listing choices of firms between exchanges, the valuation effects of listings on firm equity, and exchanges' listing standards emerge endogenously in equilibrium. Our model has implications for: the relationship between firm characteristics and the benefits from cross (and dual) listing; the price effects of cross listings; the relationship between cross listing and financial analyst following; the relationship between an exchange's reputation and its listing standards; the impact of competition on an exchange's listing standard; the impact of an alliance between exchanges on the listing standards of the allied exchange and of exchanges competing with it; and for the optimal regulation of exchanges.

Abstract:
We use the Longitudinal Research Database (LRD) of the U.S. Census Bureau, which covers almost the entire universe of private and public U.S. manufacturing firms, to study several related questions regarding the efficiency gains generated by venture capital (VC) investment in private firms. First, do VCs indeed improve the efficiency (total factor productivity, TFP) of private firms, and if so, are certain kinds of VCs (high reputation vs. low reputation) better at generating such efficiency gains than others? Second, do VCs invest in more efficient firms to begin with (screening) or do they improve efficiency after investment (monitoring)? Third, do efficiency improvements due to VC backing arise from increases in sales or reductions in costs? Fourth, do such efficiency gains affect the probability of a successful exit (IPO or acquisition) for VC backed firms? Our analysis shows that the overall efficiency of VC backed firms is higher than that of non-VC backed firms at every point in time. This efficiency advantage of VC backed firms arises from both screening and monitoring: the efficiency of VC backed firms prior to receiving financing is higher than that of non-VC backed firms and further, the growth in efficiency subsequent to receiving VC financing is greater for such firms relative to non-VC backed firms. The above increases in efficiency of VC backed firms are spread over the first two rounds of VC financing after which the TFP of such firms remains constant till exit. Further, we show that while the TFP of firms prior to receiving financing is lower for high reputation VC backed firms, the increase in TFP subsequent to financing is significantly greater for these firms, consistent with high reputation VCs having greater monitoring ability. The above results are robust to correcting for endogeneity in the selection of firms by VCs. We show that while overall efficiency gains generated by VC backing arise primarily from improvements in sales, the efficiency gains of high reputation VC backed firms arise from both improvement in sales and from lower increases in production costs. Finally, we show that both screening and monitoring activities of VCs positively affect the probability of a successful exit (IPO or acquisition).

VC financing, monitoring, screening, efficiency, TFP

Abstract:
We develop a non-tax rationale for leasing in a double-sided asymmetric information setting, and analyze how various contractual provisions in leasing contracts arise in equilibrium. In our model, a manufacturer of capital goods has private information about their quality; entrepreneurs (users of these capital goods) come to learn this quality only over a period of time. Each unit of the capital goods requires a certain level of maintenance in each period. Entrepreneurs differ in their cost of providing this maintenance; this maintenance cost is information private to each entrepreneur. Leasing emerges as an equilibrium solution to this double-sided adverse selection problem. Various contractual provisions in leasing contracts (e.g., short-term versus long-term leases with non-cancellation provisions, option to buy at lease termination, and service leases) also emerge as equilibrium solutions under alternative settings. Leases with metering provisions emerge in equilibrium when, in addition to maintenance cost, entrepreneurs differ in other dimensions such as their intensity of using the capital good, and their degree of risk aversion. Our model has implications for the lease versus sell decision, the situations under which various leasing contract provisions are appropriate, and for the relative magnitudes of sales prices and the leasing costs for leases with different contractual provisions.

Abstract:
We analyze how corporate venture capitalists (CVCs) create value for entrepreneurial firms backed by them and how value creation by CVCs differs from that of independent venture capitalists (IVCs). Making use of a large data set consisting of a sample of CVC-backed and IVC-backed firms (starting from their first round of investment in an entrepreneurial firm and going well into the post-IPO market), we explore three related research questions: First, do CVCs exploit their knowledge and industry expertise when choosing portfolio firms, and invest in significantly different kinds of firms compared to independent venture capitalists (IVCs)? Second, do they succeed in creating greater product market value subsequent to investment compared to IVCs? Finally, do they allow portfolio firms to access the equity markets more efficiently? Our empirical findings indicate that there are two ways in which CVCs uniquely create value for entrepreneurial firms. First, CVC create value by investing significant amounts in younger and riskier firms involving pioneering technologies: since many such firms would not have received private equity financing from IVCs, these firms may not have been able to grow and mature without CVC funding. Second, CVCs seem to play an important role in signaling the true value of firms backed by them to three different constituencies: first, to IVCs, prompting them to co-invest in these firms pre-IPO; second, to various financial market players such as underwriters, institutional investors, and analysts, allowing them to access the equity market at an earlier stage in their life-cycle compared to firms backed by IVCs alone; and third, directly to IPO market investors, allowing CVC-backed firms to obtain higher IPO market valuations compared to the valuation of firms backed by IVCs alone.

corporate venture capital, venture capital, IPOs

Abstract:
Practitioners have noted that firms tend to increase their product market advertising prior to an IPO or a seasoned equity issue. Further, recent empirical evidence indicates that firms with a greater level of product market advertising have lower bid-ask spreads and a larger number of both individual and institutional investors in their equity. We develop a theoretical model of the interaction between a firm's product market advertising and its corporate financing decisions in the above context. We consider a firm which faces asymmetric information in both the product and the financial market (about the quality of its products and the intrinsic value of its projects) and which needs to raise external financing to fund its growth opportunity (new project). Any product market advertising undertaken by the firm is visible in the financial market as well. We show that, in equilibrium, the firm uses a combination of product market advertising, IPO underpricing, and underfinancing (raising a smaller amount of external capital than the full information optimum) to convey its true product quality and the intrinsic value of its projects to consumers and investors. Our model has several implications for IPO underpricing and product market advertising. Two of these predictions are as follows. First, firms will choose a higher level of product market advertising when they are planning to issue new equity or other information-sensitive securities, compared to situations where they have no immediate plans to sell such securities. Second, product market advertising and IPO underpricing are substitutes for a firm going public. The empirical evidence supports these two predictions: First, firms indeed increase their product market advertising in their IPO year relative to a benchmark year two years before their IPO. Further, we find that, in the five-year span around the IPO year (i.e., the IPO year, and the two years before and after the IPO year), the peak advertising level is reached in the IPO year. Second, the extent of underpricing is smaller as the level of product market advertising is greater.

Initial public offerings, advertising

Abstract:
Using a unique sample of plant level data from the Longitudinal Research Database (LRD) of the U.S. Census Bureau, we identify, how (the precise channel and mechanism), where (parent or subsidiary), and when (the dynamic pattern) efficiency improvements arise following corporate spin-offs. We analyze the source of productivity improvements in spin-offs by comparing the magnitude of post-spin-off changes in the wages, employment, materials costs, rental and administrative expenses, sales, and capital expenditures in the plants belonging to firms undergoing spin-offs relative to the magnitude of such changes in a control group of plants belonging to firms not undergoing spin-offs. We show that the total factor productivity (TFP) of plants belonging to spin-off firms (parent or spun-off subsidiary), increase on average immediately following the spin-off and is long lived. This post spin-off productivity improvement can be attributed to cost savings but not to better product market performance. Further, such improvements arise primarily in plants that remain with the parent; plants belonging to the spun-off subsidiary do not experience such productivity improvements. However, contrary to speculation in the previous literature, we show that plants that are spun-off do not underperform parent plants prior to the spin-off. We identify acquisitions subsequent to spin-offs and find that productivity improves for both subsequently acquired and non-acquired groups of plants: while such improvements occur immediately after the spin-off for the non-acquired plants, for the acquired plants they start only after being taken over by another firm. Finally, we show that while post spin-off productivity improves in both related and unrelated spin-offs, unrelated spun-off entities show greater improvements in productivity compared to related spun-off entities.

Spin-offs, Restructuring, Total Factor Productivity (TFP), Employment, Wages

Abstract:
Using a sample of debt and seasoned equity issues from 1980-2004 and different proxies of investor optimism and the dispersion in investor beliefs, we empirically analyze, for the first time in the literature, the effect of heterogeneous beliefs among outside investors on the capital structure and security issuance choices made by a firm. The paper consists of three parts: In the first part of the paper, we study how heterogeneous beliefs affect a firm's choice between equity and debt for raising external financing; in the second part of the paper, we study the effect of heterogeneous beliefs on the price impact of a security issue on the firm's equity; and in the third part of the paper, we study the effect of heterogeneous beliefs on the long-term stock performance of equity and debt issuers. Our empirical results can be summarized as follows. First, the probability of a firm issuing equity rather than debt is increasing in both the average level of optimism of outside investors and the dispersion in outsider beliefs. Second, the price impact on the firm's equity is negative for an equity issue and zero for a debt issue; further, the price impact of an equity issue is decreasing (more negative) as the dispersion in outsider beliefs is greater. Finally, while the long-term stock returns to both equity and debt issuers is negative, the stock returns to equity issuers is significantly more negative than that of debt issuers. Further, the more optimistic outsiders are on average about a firm's prospects at the time of an equity issue and the more dispersed their beliefs, the more negative the long-term stock returns to the firm. Overall, our results indicate the importance of heterogeneity in investor beliefs as a determinant of the financing decision of a firm.

Heterogeneous beliefs, Security Issuance, Price Impact, Capital Structure

Abstract:
We analyze the profitability and informativeness of institutional trading in IPOs using a large sample of proprietary transaction-level trading data. We analyze the pattern and profitability of institutional IPO allocation sales, the profitability of post-IPO institutional trading, and the predictive power of institutional trading for subsequent long-run IPO performance. Our results can be summarized as follows. First, institutions continue to sell significant portions of their IPO allocations beyond the immediate post-IPO period. Larger institutions sell their allocations faster than smaller institutions, suggesting that they have greater bargaining power with respect to the investment banking syndicate. Second, while institutions realize most of the money left on the table for IPO allocations sold within the first year, the realized profits from institutional allocation sales over a two-year period is significantly lower. Third, post-IPO institutional trading outperforms a buy-and-hold investment strategy in IPOs (but does not outperform or underperform the market in general), suggesting that institutions do possess some private information about IPOs. Institutions outperform more when trading shares in IPOs about which there is higher information asymmetry (younger firms and those underwritten by less reputable investment banks); further, larger institutions outperform by a higher margin than smaller institutions, suggesting that they have a comparative advantage in information production. Fourth, institutional trading has predictive power for subsequent long-run IPO performance, even after controlling for publicly available information, though this predictive power decays over time, becoming insignificant after the initial three to four months. Overall, our results indicate that institutional investors possess a significant informational advantage over retail investors about IPOs and receive considerable compensation for participating in these IPOs.

Initial public offerings, Institutional investors, Trading, IPO allocations, Flipping

Abstract:
We develop a model of the seasoned equity offering (SEO) process, starting from the SEO announcement, through pre-offer trading, and ending in the offering itself. We use our model to advance a new rationale for the SEO discount and SEO underpricing, and also to analyze the role of institutional investors in SEOs. We consider a firm insider (manager) with private information about his firm's intrinsic value, and who wishes to sell a certain number of shares of its equity to outsiders in an underwritten SEO. There are two kinds of investors in the equity market: institutional investors, who can produce (noisy) information about the firm at a cost, and retail investors, who are unable to do so, and whose demand for equity is therefore driven purely by liquidity considerations. Three ingredients drive the equilibrium in our model. First, insiders of higher intrinsic value firms are better off inducing a significant extent of information production by institutional investors, since such information production enables them to obtain a higher offer price in the SEO. Second, institutional investors may use their information at two different venues: in the pre-offering market, and in the SEO itself. Third, firm insiders are able to partially assess potential SEO demand for their equity from the pre-offer market price. However, given retail trading in the pre-offer market, the above inference is noisy, so that there may be a residual probability of SEO failure. The equilibrium SEO discount therefore depends on the magnitude of the firm's cost of SEO failure. When this cost is small, the firm sets the SEO discount to be the same across all possible states (prices) in the pre-offer market, just enough to cover institutional investors' information production costs. When this cost is large, the firm sets larger SEO discounts when the pre-offer price is less informative about potential SEO demand, and smaller discounts when it is more informative (in an effort to minimize the probability of SEO failure). Our model generates a number of testable predictions on the relationship between institutional demand for a firm's equity in the pre-offer market, the stock return from the announcement day to the day before the offering, institutional share allocation in the SEO, and the SEO discount. In an extension to our basic model, we incorporate the post-offering market as well, thus allowing us to relate the above variables also to SEO underpricing, and to institutional demand for equity in the post-offer market.

Seasoned Equity Offerings, SEO discount, SEO underpricing, Information production, Institutional investors

Abstract:
We develop a model of seasoned equity issues (SEOs) under asymmetric information where, in addition to observing the firm's issue/no issue decision, outsiders obtain "soft information" signals about firms through noisy voluntary disclosures made by firms or information production by outsiders. We show that, if sufficiently precise soft information is available to outsiders, firms' equity issue behavior is significantly altered in equilibrium relative to that in existing models of SEOs. In particular, while existing models predict that the announcement effect to a public offering of equity will always be negative, our model predicts that the announcement effect will be positive for a significant fraction of SEOs. We predict that the announcement effect will be positive or negative depending on the realization of outsiders' soft information, the value of the firm's assets-in-place, and the net present value of its growth opportunities, with firms about which outsiders have more favorable soft information receiving algebraically larger (more positive or less negative) SEO announcement effects. We also have predictions for the relationship between the precision of outsiders' soft information and the amount of underinvestment in that firm, and for a firm's debt to equity ratio. Finally our model provides a rationale for the existence of "investor relations" departments in many firms. We test two of the predictions of our model using stock price data of a sample of firms making equity issues, and using revisions in analyst recommendations and earnings forecasts as proxies for the realizations of outsiders' soft information signals about these firms. The evidence is consistent with the predictions of our model..

Equity Issues, Announcement Effects, Financing Policy

Abstract:
We develop measures of the management quality of firms making seasoned equity offerings (SEOs) and make use of a unique sample of hand-collected data to examine the relationship between the reputation and quality of a firm's management and its financial policies, SEO characteristics, and post-SEO performance (a relationship that has so far received little attention in the literature). We hypothesize that better and more reputable managers are able to convey the intrinsic value of their firm more credibly to outsiders, thus reducing the information asymmetry facing their firm in the equity market. Given this, firms with better and more reputable managements will have more access to the equity market, so that we expect lower leverage ratios for these firms. In addition, they will have less need to signal using dividends, so that they will have lower dividend payout ratios. Further, given that financial intermediaries like investment banks and institutional investors will incur lower costs of producing information about such firms, we expect these firms to be associated with more reputable underwriters, smaller underwriting expenses, and larger institutional holdings. Further, since better managers are likely to select better projects (having a larger NPV for any given scale) and implement them more ably, higher management quality will also be associated with larger SEO offer sizes, higher levels of investment and R&D expenditures, and better post-SEO operating performance. We present evidence consistent with the above hypotheses. Our direct tests of the relationship between management quality and asymmetric information also indicate that higher management quality leads to a reduction in the extent of information asymmetry facing a firm in the equity market.

Abstract:
This paper presents the first theoretical as well as the first empirical analysis of the choice of firms between preparing or not preparing the equity market in advance of a possible dividend cut. We use a hand-collected data set of dividend cutting firms that allows us to distinguish between prepared and non-prepared dividend cutting firms. In our model, a firm has assets in place (which will generate an intermediate cash flow), and a growth opportunity. Firm insiders have private information not only about the probability of their firm realizing a high intermediate cash flow, but also about the net present value of its growth opportunity. We characterize the firm insiders' equilibrium choice between preparing and not preparing the market, as well as their decision regarding whether or not to cut the firm's dividend (subsequent to the realization of the firm's intermediate cash flow). In equilibrium, firms in temporary financial difficulties but good long-term growth prospects prepare the market in advance of dividend cuts, while those with permanently declining earnings are less likely to prepare the market. Our analysis generates several testable predictions. First, the abnormal stock returns upon the announcement of a dividend cut will be less negative for prepared compared to non-prepared dividend cutting firms. Second, the abnormal stock returns of firms preparing the market for a dividend cut will be negative on the market preparation day. Third, the long-run operating, dividend payment, and stock return performance of prepared dividend cutting firms will be better than that of non-prepared dividend cutting firms. Fourth, the post-dividend-cut equity holdings of institutional investors in prepared dividend cutting firms will be larger than those in non-prepared dividend cutting firms. The results of our empirical analysis support the above predictions of our theory.

Market Preparation, Dividend Cuts, Asymetric Information

Abstract:
We present a direct test of the choice of the medium of exchange in acquisitions when both acquirers and targets possess private information about their own intrinsic values. We test three hypotheses: first, whether acquirers are more likely to choose a stock offer as their equity is more overvalued; second, whether acquirers facing a greater extent of information asymmetry in evaluating targets are more (or less) likely to use a stock versus a cash offer; and third, whether a cash offer deters competing bids. Our findings are as follows. First, acquirers choosing a stock offer are overvalued and those choosing a cash offer are correctly valued. Second, the greater the extent of acquirer overvaluation, the greater the likelihood of it using a stock offer; further, the greater the extent of information asymmetry faced by an acquirer in evaluating its target, the greater its likelihood of using a cash offer. Third, the extent of an acquirer’s under- or overvaluation significantly affects the abnormal returns to its equity upon the acquisition announcement. Finally, the use of cash by an acquirer deters competing bids. We conclude that private information held by both acquirers and targets together determine the medium of exchange.

Mergers and acquisitions, Medium of exchange, Asymmetric information

Abstract:
We present the first analysis in the literature of the relationship between the quality and reputation of a firm's management and the prevalence of anti-takeover provisions in the corporate charters of IPO firms, and the influence of this relationship on post-IPO performance. We test the implications of two theories regarding the above two relationships: the "managerial entrenchment" hypothesis, which implies that anti-takeover provisions are meant mainly to enhance the control benefits enjoyed by existing firm management by minimizing the probability of takeovers by rival management teams; and the "long-term value creation" hypothesis, which argues that such provisions, while they entrench firm management, can also be value enhancing in the hands of higher quality management teams. Our empirical results can be summarized as follows. First, firms with higher quality managements are associated with a greater number of anti-takeover provisions relative to those with lower quality managements. Further, within the former category, firms with larger growth options are associated with a greater number of anti-takeover provisions. Second, when we divide our sample by management quality (higher versus lower) and then by the number of anti-takeover provisions (greater versus smaller) within each management quality category, firms with higher management quality and a greater number of anti-takeover provisions outperform firms in the remaining three categories in terms of both post-IPO operating and post-IPO stock return performance. The evidence thus rejects the managerial entrenchment hypothesis and supports the long-term value creation hypothesis.

Management Quality, Anti-Takeover Provisions, Initial Public Offerings, Operating Performance, Stock Return Performance

Abstract:
Using a large sample of transaction-level institutional trading data, we directly test Brennan and Hughes' (1991) information production theory of stock splits for the first time in the literature. We compare brokerage commissions paid by institutional investors before and after a split, and relate the informativeness of institutional trading to brokerage commissions paid. We also compute realized institutional trading profitability net of brokerage commissions and other trading costs. Our results can be summarized as follows. First, both commissions paid and trading volume by institutional investors increase after a stock split. Second, institutional trading immediately after a split has predictive power for the firm's subsequent long-term stock return performance; this predictive power is concentrated in stocks which generate higher commission revenues for brokerage firms and is greater for institutions that pay higher brokerage commissions. Third, institutions make positive abnormal profits during the post-split period even after taking brokerage commissions and other trading costs into account; institutions paying higher commissions significantly outperform those paying lower commissions. Fourth, the information asymmetry faced by firms decreases after a split; the greater the increase in brokerage commissions after a split, the greater the reduction in information asymmetry. Overall, our results are broadly consistent with the implications of the information production theory.

Institutional Investors, Stock Splits, Brokerage Commissions, Information Production

Abstract:
Putable convertibles, which are convertible bonds that allow bondholders to "put" or sell the bonds to the issuer at pre-specified prices on pre-specified dates, have become an increasingly popular means of raising capital in recent years. This paper presents the first theoretical as well as the first empirical analysis of firms' rationale for issuing putable convertibles in the literature. Using a sample of firms choosing to issue either putable or ordinary convertibles, we distinguish between two possible rationales for the issuance of putable convertibles: the risk-shifting hypothesis and the asymmetric information (or undervaluation) hypothesis. We make use of two simple theoretical models to demonstrate how putable convertibles can help a firm resolve the problems associated with risk-shifting and asymmetric information, respectively, and develop testable hypotheses regarding the firm's choice between putable and ordinary convertibles, which we test in our empirical analysis. The results of our empirical analysis can be summarized as follows. First, firms that issue putable convertibles are larger, less risky firms, having larger cash flows, smaller growth opportunities, and lower bankruptcy probability compared to those issuing ordinary convertibles. Second, putable convertible issuers have lower pre-issue market valuation, less negative announcement effects, and better post-issue operating performance compared to ordinary convertible issuers. Third, putable convertible issuers have better post-issue long-run stock return performance compared to ordinary convertible issuers. Overall, the results of our univariate as well as multivariate analyses support the asymmetric information hypothesis but reject the risk-shifting hypothesis.

Putable Convertibles, Convertible Bonds, Issuing Convertible Debt, Performance

Abstract:
Using a large sample of proprietary transaction-level institutional trading data, we empirically analyze, for the first time in the literature, the role of institutional investors in corporate spin-offs. In the first part of the paper, we study the imbalance in post-spin-off institutional trading between parent and subsidiary, and analyze this imbalance to test three different hypotheses regarding institutional investors' role in spin-offs: information production, pure play, and risk management. In the second part of the paper, we examine the information production role of institutional investors in detail by analyzing the predictability of institutional trading around corporate spin-offs for the short-term and the long-term stock returns following spin-offs. In the third part of the paper, we study the pattern and profitability of institutional trading following spin-offs. Our empirical results can be summarized as follows. First, there is significant imbalance in post-spin-off institutional trading between parents and subsidiaries; this imbalance increases corresponding to the difference in the extent of information asymmetry characterizing the two entities, beta risk, and long-term growth prospects. Second, institutional trading in the combined firm two months prior to the spin-off has significant predictive power for the announcement effect of a spin-off. Third, institutional trading in the subsidiary immediately after spin-off completion also has predictive power for its subsequent long-term stock returns; this predictive power is greater when the subsidiary's size constitutes only a smaller fraction of the combined firm's size. Fourth, the predictive power of institutional trading is weaker for the parent firm's long-term returns; further, unlike in the case of the subsidiary, institutional investors start exploiting their private information after the spin-off announcement, but before the spin-off is completed. Finally, institutional investors are able to realize superior profits by trading in the equity of the subsidiary in the first quarter after the spin-off. While our results provide some support for all three hypotheses regarding the role of institutional investors in corporate spin-offs, they provide particularly strong support for the information production hypothesis.

Corporate Spin-offs, Institutional investors, Institutional trading, Information production

Abstract:
Using a large sample of proprietary transaction-level institutional trading data, we empirically analyze, for the first time in the literature, the role of institutional investors in corporate spin-offs. In the first part of the paper, we study the imbalance in post-spin-off institutional trading between parent and subsidiary, and analyze this imbalance to test three different hypotheses regarding institutional investors' role in spin-offs: information production, pure play, and risk management. In the second part of the paper, we examine the information production role of institutional investors further by analyzing the predictability of institutional trading around corporate spin-offs for the short-term and the long-term stock returns following spin-offs. In the third part of the paper, we study the pattern and profitability of institutional trading following spin-offs. Our empirical results can be summarized as follows. First, there is significant imbalance in post-spin-off institutional trading between parents and subsidiaries; this imbalance increases corresponding to the difference in the extent of information asymmetry characterizing the two entities, beta risk, and long-term growth prospects. Second, institutional trading in the combined firm two months prior to the spin-off has significant predictive power for the announcement effect of a spin-off. Third, institutional trading in the subsidiary immediately after spin-off completion also has predictive power for its subsequent long-term stock returns; this predictive power is greater when the subsidiary's size constitutes only a smaller fraction of the combined firm's size. Fourth, the predictive power of institutional trading is weaker for the parent firm's long-term returns; further, unlike in the case of the subsidiary, institutional investors start exploiting their private information after the spin-off announcement, but before the spin-off is completed. Finally, institutional investors are able to realize superior profits by trading in the equity of the subsidiary in the first quarter after the spin-off. While our results provide some support for all three hypotheses regarding the role of institutional investors in corporate spin-offs, they provide particularly strong support for the information production hypothesis.

Corporate Spin-offs, Institutional investors, Institutional trading, Information production.

Abstract:
Using a large sample of proprietary transaction-level institutional trading data, we empirically analyze, for the first time in the literature, the role of institutional investors in corporate spin-offs. In the first part of the paper, we study the imbalance in post-spin-off institutional trading between parent and subsidiary, and analyze this imbalance to test three different hypotheses regarding institutional investors' role in spin-offs: information production, pure play, and risk management. In the second part of the paper, we examine the information production role of institutional investors further by analyzing the predictability of institutional trading around corporate spin-offs for the short-term and the long-term stock returns following spin-offs. In the third part of the paper, we study the pattern and profitability of institutional trading following spin-offs. Our empirical results can be summarized as follows. First, there is significant imbalance in post-spin-off institutional trading between parents and subsidiaries; this imbalance increases corresponding to the difference in the extent of information asymmetry characterizing the two entities, beta risk, and long-term growth prospects. Second, institutional trading in the combined firm two months prior to the spin-off has significant predictive power for the announcement effect of a spin-off. Third, institutional trading in the subsidiary immediately after spin-off completion also has predictive power for its subsequent long-term stock returns; this predictive power is greater when the subsidiary's size constitutes only a smaller fraction of the combined firm's size. Fourth, the predictive power of institutional trading is weaker for the parent firm's long-term returns; further, unlike in the case of the subsidiary, institutional investors start exploiting their private information after the spin-off announcement, but before the spin-off is completed. Finally, institutional investors are able to realize superior profits by trading in the equity of the subsidiary in the first quarter after the spin-off. While our results provide some support for all three hypotheses regarding the role of institutional investors in corporate spin-offs, they provide particularly strong support for the information production hypothesis.

corporate Spin-offs, Institutional investors, Institutional trading, Information production

Abstract:
This paper develops a theory of the role of institutional investors and affiliated analysts in corporate restructuring, and analyzes a firm's choice between spin-offs, carve-outs, and tracking stock issues, for the first time in the literature. We consider a setting with a continuum of firm types where insiders of a firm with two divisions have private information about their true values and face an equity market consisting of retail investors (liquidity traders) and institutional investors. Institutional investors may engage in costly information production about the divisions of the firm, with some investors having a comparative advantage in producing information about division 1, and others having a similar comparative advantage for division 2. We show that, in the above setting, stock breakups increase information production by institutional investors (relative to that about a consolidated firm), with the highest increase in information production associated with spin-offs, the next highest associated with equity carve-outs, and the lowest associated with tracking stock issues. In equilibrium, insiders with the most favorable private information choose to implement spin-offs; those with less favorable private information implement carve-outs and tracking stock issues; those with unfavorable private information retain a consolidated structure. In addition to explaining the positive announcement effect and increase in analyst coverage that has been empirically documented following all three forms of stock breakups, our model generates a number of novel testable predictions for firms' choice between spin-offs, carve-outs, and tracking stock issues, and for institutional trading around these three forms of restructuring.

restructuring, corporate spin-offs, equity carve-outs, tracking stock issues, institutional trading, information production

Abstract:
We develop a new rationale for IPO waves based on product market considerations, and empirically test the implications of our theory. We model an industry with two competing firms, one of which has higher productivity of capital compared to the other. The two firms assess a significant probability of a positive productivity shock affecting their industry in the near future. Going public, though costly, not only allows each firm to raise external capital at a lower cost compared to a private firm, but also allows it to grab market share from its competitor if the latter remains private. In the above setting, we solve for the decision of each firm whether to go public or remain private, and if it chooses to go public, the optimal timing of going public. We show that, in equilibrium, even firms with sufficient internal capital to optimally fund their investment may go public, driven by the possibility of their product market competitors going public. We also show that IPO waves may arise in equilibrium even in industries which do not experience a positive productivity shock. Our model develops several testable predictions for IPO waves and post-IPO profitability, two of which are as follows. First, firms going public during an IPO wave will have lower post-IPO profitability than those going public off the wave. Second, firms going public earlier in an IPO wave will have higher post-IPO profitability than those going public later in the wave. We empirically test these and other predictions of our model and find supporting evidence.

IPO waves, going public, product market competition

Abstract:
We analyze the relation between antitakeover provisions (ATPs) and the performance of spin-off firms. We find that firms protected by more ATPs before spin-offs have higher abnormal announcement returns and greater improvements in post-spin-off operating performance than firms with fewer ATPs. Further, firms that reduce the number of ATPs after spin-offs have greater improvements in operating performance than firms that do not reduce the number of ATPs. Finally, CEOs of pre-spin-off firms tend to retain more ATPs in parent firms and assign fewer ATPs to the spun-off units if they remain as the CEOs of the parents but not the spun-off units. Overall, our results indicate a positive relation between ATPs and the value gains to spin-offs.

Spin-offs, antitakeover provisions, managerial entrenchment, shareholders' interest

Abstract:
This paper studies the effect of advertising on stock returns both in the short run and in the long run. We find that a greater amount of advertising is associated with a larger stock return in the advertising year but a smaller stock return in the year subsequent to the advertising year, even after we control for other price predictors, such as size, book-to-market, and momentum. We conjecture that this advertising effect on stock returns is due to the effect of advertising on investor attention. Advertising could help a firm attract investors' attention. Stock price increases in the adverting year due to the attracted attention, but decreases in the subsequent year as the attracted attention wears out over time in the long run. We test this "investor attention hypothesis" using trading volume and the number of financial analysts covering to proxy for investors' attention on the firm's stock. We document five consistent findings. First, advertising increases a firm's visibility among investors in the advertising year. Second, an increased level of investor attention is associated with a larger contemporary stock return and a smaller future stock return. Third, the effect of advertising on stock returns is stronger in firms with more visibility in the advertising year. In particular, when a high advertising firm attracts more investor attention in the stock market, the stock return of the high advertising firm increases to a larger degree in the contemporary adverting year and decreases to a larger degree in the subsequent years. However, the stock return of such a high advertising firm decreases to a smaller degree if the attention attracted in the advertising year persists subsequent to the advertising year. Fourth, the effect of advertising on future stock returns is stronger if investors face a larger cost of arbitrage. Finally, we also find that the advertising effect is stronger for small firms, value firms, and firms with poor ex-ante stock performance or poor ex-ante operating performance.

Advertising, Stock returns, Attention

Abstract:
We analyze how corporate venture capitalists (CVCs) create value for entrepreneurial firms backed by them and how value creation by CVCs differs from that of independent venture capitalists (IVCs). Making use of a large data set consisting of a sample of CVC-backed and IVC-backed firms (starting from their first round of investment in an entrepreneurial firm and going well into the post-IPO market), we explore three related research questions: First, do CVCs exploit their knowledge and industry expertise when choosing portfolio firms, and invest in significantly different kinds of firms compared to independent venture capitalists (IVCs)? Second, do they succeed in creating greater product market value subsequent to investment compared to IVCs? Finally, do they allow portfolio firms to access the equity markets more efficiently? Our empirical findings indicate that there are two ways in which CVCs uniquely create value for entrepreneurial firms. First, CVC create value by investing significant amounts in younger and riskier firms involving pioneering technologies: since many such firms would not have received private equity financing from IVCs, these firms may not have been able to grow and mature without CVC funding. Second, CVCs seem to play an important role in signaling the true value of firms backed by them to three different constituencies: first, to IVCs, prompting them to co-invest in these firms pre-IPO; second, to various financial market players such as underwriters, institutional investors, and analysts, allowing them to access the equity market at an earlier stage in their life-cycle compared to firms backed by IVCs alone; and third, directly to IPO market investors, allowing CVC-backed firms to obtain higher IPO market valuations compared to the valuation of firms backed by IVCs alone.

Corporate Venture Capital, value creation, IPOs

Abstract:
We analyze how corporate venture capitalists (CVCs) create value for entrepreneurial firms backed by them and how value creation by CVCs differs from that of independent venture capitalists (IVCs). Making use of a large data set consisting of a sample of CVC-backed and IVC-backed firms (starting from their first round of investment in an entrepreneurial firm and going well into the post-IPO market), we explore three related research questions: First, do CVCs exploit their knowledge and industry expertise when choosing portfolio firms, and invest in significantly different kinds of firms compared to independent venture capitalists (IVCs)? Second, do they succeed in creating greater product market value subsequent to investment compared to IVCs? Finally, do they allow portfolio firms to access the equity markets more efficiently? Our empirical findings indicate that there are two ways in which CVCs uniquely create value for entrepreneurial firms. First, CVC create value by investing significant amounts in younger and riskier firms involving pioneering technologies: since many such firms would not have received private equity financing from IVCs, these firms may not have been able to grow and mature without CVC funding. Second, CVCs seem to play an important role in signaling the true value of firms backed by them to three different constituencies: first, to IVCs, prompting them to co-invest in these firms pre-IPO; second, to various financial market players such as underwriters, institutional investors, and analysts, allowing them to access the equity market at an earlier stage in their life-cycle compared to firms backed by IVCs alone; and third, directly to IPO market investors, allowing CVC-backed firms to obtain higher IPO market valuations compared to the valuation of firms backed by IVCs alone.

Corporate venture capital, certification, monitoring, value creation

Abstract:
Using a unique sample from the Longitudinal Research Database (LRD) of the U.S. Census Bureau, we study several related questions regarding the efficiency gains generated by venture capital (VC) investment in private firms. First, does VC backing improve the efficiency (total factor productivity, TFP) of private firms, and are certain kinds of VCs (higher reputation versus lower reputation) better at generating such efficiency gains than others? Second, how are such efficiency gains generated: Do venture capitalists invest in more efficient firms to begin with (screening) or do they improve efficiency after investment (monitoring)? Third, how are these efficiency gains spread out over rounds subsequent to VC investment? Fourth, what are the channels through which such efficiency gains are generated: increases in product market performance (sales) or reductions in various costs (labor, materials, total production costs)? Finally, how do such efficiency gains affect the probability of a successful exit (IPO or acquisition)? Our main findings are as follows. First, the overall efficiency of VC backed firms is higher than that of non-VC backed firms. Second, this efficiency advantage of VC backed firms arises from both screening and monitoring: the efficiency of VC backed firms prior to receiving financing is higher than that of non-VC backed firms and further, the growth in efficiency subsequent to receiving VC financing is greater for such firms relative to non-VC backed firms. Third, the above increase in efficiency of VC backed firms relative to non-VC backed firms increases over the first two rounds of VC financing, and remains at the higher level till exit. Fourth, while the TFP of firms prior to VC financing is lower for higher reputation VC backed firms, the increase in TFP subsequent to financing is significantly higher for the former firms, consistent with higher reputation VCs having greater monitoring ability. Fifth, the efficiency gains generated by VC backing arise primarily from improvement in product market performance (sales); however for higher reputation VCs, the additional efficiency gains arise from both an additional improvement in product market performance as well as from reductions in various input costs. Finally, both the level of TFP of VC backed firms prior to receiving financing and the growth in TFP subsequent to VC financing positively affect the probability of a successful exit (IPO or acquisition).

Abstract:
Using a hand-collected data set of private firm acquisitions and IPOs, this paper presents an empirical analysis of a private firm's choice between IPOs and acquisitions, and develops the first empirical analysis in the literature of the “IPO valuation premium puzzle” (where many private firms seem to choose to be acquired rather than to go public at higher valuations). In the first part of the paper, we test several new hypotheses regarding a firm's choice between IPOs and acquisitions and develop several new empirical findings. First, firms operating in less concentrated industries characterized by the absence of a dominant market player (and therefore more viable against product market competition) are more likely to go public rather than be acquired. Second, firms facing a greater extent of information asymmetry in the equity market, more capital intensive firms, and those operating in industries characterized by greater private benefits of control, are more likely to go public rather than to be acquired. Third, the likelihood of an IPO over an acquisition is greater for venture backed firms and those characterized by higher pre-exit sales growth. Finally, we document that the passage of the Sarbanes-Oxley Act has motivated a larger proportion of firms to favor acquisitions over IPOs. Our comparison of private firm valuations in IPOs and acquisitions in the second part of the paper indicates that IPO valuation premia disappear for larger firms after controlling for various factors affecting a firm's choice between IPOs and acquisitions. Further, after controlling for the long run component of the expected payoff to firm insiders from an IPO exit, we find that the IPO valuation premium vanishes even for smaller venture backed firms and shrinks substantially for non-venture backed firms as well. Thus, we are able to resolve the IPO valuation premium puzzle for the first time in the literature.

IPOs, acquisitions, exit, product market competition

Abstract:
We develop a new theoretical rationale for the formation of syndicates in venture capital (VC) financing and analyze the dynamics of VC interaction subsequent to syndicate formation. In our model, an entrepreneur needs financing from a venture capitalist to implement his firm's positive net present value project. In addition to financing, VCs can provide the firm with two inputs (each in a different area of activity), which can increase the probability of project success: these inputs can be provided either by a single VC, or by two different VCs, each operating in his own area of expertise. The effort exerted by a VC in providing the above inputs is unobservable to the entrepreneur but observable to other VCs who may form part of a syndicate with him. We analyze the firm's equilibrium choice between financing the project by contracting with a single VC, by contracting individually with two VCs, or by contracting with a syndicate consisting of two VCs. Our analysis generates several testable predictions. First, it predicts that firms with more complex projects are more likely to seek financing from a VC syndicate. Second, firms obtaining financing from a VC syndicate throughout various financing rounds are more likely to have a successful exit compared to those which have syndicate financing in earlier rounds but switch to financing from a single VC in later rounds. Finally, VCs forming part of a syndicate which backed a successful firm are more likely to form a syndicate again backing future projects. We present empirical evidence consistent with the above predictions of our model.

Peer Monitroing, Venture Capital, Syndication

Abstract:
At what point in a firm’s life should it go public? How do a firm’s ex ante product market characteristics relate to its going public decision? Further, what are the implications of a firm going public on its post-IPO operating and product market performance? In this paper, we answer the above questions by conducting the first large sample study of the going public decisions of U.S. firms in the literature. We use the Longitudinal Research Database (LRD) of the U.S. Census Bureau, which covers the entire universe of private and public U.S. manufacturing firms. Our findings can be summarized as follows. First, a private firm’s product market characteristics (market share, competition, capital intensity, cash flow riskiness) significantly affect its likelihood of going public. Second, private firms facing less information asymmetry and those with projects that are cheaper for outsiders to evaluate are more likely to go public (consistent with Chemmanur and Fulghieri (1999)). Third, IPOs of firms occur at the peak of their productivity cycle (consistent with Clementi (2002)): the dynamics of total factor productivity (TFP) and sales growth exhibit an inverted U-shaped pattern. Finally, sales, capital expenditures, and other performance variables exhibit a consistently increasing pattern over the years before and after the IPO. The last two findings are consistent with the widely documented post-IPO operating underperformance of firms being due to the real investment effects of a firm going public, and inconsistent with underperformance being solely due to earnings management immediately prior to the IPO.

Abstract:
We model firms' choice between bank loans and publicly traded debt, allowing for debt-renegotiation in the event of financial distress. Entrepreneurs, with private information about their probability of financial distress, borrow from banks (multi-period players) or issue bonds to implement projects. If a firm is in financial distress, lenders devote a certain amount of resources (unobservable to entrepreneurs) to evaluate whether to liquidate the firm or to renegotiate its debt. We demonstrate that banks' desire to acquire a reputation for making the "right" renegotiation versus liquidation decision provides them an endogenous incentive to devote a larger amount of resources than bondholders toward such evaluation. In equilibrium, bank loans dominate bonds from the point of view of minimizing inefficient liquidation; however, firms with a lower probability of financial distress choose bonds over bank loans.

Abstract:
We develop a model of corporate myopia in which the interaction between asymmetric information and short-term trading by equity holders induces firms to undertake short-term rather than long-term projects, which are intrinsically more valuable. We study the effectiveness of alternative policy prescriptions in eliminating myopia. We show that a capital gains tax cut for long-term equity holders induces optimal project selection; an across-the-board tax cut has no such impact. We characterize the long-term capital gains tax rate which eliminates corporate myopia. Further, we show that a long-term capital gains tax-cut does not induce a bias toward inefficient long-term projects when it is, in fact, short-term projects which are more valuable. In contrast, an investment tax credit directed at long-term projects lead to such a bias. Finally, we show that reducing the long-term capital gains tax rate to the level required to eliminate myopic investment behavior may also lead to an increase in government tax revenues.

Abstract:
We address the question: At what stage in its life should a firm go public, rather than undertake its projects using private equity financing? In our model, a firm may raise external financing either by placing shares privately with a risk-averse venture capitalist, or by selling shares in an IPO to numerous small investors. The entrepreneur has private information about his firm's value, but outsiders can reduce this informational disadvantage by evaluating the firm at a cost. The equilibrium timing of the going-public decision is determined by the firm's trade-off between minimizing the duplication in information production by outsiders (unavoidable in the IPO market, but mitigated by a publicly observable share price) and avoiding the risk-premium demanded by venture capitalists. Testable implications are developed for the cross-sectional variations in the age of going-public across industries and countries.

Abstract:
We develop a model of corporate myopia in which the interaction between asymmetric information and short-term trading by the firm's equity holders induces firm managers to undertake short-term projects rather than long-term projects, which are intrinsically more valuable. In this setting, we analyze the impact of a reduction in the capital gains tax rate on project selection. We show that a capital gains tax cut for investors who hold equity in the firmbeyond a certain length of time can induce optimal project selection by firm managers; an across-the-board tax cut, on the other hand, has no such impact. We characterize the long-term capital gains tax rate which eliminates corporate myopia. We demonstrate that a long-term capital gains tax cut does not create a bias toward inefficient long-term projects in situations where it is the short-term project that is intrinsically more valuable. We further show that, under certain conditions, reducing the long-term capital gains tax rate to the level required to eliminate myopic investment behavior can also lead to an increase in government tax revenues.

Abstract:
We develop a theory of unit IPOs, in which the firm going public issues a package of equity with warrants. We model an equity market where insiders have private information about the riskiness as well as the expected value of their firm's future cash flows. We demonstrate that, in equilibrium, high risk firms issue underpriced "units" of equity and warrants; lower risk firms, on the other hand, issue underpriced equity alone. In contrast to the existing literature, underpricing arises as a signal in our model in the context of a one-shot equity offering. Though developed in the context of IPOs, our model can also explain the issuance of seasoned equity offerings packaged with warrants. Further, the intuition behind the model generalizes readily to provide a new rationale for packaging call option like claims with risky securities other than equity (e.g., convertible debt, debt with warrants) as well.

Abstract:
We develop a theory of unit IPOs, in which the firm going public issues a package of equity with warrants. We model an equity market characterized by asymmetric information, where insiders have private information about the riskiness as well as the expected value of their firm's future cash flows. We demonstrate that, in equilibrium, high risk firms issue "units" of equity and warrants, and the package of equity and warrants is underpriced; lower risk firms, on the other hand, issue underpriced equity alone. An important feature of our model is that, in contrast to the existing literature, underpricing is used as a signal in equilibrium in the context of a one-shot equity offering. While the model is developed in the context of IPOs of equity, it is also applicable with minor modifications to the case of seasoned equity offerings packaged with warrants; further, the intuition behind the model generalizes readily to provide a new rationale for packaging call option-like claims with other risky securities (e.g., convertible debt, debt with warrants) as well.

Abstract:
We develop a theoretical analysis of a private firm's choice of exit mechanism between IPOs and acquisitions. We consider an entrepreneur managing a private firm backed by a venture capitalist. The entrepreneur and venture capitalist desire to exit partially from the firm, motivated either by the desire to satisfy their liquidity demands or to raise external financing for the firm (or both). A crucial factor driving a private firm's choice between IPOs and acquisitions is competition in the product market: while a stand-alone firm has to tend for itself after going public, an acquirer is able to provide considerable support to the firm in the product market, thus increasing its chances of succeeding against competitors and establishing itself in the product market. Further, unlike atomistic investors in the IPO market who are at an informational disadvantage with respect to firm insiders, potential acquirers are able to value the firm correctly by virtue of their industry expertise. On the negative side, acquirers have considerable bargaining power with respect to the entrepreneur, which allows them to extract some of the firm's net present value from insiders, unlike investors in the competitive IPO market. Finally, while the entrepreneur is able to maintain his private benefits from control even after his firm goes public, he is likely to lose these after an acquisition. In this setting, we derive a number of testable implications regarding a firm's equilibrium choice between IPOs and acquisitions. Our theoretical analysis is able to explain the “IPO valuation premium puzzle”: i.e., the empirical finding that many firms that are able to obtain higher valuations in the IPO market nevertheless choose to be acquired.

IPOs, acquisitions, venture capital, entrepreneurial finance, exit strategy, product market competition

Abstract:
Accelerated share repurchase (ASR) programs are an innovative way of repurchasing shares in which a company purchases shares of its own stock from an investment bank at a set price on a specific date; typically, the investment bank borrows the shares and is in a short position that it will cover through open-market purchases over a period of time. ASRs have become an increasingly popular means of repurchasing shares in recent times. This paper presents an empirical analysis of firms' rationale for using ASRs rather than the traditional open market repurchase (OMR) programs. Using a hand-collected sample of ASR announcements, we test five hypotheses regarding firms' rationale for using ASR programs: the distribution of excess cash hypothesis; the signaling or undervaluation hypothesis; the target leverage-ratio hypothesis; the takeover avoidance hypothesis; and the management compensation hypothesis. We find that firms undertaking ASR programs are significantly larger than those undertaking OMR programs, and that ASR programs have larger median deal values than OMR programs. Further, ASR firms have significantly smaller cash holdings, higher dividend payout ratios, higher pre-announcement leverage ratios, and similar probabilities of being takeover targets compared to OMR firms. CEOs of ASR firms have lower equity-based compensation than CEOs of OMR firms. Finally, firms undertaking ASR programs have lower pre-announcement market valuations, greater positive announcement effects, and better post-announcement operating and stock return performance, compared to those undertaking OMR programs. Overall, the results of our analyses of firms' choice between ASR and OMR programs are consistent with the predictions of the undervaluation hypothesis but inconsistent with the predictions of the distribution of excess cash, the target leverage-ratio, the takeover avoidance, and the management compensation hypotheses.

Accelerated Share Repurchase, Open Market Repurchase, Signalling

Abstract:
Several theoretical papers have argued that the valuation of equity will reflect the beliefs of the most optimistic investors and be at a premium over intrinsic value when rational investors subject to short sale constraints have heterogeneous priors. We test the above theories by analyzing the effect of IPO underwriter reputation on the heterogeneity in investor beliefs and the tightness of short sale constraints and consequently on equity valuation in IPOs. We propose a “market power” hypothesis, postulating that higher reputation underwriters are able to attract a greater number of higher quality market participants (such as institutional investors, analysts, and co-managing underwriters) to the IPOs backed by them, thereby yielding higher IPO valuations by increasing the heterogeneity in investor beliefs and the tightness of short sale constraints. We empirically distinguish between the above hypothesis and the “certification hypothesis,” which implies that higher reputation underwriters are associated with IPOs priced closer to intrinsic value. We find that equity in higher reputation underwriter backed IPOs are priced higher and further away from intrinsic value compared to lower reputation underwriter backed IPOs. We show that the above relationship between underwriter reputation and IPO valuation is driven by the greater heterogeneity in investor beliefs, tighter short sale constraints, and greater participation by institutional investors, analysts, and higher reputation co-managing underwriters that characterize higher reputation underwriter backed IPOs. Overall, our results support the market power hypothesis and reject the certification hypothesis.

Investment banks, Underwriter reputation, IPOs

Abstract:
We study the impact of product market advertising on IPO valuation and long-run post-IPO stock returns. We find that a firm going public with a greater extent of advertising in its IPO year is valued higher both in the IPO as well as in the immediate market, and experiences lower long-run post-IPO stock returns. Such an IPO firm is also characterized by a greater upward price revision from the mid-point of its filing range during its book-building period. We conjecture that the above results are due to the effect of advertising on the heterogeneity in IPO market investor beliefs about the prospects of the firm going public: advertising may make retail investor investors more optimistic about the firm (leaving institutional investors unaffected), thus increasing the heterogeneity in beliefs among investors as a whole. This, in turn, increases both IPO valuation and immediate aftermarket valuation, and lowers long-run stock returns. We test this "heterogeneous beliefs hypothesis" using the dispersion in analysts' earnings forecasts and the stock turnover in the IPO aftermarket as proxies for the degree of heterogeneity in investor beliefs. We document three important findings consistent with the heterogeneous beliefs hypothesis. First, product market advertising increases both analyst forecast dispersion about the firm going public and stock turnover in the IPO aftermarket. Second, a greater extent of product market advertising is associated with a smaller fraction of equity holdings in the IPO firm's stock by institutional investors. Third, the higher IPO valuation and long run post-IPO stock returns induced by product market advertising are related to the higher analyst forecast dispersion, the higher stock turnover, and the lower institutional investor holdings experienced by the IPO firm.

IPO, Advertising, IPO Long Run Return, IPO Valuation

Abstract:
We develop a theory of the management of innovation and equity carve-outs under heterogeneous beliefs among investors in the equity market. We consider a setting where an employee of a firm generates an idea for a new project (“innovation”) which can be financed either by issuing equity against the future cash flows of the entire firm, i.e., both assets in place and the new project (“integration”), or by undertaking an equity carve-out of the new project (“non-integration”). The patent underlying the new project is owned by the firm. However, the employee generating the idea needs to be motivated to exert optimal effort for the project to be successful. The most important ingredient driving the firm's choice between integration and non-integration is heterogeneity in beliefs among outside investors (each of whom has limited wealth to invest in the equity market) and between firm insiders and outsiders. If outsider beliefs are such that the marginal outsider financing the innovation is more optimistic about the prospects of the new project than firm insiders, and this incremental optimism of the marginal outsider over firm insiders is greater regarding the new project than about the firm’s assets in place, then the firm will implement the project under non-integration rather than integration. Two other ingredients driving the choice between integration and non-integration are the cost of motivating the employee to exert optimal effort for project implementation, and the synergy between the new project and the firm's assets in place, which is eliminated under non-integration. We derive a number of testable predictions regarding a firm's equilibrium choice between integration and non-integration. We also provide a rationale for the “negative stub values” documented in the equity carve-outs of certain firms (e.g., the carve-out of Palm from 3Com) and develop predictions for the magnitude of these stub values.

heterogeneous beliefs, management of innovation, equity carve-outs

Abstract:
We develop a theory of the management of innovation and equity carve-outs under heterogeneous beliefs among investors in the equity market. We consider a setting where an employee of a firm generates an idea for a new project (“innovation”) which can be financed either by issuing equity against the future cash flows of the entire firm, i.e., both assets in place and the new project (“integration”), or by undertaking an equity carve-out of the new project (“non-integration”). The patent underlying the new project is owned by the firm. However, the employee generating the idea needs to be motivated to exert optimal effort for the project to be successful. The most important ingredient driving the firm's choice between integration and non-integration is heterogeneity in beliefs among outside investors (each of whom has limited wealth to invest in the equity market) and between firm insiders and outsiders. If outsider beliefs are such that the marginal outsider financing the innovation is more optimistic about the prospects of the new project than firm insiders, and this incremental optimism of the marginal outsider over firm insiders is greater regarding the new project than about the firm’s assets in place, then the firm will implement the project under non-integration rather than integration. Two other ingredients driving the choice between integration and non-integration are the cost of motivating the employee to exert optimal effort for project implementation, and the synergy between the new project and the firm's assets in place, which is eliminated under non-integration. We derive a number of testable predictions regarding a firm's equilibrium choice between integration and non-integration. We also provide a rationale for the “negative stub values” documented in the equity carve-outs of certain firms (e.g., the carve-out of Palm from 3Com) and develop predictions for the magnitude of these stub values.

heterogeneous beliefs, management of innovation, equity carve-outs

Abstract:
We develop measures of the management quality of firms and make use of a unique sample of hand-collected data to examine the relationship between the reputation and quality of a firm's management and its financial policies, a relationship that has so far received little attention in the literature. We hypothesize that better and more reputable managers are able to convey the intrinsic value of their firm more credibly to outsiders, thus reducing the information asymmetry facing their firm in the equity market. Given this, firms with better and more reputable managements will have more access to the equity market, so that we expect lower leverage ratios for these firms. In addition, they will have less need to signal using dividends, so that they will have lower dividend payout ratios. Further, since better managers are likely to select better projects (having a larger NPV for any given scale) and implement them more ably, higher management quality will also be associated with higher levels of investment and R&D expenditures. We present evidence consistent with the above hypotheses. Our direct tests of the relationship between management quality and asymmetric information also indicate that higher management quality leads to a reduction in the extent of information asymmetry facing a firm in the equity market.

Management Quality, Capital Structure, Dividend Policy, Investment Policy, Asymmetric Information

Abstract:
Tradeoff theory points to the direct bankruptcy costs as the main reason for the low leverage; however, the empirical evidence does not justify the direct bankruptcy costs as a sufficient disincentive to issue debt. Berk, Stanton, and Zechner (2007) propose that human capital costs in financial distress and bankruptcy are large enough to be a disincentive to issue debt. The purpose of this paper is to empirically test the impact of leverage on labor costs. We find that the leverage ratio has a significant and positive impact on average employee pay. We numerically demonstrate that the additional total labor expenses associated with an increase in leverage is large enough to offset the incremental tax benefits of debt. We also find that leverage has a significantly positive impact on CEO compensation. In the pooled cross-section regression, firms with higher leverage pay their CEO more. To eliminate the endogeneity problem, we study the relationship between the compensation of the newly appointed CEOs who are hired from outside and the firm leverage in the year before their appointment. The leverage has significantly impacts on all three measures of the compensation of the new CEOs. An increase of one standard deviation in leverage corresponds to more than 16% of increase in CEO compensation. The positive impact of leverage on average employee pay is greater in old economy firms than new economy firms. The impact of leverage on CEO cash compensation is significant in both old and new economy firms. Overall, our analysis provides empirical support for the role of human capital costs in limiting the use of debt, consistent with the theory advanced by Berk, Stanton, and Zechner (2007).

Capital structure, labor costs, CEO compensation