Institutional Trading, Information Production, and the SEO Discount: a Model of Seasoned Equity Offerings

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.

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

JEL Classification: G32, G24, G14