Credibility and Multiple SEOs: What Happens When Firms Return to the Capital Market?

• DOI: http://doi.org/10.1111/fima.12099
• Published date: 01 August 2016
• Author: Jing Zhao,Mark D. Walker,Keven Yost
• Date: 01 August 2016

Credibility and Multiple SEOs: What

Happens When Firms Return to the

Capital Market?

Mark D. Walker, Keven Yost, and Jing Zhao∗

Using a sample of firms that conducted multiple seasoned equity offerings (SEOs) from 1995 to

2012, we examine whether firms can build credibility for subsequent SEOs by following through

on their stated use of the proceeds fromearlier SEOs. We find that firms that state their intention to

invest these funds in projectsand those that make no such statements, but do invest have relatively

more positive announcement returnsaround subsequent SEO announcements. Our results suggest

that the markets areaware of the potential agency costs of equity, have a long memory, and update

their beliefs as to the likely use of funds raised by firms.

Issuing seasoned equity is costly. In addition to floatation costs, there are potential costs

associated with asymmetric information and potential agency costs associated with a large inflow

of free cash flow to managers. Prior studies have found the market reaction to seasoned equity

offering (SEO) announcements to be approximately –2% to –4%. Previous studies have offered

various explanations for the observed decline. One line of thought is that an equity issue updates

(negatively) the market’s view of the value of the firm. Another view posits that newly raised

capital might be used for agency spending. However, SEOs are heterogeneous and firms do not all

issue for the same reason nor does the market react the same to each. Weexamine the connection

between the firm’s ex ante declarations and ex post performance from one SEO and the market’s

response to a subsequent announcement of an SEO.

DeAngelo, DeAngelo, and Stulz (2010, p. 294) get to the heart of the matter in discussing their

results:

“One possibility is that investor rationality forces managers to disguise (hence limit) attempts to

sell overvalued shares. For example, managers’ blatantly obvious and/or repeated attempts to

sell overvalued equity tend to self-destruct because investors who perceive the ploy immediately

reduce the price they are willing to pay for that firm’s securities.”

The same intuition that DeAngelo, DeAngelo, and Stulz (2010) discuss for a manager’s repeated

attempts to time the market can be applied to a manager’s repeated use of proceeds for agency

spending or, less strictly, using proceeds on projects that are less valuable than initially claimed.

We thank Marc Lipson (Editor), an anonymous referee, Don Autore, Murray Carlson, David Denis, Diane Denis,

Aimee Hoffmann, Charles Knoeber, Fanis Tsoulouhas, and seminar participants at North CarolinaState University, the

2011 Northern Finance Association meetings, the 2012 Eastern Finance Association meetings, and the 2012 Financial

Management Association meetings for helpful comments.

∗Mark D.Walker is an Associate Professorin the Department of Business Management at North Carolina State University

in Raleigh, NC. Keven Yostis an Associate Professor in the Department of Finance at Auburn University in Auburn, AL.

Jing Zhao is an Assistant Professor in the Department of Business Management at North Carolina State University in

Raleigh, NC.

Financial Management •Fall 2016 •pages 675 – 703

676 Financial Management rFall 2016

DeAngelo, DeAngelo, and Stulz (2010) imply that the firm should bear a cost in lost credibility

in the market for equity capital for trying to garner a short term benef it.

There are at least two advantages to using SEOs to study the impact of credibility. First, SEOs

are economically significant. The average book value of assets for our returning SEO firms is

$544 million and the average issue amount is $113 million. The magnitude of a typical SEO

suggests that any value impact of credibility when firms return to the equity market for an

SEO is likely to be economically important. Second, issuing seasoned equity potentiallyinvolves

substantial asymmetric information. As Fama and French(2005) point out, f irms may issue equity

in a variety of ways (e.g., convertible debt, warrants, rights issues, employee options, employee

grants, and employee benefit plans). The equity issued via these alternative methods is likely

more frequent and smaller in magnitude with less asymmetric information. Thus, the economic

magnitude and relevance of credibility should be smaller.SEOs provide an interesting laboratory

to examine firms’ credibility with the capital markets due to the relative amount of capital raised

and extent of asymmetric information.

In order to better understand how firms might build (or destroy) credibility, we first examine

what the firm tells the market regarding the expected use of funds. We categorize SEOs by their

stated use of funds from their Securities and Exchange Commission (SEC) S-filings prior to the

issue. SEOs are categorized as an INVEST SEO if the primary reason is investment, a DEBT SEO

if the primary reason is debt repayment, or a GENERAL SEO if the primary reason is vaguely

stated as for general corporate purposes. We confine our sample to those firms with multiple

SEOs allowing us to investigate the connection from one SEO to the next.

Firms are not required to provide specifics regarding the use of funds, yet many do so. One

reason for providing specifics might be to create a bonding mechanism with investors. If so, we

expect that firms returning to the market after an INVEST SEO will be rewarded for having built

credibility. In contrast, if the statements are not meaningful or are used to deceive the market

regarding the quality of the firm’s growth prospects, then we do not expect any relation between

the prior stated use and subsequent SEOs. We find that the announcement return associated with

an SEO is relatively greater when the SEO is preceded by an INVEST SEO. This suggests that

firms that state their intention to invest the proceeds of an SEO build credibility with the market,

allaying possible agency concerns.

Our next proxies for achieving higher credibility are the size of the firm’s investment program

in the year following an SEO relative to the issue size (deployment of capital) and the abnormal

returns for the firm’s stock over the year following the SEO (quality of investment). These

measures are useful to the extent that the market was uncertain as to whether the firm actually had

valuable projects availableand these measures indicate a benef icial use of the funds. We find that

these signals are most valuable for firms that do not provide specifics regarding the use of funds

in the previous SEO. Firms with a previous GENERAL SEO have a positive relation between the

abnormal announcement returns for the follow-on issue and both the deployment of capital and

the quality of investment. These findings do not hold for firms with a previous INVEST SEO.

In aggregate, our evidence suggests that market participants update their beliefs as to the

probability that a firm makes benef icial use of proceeds of an SEO. Firms can build credibility

through their statements to the market regarding the specifics for their use of funds. For firms that

do not want to divulge specifics about the intended use of funds, possibly for strategic reasons,

they can build credibility in the equity market by using the funds wisely, which is observed and

valued ex post.

Hovakimian and Hutton’s (2010) finding that firms that had strong performance following an

SEO are more likely to return to the market has implications for our sample. Firms with INVEST

SEOs that do not return to the market (“dogs that don’t bark”) are likely to be those firms that