CREDIT RATINGS AND THE COST OF ISSUING SEASONED EQUITY

• DOI: http://doi.org/10.1111/jfir.12171
• Date: 01 July 2019
• Author: Garrett A. McBrayer
• Published date: 01 July 2019

CREDIT RATINGS AND THE COST OF ISSUING SEASONED EQUITY

Garrett A. McBrayer

Boise State University

Abstract

I examine the effects of issuer credit ratings on the costs associated with seasoned equity

offerings (SEOs). The evidence from a panel of SEOs from 1990 to 2014 shows that

when firms issue seasoned equity, those with issuer credit ratings pay reduced

investment banking fees. I confirm these results by conducting a propensity-score

matched-sample comparison analysis of firms that obtain new, long-term issuer credit

ratings with an unrated control group. Controlling for known determinants of SEO fees, I

find that firms that obtain a new credit rating before issuing seasoned equity pay

significantly reduced investment banking fees. In economic terms, underwriting fees for

newly rated firms are 7.2% lower than those for similar, yet unrated firms. Finally, I

examine the indirect costs of issuance and find evidence that credit-rated firms face

reduced market-based costs to issue. Rated firms incur lower dilutionary costs to issue

and have more positive abnormal returns surrounding the issue.

JEL Classification: D82, G14, G24

I. Introduction

Information asymmetries pertaining to the valuation of a firm’s assets have direct effects

on the risks inherent in investing in the firm’sfinancial claims. In secondary equity

markets, the adverse selection costs associated with an investment in a firm’s equity are a

positive function of information asymmetry (e.g., Benston and Hagerman 1974; Kyle

1985; Glosten and Harris 1988; Stoll 1989; Lin, Sanger, and Booth 1995; Huang and

Stoll 1997). Investors account for potential losses when trading with an information-

motivated trader. In primary markets, the observed underpricing of initial public

offerings (IPOs) has been attributed, in part, to information asymmetry. Rock (1986)

argues that the observed underpricing results from a winner’s curse problem where

information heterogeneity induces informed investors to bid on only the best IPOs,

leaving less informed investors with only overpriced issues. Habib and Ljungqvist

(2001) show that issuing firms take costly action to reduce information asymmetry before

IPO issuance. The authors suggest that issuing firms may, for example, hire more

reputable, and thus more expensive, underwriters for their certification ability.

Mechanisms that mitigate the adverse selection costs of equity issuance improve the

I am grateful for the invaluable comments and suggestions from Wayne Lee, Alexey Malakhov, Tim Yeager,

and Pu Liu, as well as from seminar participants at the 2018 Financial Management Association annual meetings,

the University of Arkansas, and Boise State University. All errors remain my own.

The Journal of Financial Research Vol. 0, No. 0 Pages 1–28 2019

DOI: 10.1111/jfir.12171

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© 2019 The Southern Finance Association and the Southwestern Finance Association

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efficiency of primary equity markets. In this article, I explore one such mechanism: the

presence of an issuer credit rating.

Credit rating agencies play critical roles in alleviating the information

asymmetries that exist between borrowers and lenders and in apportioning risks in

financial markets. In debt markets, firms that obtain credit ratings from S&P and/or

Moody’s have increased leverage (Faulkender and Petersen 2006), are able to raise more

funds in syndicated debt financing (Sufi2009), and suffer less from underinvestment due

to capital constraints (Harford and Uysal 2014). What is it, then, that makes credit ratings

a mechanism for a reduction in information asymmetry? Boot, Milbourn, and Schmeits

(2006) argue that credit ratings serve as a coordinating mechanism. The threat of adverse

rating changes motivates firms to take corrective actions. Thus, in the Boot, Milbourn,

and Schmeits model, this threat leads to homogeneity in investor beliefs.

The literature on the role of credit ratings in debt markets is well developed. An

and Chan (2008) find that credit-rated firms exhibit reduced underpricing at IPO issuance

relative to unrated issuers. When they examine credit rating levels (i.e., the rating

obtained by the firm), they do not find an association between the level obtained and IPO

underpricing. An and Chan conclude that the credit rating itself conveys useful

information for reducing the value uncertainty of IPO issuing firms to financial markets.

The authors’findings warrant at least two follow-up questions. First, does the value

certification of credit ratings extend to seasoned equity offerings (SEOs) as well as IPOs?

Or, stated differently, given that SEO-issuing firms are “known”to financial markets,

does the value certification benefit to being credit rated still exist? Second, does An and

Chan’s result extend to “sophisticated”market participants? Do the underwriters of

SEOs, that is, investment banks, recognize the value certification benefits of being credit

rated and reward credit-rated firms with lower investment banking fees?

In this article, I examine the SEO costs incurred by credit-rated firms relative to

their unrated contemporaries. Using a panel of U.S. common share SEOs from 1990 to

2014, I document that the fees paid by credit-rated firms are significantly reduced relative

to those paid by unrated firms. Having a credit rating when issuing an SEO leads to a

reduction in the fees charged by the underwriting investment bank, consistent with the

notion that the credit rating enhances the value certainty of the issuing firm. One concern

when examining the effects of credit ratings on SEO underwriting fees is the potential

endogeneity problem noted in An and Chan (2008). The decision to become credit rated

and the decision to issue seasoned equity may be endogenous to each other when firm

characteristics that affect SEO behavior also affect the decision to be rated.

To alleviate the endogeneity concern, I employ three empirical approaches.

First, I employ a Heckman two-stage model where the decision to become rated is

modeled in the first stage and an inverse Mills ratio is included in the second stage to

control for in-sample bias. A reduction in fees is evident after accounting for the potential

bias resulting from the first-stage decision to become rated. Second, I examine how the

association between credit ratings and fees changes across two levels of credit quality:

investment grade versus speculative grade. I find that both levels of credit quality exhibit

reduced SEOs fees but that the benefits are most pronounced for investment-grade firms.

This result is consistent with He, Wang, and Wei (2010), who find that information

asymmetry increases as credit ratings decreases, leading to a reduction in value certainty.

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