360 B.E. Eckbo et al.
of the proceeds of the typical SEO. If one views this dilution effect as an issue cost
(which is arguably the case), then it swamps even relatively high firm commitment
underwriting costs. Differential average market reactions across issues and issuer types
are also important. The market reaction is less negative for regulated utilities, for smaller
issues, for less risky securities such as debt, for issue methods that involve preemptive
rights, for shelf offerings, and for private placements (which tend to elicit a positive
market reaction).
These empirical regularities are broadly consistent with the predictions of separating
equilibria reflecting adverse selection in issue markets. For SEOs internationally, where
the equity flotation method typically involves preemptive rights, the empirical evidence
is also largely consistent with theories of adverse selection. Samples of foreign issues
are interesting both because they allow a study of rights (which have largely disappeared
in the U.S.), and because they provide greater variation in institutional and ownership
characteristics of issuing firms. We expect future studies of foreign security issues to
contribute substantially towards our understanding of the economics of the issuance
process.
The survey ends with a review of the empirical literature on post-issue stock returns—
so-called “long-run” performance studies—and we complement this literature with our
own performance estimates. The key theoretical question in this literature is whether
firms are able to exploit their private information at the expense of outside investors.
In the vernacular ofLoughran and Ritter (1995), are firms able to time their equity
issues to temporary “windows of opportunity”, when it is possible to sell overpriced
equity to new investors? Do investors who purchase and hold the new shares through the
subsequent price correction period realize a negative risk-adjusted (abnormal) holding-
period stock return?
The literature is in substantial agreement that the average realized two-to-five-year
holding period (raw) returns following equity issues is significantly lower than the
average return realized by non-issuing firms matched to have similar size and book-
to-market value. We show that this result also holds for security issues beyond SEOs
and IPOs, such as private equity issues, and issues of straight and convertible debt. The
extant evidence that issuers underperform non-issuing matched firms appears convinc-
ing. The controversy starts when one interprets this underperformance as a measure of
abnormal returns to issuers. In the jargon of asset pricing theory, the difference between
the return to issuers and non-issuing matched firms is a measure of abnormal (or un-
expected) returns, only if the two types of firms have identical exposures to priced risk
factors. A number of studies have shown that the assumption of equal risk exposures is
unlikely to hold.
Recent research also indicates that security issuers often exercise large real invest-
ment options around the same time. Theory predicts that converting investment options
to assets in place should cause risk profiles—and therefore issuers’ expected returns—to
fall. This has the effect of making their initial “matching firms” too risky in the port-
issue period. This mismatch causes the benchmark expected returns of the “matching”
firms to be too high and thus, the long term performance of issuers is biased downward.