a comparison of the motivations for and the information ... jb.pdf · alternative types of equity...

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(Journal of Business, 2004, vol. 77, no. 3)� 2004 by The University of Chicago. All rights reserved.0021-9398/2004/7703-0008$10.00

Randall A. HeronIndiana University

Erik LieCollege of William and Mary

A Comparison of the Motivations forand the Information Content ofDifferent Types of Equity Offerings*

I. Introduction

In the absence of information asymmetries and taxes,Modigliani and Miller (1958) show that the mannerin which firms finance their investments is irrelevant.However, they further note that, when managers be-lieve that the capital market undervalues the firm’sequity, the optimal financing choice is to issue risk-free debt or use a pre-emptive stock issue. Expandingon the notion of information asymmetry, Myers andMajluf (1984) develop an adverse selection model thatassumes that managers are more informed about thefirm’s prospects than potential investors. Investors,recognizing their informational disadvantage, interpretequity issues as a signal that the firm is overvalued.Thus, firms only issue stock when they have exhaustedtheir internal funds and debt sources and/or when man-agers indeed believe that the stock is overvalued.

In support of Myers and Majluf’s model, Asquithand Mullins (1986), Masulis and Korwar (1986), andMikkelson and Partch (1986) document negative mar-ket reactions to the announcements of equity offerings.

* We thank an anonymous referee, Oya Altinkilic, DonghangZhang, and seminar participants at the College of William andMary, Indiana University—Indianapolis, Louisiana State Univer-sity, and Virginia Tech for helpful suggestions. Contact the cor-responding author, Erik Lie, at [email protected].

We examine the choiceof equity offering typeand the accompanying in-formation content using asample of 4,708 equityofferings announced be-tween 1980 and 1998.We find evidence that an-nouncements of regularequity offerings involvingprimary shares conveyunfavorable informationabout future operatingperformance, while an-nouncements of regularofferings of secondaryshares and shelf registra-tions, if anything, conveyfavorable information.Further analysis suggeststhat firms sell equity inregular offerings to takeadvantage of temporarilyhigh equity values, whilefirms sell equity in rightsofferings or file shelf reg-istrations when their mar-ket value is low and theirfinancial situation tight.

606 Journal of Business

Moreover, Rangan (1998) and Teoh, Welch, and Wong (1998) find evidenceof upward earnings management preceding equity offering announcements,suggesting that managers attempt to maximize the extent of the firm’s over-valuation prior to equity issues. Subsequent to the equity offerings, Brous(1992) finds downward revisions of earnings forecasts, and Hansen andCrutchley (1990) and Loughran and Ritter (1997) show that earnings decline.

The model of Myers and Majluf (1984) focuses on what we refer to asregular offerings of primary shares, instead of rights offerings, shelf-registra-tions, or offerings of secondary shares. As a theoretical extension, Heinkeland Schwartz (1986) and Eckbo and Masulis (1992) model the choice betweenequity issues via rights offerings and regular offerings. Both models rely uponinformation asymmetry, and, consistent with the argument of Modigliani andMiller (1958), predict that managers who believe that their firm’s equity isundervalued prefer rights offerings to prevent wealth transfers from the firm’sexisting shareholders.

Although we are unaware of any theoretical models that make direct pre-dictions regarding the use of shelf registrations and offerings of secondaryshares, there are compelling reasons to believe that they convey less unfa-vorable information than regular offerings of primary shares. For instance, ifa firm’s managers believe that the firm’s equity is currently overvalued butthat the overvaluation might be temporary, they prefer to issue shares im-mediately in a primary offering instead of shelving the issue. If, on the con-trary, the managers believe that the equity is undervalued, they are inclinedto shun a regular primary issue because it would transfer wealth away fromexisting shareholders. Unlike primary issues, issues of purely secondary sharesdo not raise additional external equity capital. Thus, they do not fall underthe adverse selection framework of Myers and Majluf (1984), where managersraise external equity when they believe the firm is overvalued. We thereforeexpect any information effect to be less pronounced for secondary sharesissues.

Like announcements of regular equity offerings of primary shares, an-nouncements of other types of equity offerings are associated with a negativestock price reaction (see Mikkelson and Partch [1985] and Asquith and Mullins[1986] for secondary shares; Bhagat, Marr, and Thompson [1985], Moore,Peterson, and Peterson [1986], Hansen [1989], and Denis [1991] for shelfregistrations; and Hansen [1989], Eckbo and Masulis [1992], and Singh [1997]for rights offerings). However, we are unaware of any empirical research thatcontrasts the patterns of earnings management and operating performancesurrounding regular equity offerings with those for rights offerings, shelfregistrations, and offerings of secondary shares. The incentives for managersto manipulate earnings are presumably weaker, or perhaps nonexistent, if thefirm is not raising equity from new shareholders. Further, our discussion abovesuggests that rights offerings, shelf registrations, and offerings of secondaryshares convey less unfavorable information than regular primary offerings.

Equity Offerings 607

These effects should be apparent in the patterns of earnings accruals andoperating performance.

This study improves our understanding of the information conveyed by thealternative types of equity offerings using an all-inclusive sample of 4,708equity offerings announced between 1980 and 1998. We find that any upwardearnings management before or around equity offering announcements is lim-ited to offerings of primary shares and combinations of primary and secondaryshares. There is no evidence of upward earnings management around rightsofferings and shelf registrations. Consistent with Hansen and Crutchley (1990)and Loughran and Ritter (1997), we document operating performance declinesfollowing offering announcements of primary shares and combinations ofprimary and secondary shares. In contrast, we find no evidence that operatingperformance decreases following announcements of offerings of secondaryshares. Further, operating performance increases after shelf registrations an-nouncements, while there is no significant change in operating performanceafter rights offerings announcements. In a multivariate setting, the changes inoperating performance around equity offerings are inversely related to thefraction of primary shares, and they tend to be more positive for shelfregistrations.

The results of our tests of earnings management and operating performanceshow that the motivations differ across the types of equity offerings. Firmsthat announce regular offerings of primary shares appear to time their offeringsto take advantage of temporarily high earnings that presumably have inflatedthe stock prices. This does not appear to be the case for other types of equityofferings. An examination of the time series of asset market-to-book values(M/B) supports this conjecture further. Firms that offer primary shares in aregular offering experience dramatic increases in M/B before their offeringannouncements and sharp drops in M/B afterward. This pattern is more modestfor other types of offerings, and in the case of rights offerings, the pattern isactually reversed.

We further show that firms that use rights offerings and shelf registrationsface tight financial situations, as their leverage is high and their cash level islow relative to their industry peers. The evidence therefore suggests that thesefirms do not have enough financial slack to issue debt and that the market’scurrent valuation of the firm’s shares is such that a regular equity offeringwould transfer too much wealth away from existing shareholders. Overall,our results are consistent with the notion that corporate managers act in thebest interests of the firm’s existing shareholders and that they are less likelyto opportunistically time the announcements of shelf registrations and rightsofferings than the announcements of regular equity offerings.

This article proceeds as follows. Section II reviews the related literature.Section III discusses the sample selection and provides selected sample sta-tistics. Section IV presents our empirical tests, and Section V summarizes andconcludes the article.


II. Related Literature

A. Regular Equity Offerings

Asquith and Mullins (1986), Masulis and Korwar (1986), and Mikkelson andPartch (1986) document that announcement returns for equity offerings av-erage roughly from �2% to �3%. One explanation for the negative returnsis that the announcements convey unfavorable information about future earn-ings. Several studies examine this conjecture more closely. Healy and Palepu(1990) and Hansen and Crutchley (1990) examine changes in earnings fol-lowing offering announcements. While Hansen and Crutchley find a systematicdecrease in earnings, Healy and Palepu (1990) do not. Brous (1992) finds thatearnings forecasts tend to increase before and then decrease after equity of-fering announcements, and Jain (1992) finds a positive relation between an-nouncement returns and revisions in earnings forecasts after offeringannouncements.

Loughran and Ritter (1997) update the literature on earnings around equityofferings using a substantially larger sample, and in doing so, report thatoperating performance peaks at the time of the offer. Further, Teoh et al.(1998) and Rangan (1998) provide evidence that issuing firms manage earn-ings upward prior to the offerings, perhaps in an attempt to temporarily booststock prices. Thus, the deterioration of earnings following offering announce-ments appears to be at least partially attributable to an inevitable reversal ofefforts to manipulate earnings upward in the short run.

Additional theories to explain the negative announcement returns to equityofferings have also been advanced and tested in the financial literature. Forexample, drawing from the adverse selection model of Myers and Majluf(1984), Denis (1994) and Jung, Kim, and Stulz (1996) examine the relationbetween growth opportunities and announcement returns. While Denis con-cludes that various measures of growth opportunities do not appear to explainthe cross-sectional distribution of announcement returns, Jung et al. find apositive relation between growth opportunities (as measured by the market-to-book ratio) and announcement returns.

Finally, a number of recent studies examine long-term stock returns sub-sequent to equity offerings. Loughran and Ritter (1995), Spiess and Affleck-Graves (1995), and Brav, Geczy, and Gompers (2000) find that the stocks ofissuing firms underperform various benchmarks during the years followingthe issues. However, Eckbo, Masulis, and Norli (2000) argue that these resultsmay reflect a failure to properly control for risk. Because of the uncertaintyassociated with properly identifying benchmarks for long-term stock returns(see, e.g., Fama [1998]), we do not pursue such an analysis here.

B. Secondary Offerings

Among the few studies that investigate secondary offerings, Mikkelson andPartch (1985) document negative announcement returns for all types of sellers,


although the returns are somewhat more negative if the seller is an officer ora director. Lee (1997) examines long-term stock returns separately for primaryissues (defined as issues with at least 50% primary shares) and secondaryissues (issues with less than 50% primary shares), and he also relates thesereturns to insider trading behavior. He finds that primary issuers underperformtheir benchmarks in the long term, regardless of prior insider trading patterns.In contrast, secondary issuers do not underperform on average, although thosewith prior insider selling do. Lee interprets the differential results betweenprimary and secondary issues to imply that “an increase in free cash flowproblems plays an important role in explaining the underperformance ofSEOs” (p. 1464). Thus, unless insiders were liquidating their positions in openmarket transactions leading up to the offering, secondary offers do not appearto convey the same negative information content as regular offerings of pri-mary shares, even though insiders frequently sell shares in secondary issues.

C. Rights Offerings

Most studies of rights offerings attempt to resolve what is referred to as “therights offer paradox.” Specifically, why are rights offerings used so infre-quently in the United States when they provide lower direct flotation coststhan other equity offerings? Smith (1977) attributes the paradox to agencyproblems between managers and shareholders that arise because managersderive personal benefits from using underwriters. Hansen and Pinkerton (1982)contend that, due to high merchandising costs, rights offerings are cheaperonly for firms with concentrated ownership. Hansen (1989) argues that thereare transaction costs of selling rights in the secondary markets that are notaccounted for in direct flotation costs.

Heinkel and Schwartz (1986) and Eckbo and Masulis (1992) model theequity offer choice between regular offerings and rights offerings. Both modelscapture the notion that managers who know their firm is undervalued shouldchoose rights offerings rather than regular offerings to outsiders to preventwealth transfers from the firm’s existing shareholders when the firm’s truevalue is ultimately revealed. Eckbo and Masulis’s model suggests that expectedshareholder take-up is an important determinant of the rights offering choice.According to their model, the lower the proportion of expected shareholdertake-up, the greater the adverse selection problem, reducing the likelihoodthat managers will choose a rights offering. Consistent with their model’spredictions, they report that take-up rates for rights offerings in the UnitedStates are close to 100%. They also report that the abnormal returns for insuredrights offerings are not as unfavorable as those for firm commitment offerings.Bohren, Eckbo, and Michalsen (1997) and Singh (1997) also report evidenceconsistent with Eckbo and Masulis’s prediction that high shareholder take-upis an important determinant of the rights offering decision.


D. Shelf Registrations

Bhagat et al. (1985) examine the issuing costs of shelf registrations and doc-ument that issuing costs of securities sold via shelf registrations are lowerthan those sold via regular offerings. However, a couple of studies point outpotential disadvantages of shelf registrations. Blackwell, Marr, and Spivey(1990) suggest that shelf registrations reduce the ability of underwriters toperform due diligence, thereby making underwriters more vulnerable to lit-igation or loss of reputation. Their empirical results suggest that underwritersdemand greater compensation for shelf issues because of this potential risk.Denis (1991) argues that shelf registrations lack underwriter certification. Insupport of his argument, firms that use shelf registrations are larger and arecharacterized by less uncertainty, suggesting less need for certification. Denisfurther examines announcement returns for a small set of firms that issuedshares using both shelf and nonshelf registration and finds that they are slightlylower for shelf registrations. He suggests that these results may explain thedeclining incidence of shelf registrations during the 1980s (although they couldnot explain the rebound of shelf registrations in the 1990s documented in thisstudy).

III. Sample and Descriptive Statistics

We examine seasoned equity offerings announced between 1980 and 1998.The source of our sample is the Securities Data Company’s (SDC) equityissue database. We exclude all financial companies and utilities from oursample. Further, because our tests rely on financial data, we require the offeringfirms to be covered on both the Center for Research in Security Prices (CRSP)and Compustat. The final sample consists of 4,708 seasoned equity offeringsmade by 3,175 different firms.

Table 1 displays the yearly distribution of equity offering announcements.Of the 4,708 offerings in the sample, 43.3% are primary offerings, 34.4% aremixed offerings, 15.7% are secondary offerings, 1.2% are rights offerings,and 5.4% are shelf registrations. All types of offerings experienced a drop-off during the period 1984–90 and then a subsequent increase. For example,although there are no rights offerings or shelf registrations in our sampleduring the period 1988–90, both types of offerings recovered in the 1990s.

We also examine the sample distribution by industry classification, but wedo not tabulate this for parsimony. There is no strong industry clustering, andthe industry distribution is fairly similar across the equity offering types. Thegreatest differences across the offering types relate to business services andchemical products. In particular, 13.4% of the firms that announce mixedofferings are in business services, and this fraction is more than twice as largeas the corresponding fraction for any other offering type. Further, 13.2% ofthe firms that announce primary offerings are in chemical products, which isalmost twice as large a percentage as that for any other offering type. Overall,


TABLE 1 Sample Distribution

YearPrimary

OfferingsMixed

OfferingsSecondaryOfferings

RightsOfferings

ShelfRegistrations

1980 115 48 14 2 01981 102 48 30 0 01982 86 52 91 4 151983 203 159 96 1 761984 58 17 44 1 01985 81 74 32 0 01986 96 82 39 2 01987 99 47 18 2 11988 37 24 12 0 01989 62 52 13 0 01990 61 33 13 0 01991 170 102 27 6 71992 135 77 31 2 41993 166 131 56 8 151994 79 85 38 12 131995 149 157 45 1 181996 174 176 50 10 151997 109 165 47 2 451998 56 91 42 3 47

Total 2,038 1,620 738 56 256

Note.—The table displays the distribution of the final sample of 4,708 equity offerings announced between1980 and 1998 by year of announcement.

any differences in subsequent results across the offering types are unlikely tobe solely attributable to differences in industry groupings.

Table 2 presents selected descriptive statistics categorized according to of-fering type. Firms with shares that are sold in secondary offerings and firmsthat employ shelf registrations tend to be the largest in terms of the bookvalue of assets and the market value of equity, and they also tend to have thelowest market-to-book ratios. Rights offerings typically involve proportionallymore shares than do the other offering types. In particular, the mean (median)number of shares in a rights offering scaled by the total number of outstandingshares is 81.9% (35.2%), while for other types of offerings, neither the meannor the median exceeds 30%.1

For each sample firm, we calculate the stock performance during the prioryear (stock runup), the performance of the value-weighted index during theprior year (market runup), and the performance of an industry index duringthe prior year (industry runup). The industry index is similar to the benchmarkthat Lee (1997) uses for long-term post-event returns. In particular, for eachsample firm, we identify all firms with the same three-digit SIC code andwith available stock return data. (We relax this to two digits if less than fivefirms are identified.) Of these firms, we compose the industry index of thefive firms with the market capitalization closest to the sample firm. The in-

1. A few outliers influence heavily the mean offering size for rights offerings. In particular,three observations exceed 200% (300%, 623%, and 1,000%). Of 56 rights offerings, 27 (48%)have an offering size of 50% or more.


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dustry index return is estimated as the average return of the five firms in theindex. Thus, the industry index should capture both size and industry-wideeffects, and the difference between the returns on the stock of a sample firmand the corresponding industry index should primarily capture firm-specificeffects.

In table 2, we provide means and medians for the market runup, the dif-ference between the industry runup and the market runup (which capturesindustry-specific effects), and the difference between the stock runup and theindustry runup (which captures firm-specific effects). The mean market runupis highest for firms that announce shelf registrations (30.4%) and lowest forfirms that announce rights offerings (17.7%). Further, the mean industry-specific return is 7.5% for rights offering firms and 17%–24% for the otherfirm classifications. Perhaps most important, the firm-specific effect is morepositive for firms that issue primary shares than for firms that issue secondaryshares (mean difference between the stock and industry runups is 47.0%,71.8%, and 20.0% for firms that announce, respectively, primary, mixed, andsecondary offerings), and it is lower for firms that announce rights offerings(mean is �4.7%) and shelf registrations (mean is 28.4%) than for firms thatannounce regular offerings. Thus, firms that announce regular offerings appearmore likely to take advantage of a recent runup in the stock price than firmsthat announce rights offerings and shelf registrations.

We employ a conventional event-study methodology to compute the ab-normal stock returns presented in table 2. The market model is estimated overthe 250 trading days ending 10 days before the announcement and uses theCRSP daily equally-weighted index as the market index. The announcementperiod return is defined as the cumulative abnormal return over the 3-dayannouncement period from the day before through the day after the an-nouncement date. The mean and median announcement period returns arenegative for all equity offering types, and, with the exception of those forrights offerings, all are statistically different from zero at the 0.01 level. Themean and median are both between �1% and �2% for rights offerings andshelf registrations and between �2% and �3% for other offering types. Incomparison, past studies document 2-day mean announcement period returnsof between �1.1% and �2.6% for rights offerings (Hansen 1989; Eckbo andMasulis 1992; Singh 1997),2 �0.8% and �1.9% for shelf registrations (Bhagatet al. 1985; Moore et al. 1986), �3.0% and �4.3% for primary offerings(Asquith and Mullins 1986; Hess and Bhagat 1986; Masulis and Korwar1986), �2.2% and �3.2% for mixed offerings (Asquith and Mullins 1986;Hess and Bhagat 1986; Masulis and Korwar 1986), and �2.0% and �2.9%for secondary offerings (Mikkelson and Partch 1985; Asquith and Mullins1986).

2. Unlike the mean announcement returns for our sample of rights offerings, the mean an-nouncement returns for the rights offerings analyzed by Eckbo and Masulis (1992), Hansen(1989), and Singh (1997) differ significantly from zero. The magnitudes of the returns are roughlycomparable, however. The slight discrepancy might arise because we use a later sample period.


IV. Empirical Results

A. Earnings Management

Managers of firms that offer outside equity could benefit from boosting earn-ings prior to equity offerings if doing so entices new investors who buy theshares to pay a higher price than they would otherwise. Indeed, Rangan (1998)and Teoh et al. (1998) find evidence that firms manage earnings upward priorto announcements of equity offerings. Although neither study distinguishesbetween different types of offerings, as we discuss earlier, the incentive tomanage earnings may differ greatly according to the offering type. For ex-ample, we conjecture that the incentives to manage earnings should be smallerfor rights offerings and for shelf registrations than for other offering types.In rights offerings, a temporary boost in the stock price should not affect thewealth of existing shareholders if they exercise the rights allocated to themto buy more equity. Because the actual equity sale does not take place im-mediately for shelf registrations, a temporary stock price increase attributableto managed earnings might not affect the eventual terms of the offer.

We begin our tests of earnings management by estimating the earningsaccruals (i.e., earnings less cash flow) for each firm and then partitioning theminto current versus long-term accruals. Current accruals are adjustments toeither current assets or current liabilities, whereas long-term accruals are ad-justments to long-term assets or liabilities. Because Guenther (1994) and Sloan(1996) suggest that managers have more discretion over current accruals, weexpect that any earnings management would be most evident in current ac-cruals. A large portion of the accruals is naturally dictated by overall businessconditions and is not subject to manipulation by managers. We employ themethodology described in Teoh et al. (1998, app. A), which is a modificationof the Jones (1991) model, to weed out such nondiscretionary accruals fromtotal accruals, and we then label the remaining accruals as discretionary.3

Table 3 presents median discretionary accruals for the different types ofequity offerings. We focus on discretionary current accruals because it is thecomponent of earnings most likely to be affected by earnings management.Consistent with Rangan (1998) and Teoh et al. (1998), we find strong evidenceof upward earnings management around regular equity offerings. This earningsmanagement is most pronounced during the year of the announcement andin offerings that include primary shares (i.e., either primary shares alone or

3. In particular, for each sample firm and for each year, we apply the following procedure.First, we regress current accruals against sales growth for all firms in the same two-digit SICand define the predicted level of current accruals from the regression model to be the nondis-cretionary component and the remainder to be the managed, or discretionary, component. Sim-ilarly, we regress total accruals against the sales growth and property, plant, and equipment anddefine the predicted level of total accruals from the regression model to be the nondiscretionarycomponent and the remainder to be the discretionary component. Finally, we define discretionarylong-term accruals as the difference between discretionary total accruals and discretionary currentaccruals and nondiscretionary long-term accruals to be the difference between nondiscretionarytotal accruals and nondiscretionary current accruals.


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combinations of primary and secondary shares). There is scant evidence ofearnings management around offerings involving only secondary shares andno evidence of earnings management around rights offerings and shelf reg-istrations. Because earnings management tends to revert over time, these re-sults suggest that, all else equal, any earnings deterioration subsequent toequity offering announcements should be more pronounced for regular equityofferings involving primary shares. We examine this issue next.

B. Analysis of Operating Performance

Earlier studies of operating performance following announcements of equityofferings offer somewhat mixed evidence. While Healy and Palepu (1990)find no systematic changes in operating performance following announcementsof primary offerings, Hansen and Crutchley (1990) document a subsequentdecrease. More recently, using a substantially larger sample of 1,338 obser-vations, Loughran and Ritter (1997) document post-announcement decreasesin operating performance of roughly the same magnitude for primary offeringsand combinations of primary and secondary offerings. However, we are un-aware of any study that examines operating performance following announce-ments of regular offerings of secondary shares, rights offerings, or shelfregistrations.

In table 4, we report median levels of operating performance (operatingincome scaled by the book value of sales) around equity offering announce-ments across the different categories of equity offerings. The reported figuresare for firms with available data from one year before through 2 years afterthe announcement. We only report medians because Barber and Lyon (1996)find that nonparametric tests are uniformly more powerful than parametrictests in studies of operating performance. We adjust the operating performanceusing three different benchmarks in order to control for additional factors thatmay affect operating performance. First, to control for changing industry andeconomy-wide conditions, we subtract the median operating performance forall firms with the same three-digit SIC code from each sample firm’s operatingperformance. Second, to also control for possible mean reversion resultingfrom abnormal pre-event performance, we subtract the operating performancefor control firms in similar industries and with similar pre-event performanceas the sample firms. In particular, for each sample firm, we first identify allfirms with the same two-digit SIC code, with operating performance within�10% or within �0.01 of the performance of the sample firm in the pre-announcement year, and with available data from 1 year before through 2years after the announcement.4 If no firms meet these criteria, we first relaxthe industry criterion to a one-digit SIC, then we disregard SIC code, andfinally, if still no firms meet the criteria, we disregard the performance cri-terion. Among these firms, we choose as the control firm the single firm whose

4. The results are similar if we do not constrain the sample firms and the control firms to havedata through 2 years after the announcements.


performance is closest to that of our sample firm.5 Third, to also control forthe capital market’s pre-announcement expectations of the sample firms’ futureoperating performance, we subtract the operating performance for controlfirms in similar industries, with similar pre-event performance, and with sim-ilar market-to-book ratios as the sample firms. These control firms are gen-erated in essentially the same manner as those above. The only differencesare that the performance criterion is relaxed from �10% to �20% and thatwe introduce an additional criterion that the pre-announcement market-to-book value of assets must be within �20% or within �0.1 of that of thesample firm.

The pre-announcement performance varies greatly across the equity offeringtypes. Firms that announce regular equity offerings exhibit superior perfor-mance relative to their industry peers in the pre-announcement year, especiallyif secondary shares are involved, while firms that announce shelf registrationsexhibit normal performance and firms that announce rights offerings exhibitinferior performance. The abnormal pre-announcement performance suggeststhat the performance-adjusted figures are most reliable for the purpose ofexamining subsequent changes in performance (Barber and Lyon 1996). Also,because the sample firms tend to have high market-to-book ratios in the pre-announcement year, we focus on the performance- and M/B-adjusted figuresin the following.

For firms that announce regular offerings of primary shares or combinationsof primary and secondary shares, performance- and M/B-adjusted operatingperformance tends to increase during the announcement year but then fallssignificantly during the next couple of years. In contrast, firms that announceregular offerings of secondary shares exhibit an increase in performance- andM/B-adjusted operating performance during the event year but no decreaseafterward. Further, firms that announce shelf registrations exhibit an increaseboth during the event year and during the subsequent couple of years, whilethe changes for firms that announce rights offerings are not statistically dif-ferent from zero. In sum, these results indicate that the different equity offeringtypes convey vastly different information about future operating performance.Post-offering operating performance deteriorates for firms that undertake reg-ular offerings that involve primary shares, remains the same for firms thatundertake offerings of only secondary offerings, and increases for firms thatfile shelf registrations. These results are broadly consistent with our previousfinding that firms that undertake regular offerings involving primary sharesmanage earnings upward the most around equity offering announcements. Ourresults corroborate the patterns of long-run stock returns documented by Lee(1997), who finds that, on average, issuers of primary shares underperform

5. We also allow the control firms to be in the sample, because we would otherwise dramaticallyreduce the population of firms from which we could draw control firms, thus making it harderto ensure similarity of pre-event characteristics. However, we ensure that the control firms didnot announce an equity issue within 2 years of the sample firm’s announcement (i.e., duringyears �2 through �2).


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their stock return benchmarks, whereas firms do not underperform followingsecondary share issues.

We also examine two alternative measures of performance. First, we ex-amine operating income scaled by assets, which, unlike operating income bysales, captures changes in asset productivity. A potential drawback, however,is that, while the asset base increases immediately upon issues of primaryshares, the incremental asset base might not fully and immediately generateoperating income, thus giving the impression that performance (as measuredby operating income scaled by assets) suffers, at least in the short run. Second,we examine cash flow (defined as in Barber and Lyon [1996]) scaled by salesin an effort to remove the effect of earnings management on the performancefigures. We graph the results based on our three performance measures infigure 1. Firms that sell primary shares or a mix of primary and secondaryshares exhibit an improvement in operating income scaled by sales duringyear 0 but not in operating income scaled by assets, suggesting that the useof assets as a scaling factor might bias downward the results during the eventyear (or, alternatively, that the use of sales biases the results upward). Further,these firms experience a decline in cash flow scaled by sales during year 0,suggesting that the improvement in operating income scaled by sales is atleast partially due to earnings management. Regardless of the measure, how-ever, performance falls after issues involving primary shares. Finally, firmsthat issue only secondary shares or use shelf registrations experience an in-crease in performance irrespective of the performance measure, while thereare no clear trends for rights offerings, perhaps due to a smaller sample size.

C. Multivariate Analysis of Changes in Operating Performance

We next utilize a multivariate framework to determine whether the changesin operating performance (as measured by, alternatively, operating incomescaled by sales, operating income scaled by assets, or cash flow scaled bysales) relate to the offering type. In particular, we regress the change in op-erating performance from year �1 (the pre-announcement year) to year �2against variables indicating the offering type. We control for the effects ofpre-announcement performance, market-to-book values, firm size, and themedian change in operating performance for industry peers with the samethree-digit SIC code by including them as independent variables. In somemodels we also control for the effect of past earnings management by includingdiscretionary current and long-term accruals as independent variables.

Table 5 provides the results of the multivariate analysis of operating per-formance.6 The coefficients on both the pre-announcement performance and

6. As described in the note to table 5, the results are based on winsorized data to mitigate theinfluence of extreme values that arise when we scale by sales because many firms have verylow sales figures during the pre-announcement year. If we do not winsorize the data, the resultsfor the equity offering variables are qualitatively the same in the regressions using operatingincome scaled by assets but are statistically insignificant when using operating income scaledby sales or cash flow scaled by sales.


Fig. 1.—Median levels of performance- and M/B-adjusted performance after equityofferings. Year 0 is the announcement year. Performance is measured either as operatingincome scaled by sales, operating income scaled by assets, or cash flow scaled bysales. a, Primary offerings. b, Mixed offerings. c, Secondary offerings. d, Rightsofferings. e, Shelf registrations.

the market-to-book ratio are negative with p-values less than 0.01. If themarket-to-book ratio primarily captures the firms’ future prospects, we wouldexpect a positive sign on the market-to-book ratio. The negative sign insteadsuggests that firms with the highest market-to-book ratios will experience thelargest drop in performance, perhaps because the ratios partially capture theextent to which the sample firms have temporarily boosted their operating


TABLE 5 Regression of Change in Operating Income or Cash Flow

Dependent Variable Is the Change in:

OperatingIncome/Sales

OperatingIncome/Assets Cash Flow/Sales

(1) (2) (1) (2) (1) (2)

Intercept .044(.000)

.037(.000)

.057(.000)

.058(.000)

.058(.000)

.048(.000)

Pre-announcement operatingincome or cash flow �.226

(.000)�.206(.000)

�.297(.000)

�.305(.000)

�.299(.003)

�.27(.000)

Market-to-book value ofassets �.008

(.000)�.006(.000)

�.011(.000)

�.011(.000)

�.005(.005)

�.005(.003)

Book value of assets(billions) .001

(.049).001

(.046).001

(.004).001

(.005).001

(.149).001

(.082)Median change in operating

income or cash flow ofindustry peers .419

(.000).439

(.000).372

(.000).380

(.000).456

(.000).434

(.000)Fraction primary �.025

(.000)�.024(.000)

�.035(.000)

�.034(.000)

�.026(.000)

�.025(.000)

Rights offering .009(.667)

.005(.808)

.006(.662)

�.003(.829)

�.003(.903)

.010(.684)

Shelf registration .046(.000)

.043(.000)

.035(.000)

.035(.000)

.040(.000)

.043(.000)

Discretionary currentaccruals �.066

(.001)�.061(.000)

.268(.000)

Discretionary long-termaccruals �.071

(.008)�.042(.022)

�.025(.402)

Adjusted R2 .169 .146 .188 .206 .228 .245No. of observations 4,110 3,748 4,151 3,755 3,857 3,681

Note.—The table presents regressions of the change in operating income scaled by sales, operating incomescaled by assets, or cash flow scaled by sales from year �1 to year �2 against offering type and controlvariables. Fraction primary is the fraction of total shares offered that is primary shares. Rights offering is adummy variable that takes on a value of one if the offering takes the form of a rights offering and zerootherwise. Shelf registration is a dummy variable that takes on a value of one if the offer was shelf-registeredand zero otherwise. Discretionary accruals are measured during the pre-announcement year. The performancemeasures (both levels and changes), market-to-book ratios, and accruals have been winsorized at the fifth andninety-fifth percentiles to mitigate the effect of outliers. The p-values are in parentheses.

performance to inflate their stock prices. As expected, the coefficient on theperformance change for industry peers is positive, suggesting that industry-wide and/or economy-wide factors significantly influence firm performance.Moreover, the coefficients on discretionary accruals are negative when mea-suring performance by either operating income scaled by sales or operatingincome scaled by assets, suggesting that firms that inflate earnings experiencesubsequent drops in reported performance. In contrast, the coefficient on dis-cretionary current accruals is positive when performance is measured by thechange in the cash flow to sales measure. One possible reason for this reversalin sign is that earnings management prior to equity offerings (specifically,aggressive revenue recognition) might inflate sales (the denominator in the


Fig. 2.—Median levels of industry-adjusted market-to-book values of assets. Eachsample firm’s industry-adjusted market-to-book value is calculated as the differencebetween the sample firm’s market-to-book value and the median for firms with thesame three-digit SIC code.

cash flow to sales measure) and earnings but not cash flows. It follows thatcash flow to sales ratios should improve in the periods following earningsmanagement via aggressive revenue recognition.

More important for the purposes of this study, the coefficient on the fractionof primary shares in the offering is consistently negative with a p-value ofless than 0.001, while the coefficient on the shelf registration dummy variableis consistently positive with a p-value of less than 0.001. Thus, firms expe-rience the largest drop in performance if the offering involves a large portionof primary shares, and firms that file for shelf registrations improve theirperformance relative to other sample firms. These results are consistent withthe nonparametric statistics in table 4.

D. The Choice of Offering Type

The different patterns of earnings management and operating performanceacross the equity offering types suggest that the motivations for using themdiffer. In this section, we examine further the characteristics of the samplefirms and how these characteristics relate to the choice of offering type. This,in turn, may shed further light on the underlying motivations for the differentoffering types.

If firms time equity issues to take advantage of inflated market values, wewould expect market-to-book ratios to peak around the time of issue. Figure2 shows the median industry-adjusted market-to-book ratios from 3 years


Fig. 3.—Median levels of industry-adjusted cash and cash equivalents scaled byassets. Each sample firm’s industry-adjusted cash ratio is calculated as the differencebetween the sample firm’s cash ratio and the median for firms with the same three-digit SIC code.

before through 3 years after the offering announcements. Consistent withLoughran and Ritter (1997), the ratios peak in the pre-announcement year forregular offerings. This trend is most evident for mixed offerings, but it is alsoapparent for primary and secondary offerings. In contrast, the ratios are attheir lowest in the pre-announcement year for firms that use rights offerings,while no pattern is evident for firms that file shelf registrations. This suggeststhat managers of firms that file shelf registrations may desire to issue sharesimmediately but believe that their current market values are too low. Instead,they file shelf registrations so that they can issue equity quickly when theirfirms’ market values rebound. Similarly, managers of firms that undertakerights offerings might believe that their firms’ equity market values are pres-ently too low to warrant a regular equity offering and therefore choose a rightsoffering because it transfers less wealth from existing to new shareholdersthan does a regular offering.7

Figures 3 and 4 show industry-adjusted cash and debt ratios, respectively.These figures provide insights into the need for external equity financing.

7. The distinction between undervalued firms that choose rights offerings vs. those that fileshelf registrations might be related to the shareholder take-up issue pointed out by Eckbo andMasulis (1992). Denis (1991) reports that firms that file shelf registrations tend to be larger firms.This is also evident in our sample (see table 2). Larger firms with dispersed ownership are lesslikely to experience levels of shareholder take-up high enough to make a rights offering viableas an option.


Fig. 4.—Median levels of industry-adjusted total debt (long-term debt plus debt incurrent liabilities) scaled by assets. Each sample firm’s industry-adjusted debt ratio iscalculated as the difference between the sample firm’s debt ratio and the median forfirms with the same three-digit SIC code.

Apparently, firms that sell equity in regular offerings do not have a dire needfor equity financing in the pre-announcement year. Relative to industry peers,the cash levels of these firms are not particularly low and their debt ratiosare not particularly high. In contrast, firms that file shelf registrations, andespecially firms that sell equity via rights offerings, have fairly low cash ratiosand high debt ratios in the pre-announcement year. For example, the typicalfirm that files a shelf registration has a debt ratio that is 0.06 higher than thatof industry peers, while the corresponding figure for the typical rights offeringfirm is 0.08. Thus, both sets of firms appear to have a more immediate needfor equity financing than do the remainder of the sample firms. Combinedwith the results on market-to-book ratios, these results suggest that managersof firms that sell equity in regular offerings act opportunistically to takeadvantage of high market values, while managers of firms that file shelfregistrations or sell equity in rights offerings primarily seek to meet their needfor outside funds. This evidence is consistent with the predictions of Myersand Majluf (1984).

Next, we examine the choice of offering type in a multivariate context giventhat the firm wants to sell primary shares. In particular, we run a multinomiallogistic regression where the dependent variable indicates whether the offeringis a regular offering, a rights offering, or a shelf registration. The independentvariables include the natural logarithm of the market value of equity, themarket-to-book value of assets, the return on the market index during the year


TABLE 6 Determinants of Offering Type

Equity Offering Choice (Dependent Variable)

Rights Offerings Shelf Registrations

Intercept �2.199(.000)

�8.150(.000)

(Market value of equity)ln �.338(.000)

.792(.000)

Market-to-book value of assets �.013(.824)

�.189(.009)

Market runup �1.995(.037)

3.788(.000)

Industry runup � market runup �1.068(.003)

�.688(.001)

Stock runup � industry runup �1.077(.000)

�.179(.082)

Cash ratio �.180(.835)

�.152(.812)

Debt ratio 1.406(.015)

1.211(.002)

No. of observations 3,635

Note.—The table presents the multinomial logistic regression of the equity offering choice. Only observationswith primary offerings are included. Market runup is the return on the value-weighted index over the 250trading days ending 5 days prior to the announcement. Industry runup is the mean return for a portfolio offive stocks with similar industry and size characteristics as the sample firm over the 250 trading days ending5 days prior to the announcement. Stock runup is the stock return for the sample firm over the 250 tradingdays ending 5 days prior to the announcement. Cash ratio is cash and cash equivalents scaled by book valueof assets preceding the offer. Debt ratio is total debt (long-term debt plus debt in current liabilities) scaled bythe book value of assets preceding the offer. The p-values are in parentheses.

prior to the announcement, the difference in return on the industry index andthe market index during the prior year, the difference in return on the stockand the industry index during the prior year, the cash ratio, and the debt ratio.Similar variables have been used in other studies to examine characteristicsof firms that issue equity (e.g., Jung et al. 1996).

Table 6 presents the results of the multinomial logistic regression. Theprobability of a rights offering increases with the debt ratio and decreaseswith the market value of equity, market runup, industry-specific runup, andstock-specific runup. The probability of a shelf registration increases with thedebt ratio, the market value of equity, and the market runup and decreaseswith the industry-specific runup and the market-to-book value of assets. Theseresults generally support our earlier findings and interpretations. That is, firmsthat use rights offerings as a means to sell equity have high debt ratios,suggesting a need for an equity infusion, but neither the overall market, theindustry, nor the firms’ stock has performed well during the last year, suchthat a regular equity offering seems less appealing. Firms that file shelf reg-istrations also have high debt ratios, but the poor recent performance of thefirms’ stocks and industries and their low market-to-book ratios make a regularoffering less desirable at the present time. Consequently, these firms may tryto wait for more favorable conditions and file a shelf registration in the mean-time. Perhaps the good recent return on the market index makes the managersoptimistic that the firms’ stock will rebound in value shortly. Indeed, the


managers have a reason to be optimistic, because our results suggest that theoperating performance tends to improve in the following years.

E. The Timing Effect of Actual Issues after Shelf Registrations

It is conceivable that managers of firms that file shelf-registrations time theactual issue to take advantage of a temporary improvement in performanceor manipulate earnings before they anticipate the actual issue. The averagenumber of days between the filing date and the issue date for shelf registrationsis 102 (compared to 35 for other offerings), and in 26% of the cases the fiscalyear of the filing date differs from the fiscal year of the issue date (comparedto 6% for other offerings).8 Thus, we examine the accruals and earnings aroundthe actual issue date for shelf registrations also. The results are very similarto those reported earlier and are therefore not tabulated. We also estimatedthe abnormal returns from 3 days after the announcement to 3 days beforethe issue date. Both the mean and median abnormal returns are �1%, andneither is statistically different from zero. Thus, there is little evidence thatmanagers time the actual issue following shelf-registration announcements totake advantage of temporary operating performance improvements or stockprice improvements or that they manipulate earnings beforehand.

F. Insured versus Uninsured Rights Offers

We are able to classify 15 of the rights offers in our sample as insured and38 as uninsured. Consistent with the figures reported in Eckbo and Masulis(1992), we find that the uninsured rights offers in our sample produce a largerproportionate increase in equity capitalization than do insured offers. Specif-ically, the mean (median) offering size as a percentage of pre-announcementequity values is 103% (50%) for uninsured rights offers and 46% (36%) forinsured rights offers. These figures are higher than the mean (median) reportedby Eckbo and Masulis (1992) for industrial firms of 35% (25%) for uninsuredrights offers and 20% (14%) for insured rights offers, perhaps because ofdifferent sample periods or because, unlike our study, Eckbo and Masulisrestrict their analysis to firms listed on either the NYSE or AMEX.

Ownership is more concentrated and pre-commitment is higher for firmsthat use uninsured rights offers. In particular, the mean (median) blockholdingsis 50% (50%) for firms that use uninsured rights and 27% (19%) for firmsthat use insured rights, while the mean (median) pre-commitment is 53%(50%) for uninsured rights and 5% (0%) for insured rights.9 To the extentthat ownership concentration and pre-commitment proxy for expected share-holder take-up, our results are consistent with Eckbo and Masulis’s (1992)

8. Note that our sample only includes completed offerings. For an analysis of canceled offerings,see Clarke, Dunbar, and Kahle (2001).

9. Blockholders frequently commit to purchase both their portion of the rights offer shares aswell as shares not purchased by other stockholders, in which case we deem the pre-commitmentto be 100%.


prediction. The large blockholdings (presumably held by well-informed in-vestors) and pre-commitment in rights offers further suggest that managersdo not employ rights offers to sell investors overvalued shares, thus corrob-orating our other findings.10

G. The Role of the Identity of the Seller in Secondary Offerings

As argued by Mikkelson and Partch (1985), the information content in an-nouncements of secondary offerings might depend on the identity of the seller.In particular, if insiders possess superior information about the fundamentalvalue of the firm, the information is likely to be more negative for secondaryofferings in which the seller is an insider. Thus, we partition our sample ofsecondary offerings into those in which an insider (i.e., executive or director)sells shares versus others.

We find that insiders sell shares in 121, or 16%, of the 738 secondaryofferings, which is similar to the fraction in the sample of Mikkelson andPartch of 13%. The mean (median) announcement return is �2.9% (�2.4%)when insiders are involved and �1.8% (�1.7%) otherwise. The differencein means is statistically significant with a p-value of 0.02. However, the dif-ference in a multivariate setting (see Sec. IV.H) is 0.7% and not statisticallydifferent from zero (p-value is 0.11).

We also find that both discretionary accruals and pre-announcement op-erating performance levels are higher for secondary offerings involving in-siders. For example, the median discretionary accruals for this subset is 0.014in year �1 and 0.010 in year 0, and both are significantly higher than thosefor the subset of secondary offerings not involving insiders at the 0.05 levelof statistical significance. In terms of operating performance, in year �1, themedian unadjusted (industry-adjusted) operating income scaled by sales forsecondary offerings involving insiders is 0.155 (0.075). As expected in lightof the discretionary accruals, the median performance- and M/B-adjustedoperating income scaled by sales is higher in year 0 for the subset involvinginsiders (0.017) than for the subset not involving insiders (0.007). It is in-teresting that neither set exhibits subsequent performance deterioration. Sur-prisingly, among the secondary offerings, the performance-adjusted and per-formance- and M/B-adjusted figures are actually slightly higher aftersecondary offers with insider sales. Although announcement returns are lowerfor secondary offers involving insiders, there is no strong link between insiderparticipation in secondary issues and future operating performance, suggestingthat insiders may participate in secondary issues primarily for liquidity reasons.

H. Multivariate Analysis of Announcement Returns

We examine the abnormal stock returns around the offering announcementsmore closely to assess whether the cross-sectional determinants of the returns

10. Incidentally, we also compared earnings management and reported earnings patterns acrossuninsured and insured rights offers, but we found no discernible differences.


differ across the offering types and whether returns are systematically relatedto the type of offering in a multivariate context. (None of these results aretabulated for brevity.) In particular, we first regress announcement returnsagainst variables that have been used in past studies (e.g., Asquith and Mullins1986; Denis 1994; Jung et al. 1996) for each offering type. For primaryofferings, mixed offerings, and shelf-registrations, the returns are negativelyrelated to the firm-specific stock runup. Further, the returns are positivelyrelated to the market’s runup for mixed offerings and negatively related toindustry-specific runup for rights offerings, the market value of equity forprimary offerings, and the offering size for secondary offerings. Finally, therelation between announcement returns and market-to-book ratios is modestlynegative for secondary offerings ( ), modestly positive for mixedp p 0.078offerings ( ), and imperceptible for primary offerings. Thus, therep p 0.076is scant evidence that market-to-book ratios (and, hence, investment oppor-tunities) affect the capital market’s reaction to equity offerings.11

Next, we estimate a regression using the whole sample that includes var-iables to distinguish between the offering types. The coefficient on the fractionof primary shares involved in the offering is 0.000 ( ), while thep p 0.938coefficients on the dummy variables for the rights offerings and shelf regis-trations are 0.012 ( ) and 0.010 ( ), respectively. Thus,p p 0.117 p p 0.014ceteris paribus, the announcement returns are not related to the fraction ofprimary shares involved in the offering but are roughly 1% higher for rightsofferings and shelf registrations than for regular offerings. These results areconsistent with the univariate statistics from table 2.12

The announcement returns results seem partially inconsistent with the resultson the changes in operating performance. In particular, given that the changein operating performance around the offering announcements is negativelyrelated to the fraction of primary shares, we had expected that the announce-ment returns would be negatively related to the fraction of primary shares.Perhaps the coefficients are biased as a result of a misspecified regressionmodel. Or perhaps the stock returns do not capture all the information im-mediately. Such an explanation would be consistent with the results in Lee(1997), which, as we noted earlier, find that the long-run stock returns fol-lowing primary shares issues are lower on average than their benchmarks,while the returns following secondary shares are not.

11. We also included a dummy variable indicating that an insider is selling in the regressionfor secondary offers. The coefficient on this dummy variable is �0.007, with a p-value of 0.11.

12. A caveat is in order here. The separate regressions for the various equity offering typessuggest that the cross-sectional determinants of the returns differ. However, the regression modelbased on the whole sample implicitly assumes that the determinants are similar across the types,such that this model is likely to be misspecified. Introducing interaction variables between theequity offering type variables and the other variables may alleviate any misspecification. Theproblem with such an approach is that it becomes difficult to interpret the effect of the equityoffering types, as the equity offering type variables appear multiple times in the regression model.While our approach to assess the effect of the equity offering type on returns is imperfect, weshould note that Chaplinsky and Ramchand (2000) employ the same approach to examine whetherthe announcement returns are higher for global equity offerings than for domestic equity offerings.


V. Summary and Conclusion

In this study, we examine the choice of equity offering type and the accom-panying information content using a sample of 4,708 equity offerings an-nounced between 1980 and 1998. We find evidence of upward earnings man-agement around the announcements of regular equity offerings involvingprimary shares and a subsequent deterioration in operating performance. Con-versely, there is little evidence of earnings management around announcementsof regular offerings of secondary shares, right offerings, or shelf registrations,and the post-offering operating performance actually improves for regularofferings of secondary shares and for shelf registrations. We document patternsin market-to-book ratios, debt ratios, and cash ratios that suggest that firmssell equity in regular offerings in an effort to take advantage of temporarilyhigh equity values despite what appears to be a modest need for outside equityfunds. In contrast, firms sell equity in rights offerings or file shelf registrationswhen their market values are relatively low and the need for outside fundsis relatively large.

Overall, the evidence is consistent with the notion that managers makedecisions related to equity offerings that maximize the value for existingshareholders. When the firm is overvalued, perhaps partially as a result ofintentional upward earnings management, managers choose to sell equity inregular offerings, as this will tend to transfer wealth from new to existingshareholders. When a firm needs outside equity but is temporarily undervalued,its managers may choose to postpone an equity offering until market conditionsimprove or they may file a shelf registration in the meantime. Alternatively,they may choose a rights offering because doing so minimizes any transferof wealth from existing shareholders. Incidentally, if the major reason forissuing shares is to take advantage of overvalued equity, this would explainthe rather limited use of rights offerings.

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