Long Run Performance of the Firm After Seasoned Equity Offering

SEO

This literature review looks at the question of SEO return characteristics of large and small firms from several different perspectives. The goal is to determine whether small firms are more effected by the equity offering than larger firms. This section examines the overall evidence for performance issues (including financial anomalies and manager performance) and whether research indicates evidence for a rational or behavioral explanation.

Financial Anomalies

A firm's success in a seasoned equity or initial public offering is determined by many factors that are seemingly disconnected, but which the research shows are interdependent. Among these are the anomalies that cannot adequately be described by rational theories of pricing. As an example, Li (2012) suggests that the cyclical nature of the economy has a far greater effect on certain types of offerings (IPOs and SEOs among them) than was previously thought. Again, the relatively unpredictable nature of firms and investors can cause problems that many times cannot be predicted by analysts and managers (Phillips, 1989; Young & Zaima, 1986). The primary issue is that seems to be that economic theories, in general, have been anchored to the idea of a rational investor and firm; the combination of which makes rational decisions. In a classroom setting, this is a convenient method for teaching finance and the movement of markets, but in the real world research suggests that anomalies exist that do not fit rational theories.

Rational theory details that a firm, whether large or small, examines carefully all of the variables of the market prior to delving into a seasoned equity issue or any other endeavor (Nau, 2008). Logical processes determine whether a firm will issue stock in an IPO and whether that firm will perform and later if it will perform an SEO should condition and need dictate it. The problem is that variables exist which cannot be explained rationally (Nau, 2008). Basically, people are not always logical and they use various methods to determine whether a specific issue is a good idea or not. Li and Ong (2007) looked at market timing by following the decision making ability of REIT managers. They first determined that REIT equity issues do follow closely those of other types of SEOs, but their primary finding was that the people involved in the timing of the issuance were the primary determinant of success. This follows other research that suggests that the people involved in the decision-making processes are the most important determinant of success (Loughran, Ritter & Rydqvist, 1994).

The research indicates that anomalies occur because of people's behaviors (Chemmanur, Paeglis & Simonyan, 2010), rather than because of any quirk in the market (Clarke, Dunbar & Kahle, 2001). This is true whether the firm is large or small. Value anomalies, for example, are a primary feature of a study conducted by Phillips in 1989 trying to determine the difference between large and small firms with regard to asset pricing. He found that small firms actually had better performance than large firms in equity issues (when returns were adjusted for risk). However, a similar study found that larger firms had better returns due to the amount of information that could be gathered and the number of people involved in the decision-making process (Speiss & Affleck-Graves, 1995). A variety of studies concluded that the success of an equity issue, long-term, is more affected by the behavior of the people involved (firm managers and investors mainly) than any other factor. This is what produce a majority of the anomalies observed.

A great deal of research has also been conducted on how anomalies and other factors associated with IPOs, mergers, SEOs and other forms of growth effect small and large firm's long-term performance. SEOs are based on the theory of momentum which suggests that a stock price will continue to move in the same direction given that all else remains equal (Brau & Osteryoung, 2001). Many managers believe that momentum is a good explanation of how an issue will perform (Cornett, Mehran & Tehranian, 1998), but that belief is very often false. The stock, which has been growing at a pronounced rate for the year prior to the offering often underperforms, or even reverses, over the five years after the issue. Loughran and Ritter (1997) found that firms had only a seven percent rate of return in the five years following an SEO while on average they had a 72% return as a group in the year prior to the offering. This steep decline has been investigated in a large amount of research following this finding, but there is no consensus as to an exact reason. Abhyankar, & Ho (2001) find that trying to predict long-term success of an IPO or SEO based on past performance is an "illusion" based in "poor initial planning" and a belief in the continuance of "factors." Cudd, Eduardo and Roberts (2008) examined the idea of making decisions without quality research. Of course, this was found to depress the expected long-term return that the company expected from their projections because the projections themselves were based on very little. As an another example of underperformance, Su (1997). Looked at the dishonesty that is inherent in the market and has a tendency to inflate the expectations of investors and cause the dishonest firm to have a better IPO or SEO than their firm deserves.

Unfortunately, this seems like either a planned or mistaken inflation of real growth prior to the company's SEO, or it could be that the conclusions drawn by these studies may actually be false due to the researchers using incomplete or erroneous markers (Abhyankar & Ho, 2001). Research suggests that the question is very complex; complicated by pricing theory reasoning (Jegadeesh, 2000), improper vetting of companies prior to issuance of SEOs and IPOs (Cornett, Mehran & Tehranian, 1998; Ibbotson, Sindelar & Ritter, 1994; Jegadeesh, 2000), and such impediments to clarity as incompetent management (Chemmanur, Paeglis & Simonyan, 2010; Cudd, Eduardo & Roberts, 2008). Due to these factors, research almost unanimously suggests that firm performance post-issue falls far short of initial estimates.

Another problem occurs when researchers look at the size of the firms involved in the IPO or SEO. It has been previously stated that the size of the business does not matter as much as other factors, but it can be a problem for many different reasons. Brav, Michaely, Roberts and Zarutskie (2009) suggest that small firms are inherently more risky than larger firms, but Finkle (1998) counters that by saying that the underperformance of smaller firms could be due to a more complicated mix of factors than those examined in the other study. Evidence points to the fact that quality of personnel (Chemmanur, Paeglis & Simonyan, 2010; McLaughlin, Safieddine & Vasudevan, 2000) and firm motivation (Su & Fleisher, 1997) are greater predictors than any other factor examined. The number of variables that can be counted is infinite, but using just rational and behavioral theories for explanatory assistance seems to have helped researchers understand how prediction and success are interrelated.

Long-Term Predictions

The primary reason that a firm issues stock is so that it can generate capital to encourage present and future growth (Nau, 2008). However, when a company takes the risk inherent in any IPO or SEO, they want some relatively solid assurance that the offering will raise the capital required. The issue is expected to help the firm continue the short-term growth that it has enjoyed (generally, a firm that has a high growth rate for a twelve-month period can consider an SEO (Loughran & Ritter, 1997)), but that may not provide the sample size required to provide an accurate estimate of long-term performance.

According to Jegadeesh (2000), firms underperform their initial expectations almost every time. The study claims that it matters little whether the equity offering is from a small or large firm, they all underperform the benchmarks. One of the reasons for this is intentional. Many firms underprice their offerings because the "conventional wisdom" is that this will result in greater returns in the long-term. In a study of UK company SEOs, Levis (1993) found that the actuality is that this practice leads to an underperformance of as much as 29% as compared to firms of similar size and industry. In a similar study using Turkish companies, Erdogan (2010) discovered that at two, three and five-year benchmarks, all of the 120 IPOs he studied had underperformed the market. These findings are relatively consistent regardless the industry of the time frame used (Erdogan, 2010; Ibbotson, Sindelar & Ritter, 1994).

However, there is an anomaly that apparently erases much of the variance that is seen in these findings. Erdogan (2010) noted that much of the problem with his findings could be found in the measures that were used to calculate the difference in performance. This is consistent with other studies that have been conducted also. Kiymaz (2000) examined many of the same markets ten years before Erdogan made his examinations. He found the same issues with underpricing and firm performance relative to the bounds the researcher placed on the study. He found that the company itself and its industry were larger determinants of future growth than anything other factor. In his conclusion, Klimaz (2000) talked about the limitations placed on researchers and their inability to adequately study the firms many times. He saw this as a problem as did many other researchers (Clark, Dunbar & Kahle, 2001; Dawson, 1987; McDonald & Jacquillat, 1974).

Despite the issues common to researchers, there is the problem of actual firm underperformance and the reasons it exists. The crux of this paper is SEOs, but it is interesting how the performance of seasoned issues closely mirrors that of initial issues of stock. Speiss and Afleck-Graves (1995) analyzed 1274 firms that had issued stock between 1975 and 1989. They found that "the median return for seasoned equity offerings was measured at 10% while the return for non-issuing firms was 42.3%. It was suggested that underperformance is due to miscalculation of relative risks." This miscalculation of risk is another primary reason for the degradation of growth over the long-term. Many risks are involved in the calculation of potential, and firms that do not properly account for problems seem to be doomed to experience slow or negative growth.

One of the most persistent risks that a company endures is that of the people who are chosen to lead the organization (Xiaozhou, Jin & Hong, 2008). China has been used as a testing ground for this issue because businesses follow the Japanese model which is considered more rational than behavioral, and because the companies are emerging both in terms of growth and management (Xiaozhou, Jin & Hong, 2008). In studies conducted with Chinese and Japanese companies, the quality of leadership has been found to be the most important variable with regard to the success of an SEO or its failure (Su & Fleisher, 1997). This seems to be due to culture, but it is a fact that has been mirrored in many Western studies also.

CEO Performance Relative to SEO Performance

The overriding issue for this paper remains whether small firms are more effected by a seasoned equity offering as opposed to physically and fiscally larger firms. Many of the studies examined have concluded that it matters little what the size of the firm is, everyone will underperform its expectations whether that be for an IPO or an SEO (in a large sample of firms). However, this conclusion does not tell whether the leaders of the company can help their firm perform better during these issues when large firm performance is compared to small. The fact is that this does matter according to the research. Large firms seem to experience a smaller degree of underperformance as compared to smaller firms. The reason for this underperformance is generally found to be in the planning and understanding of the equity issue.