SEO Risk Dynamics. MurrayCarlson,AdlaiFisher,andRonGiammarino TheUniversityofBritishColumbia. December21,2009

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1 SEO Risk Dynamics MurrayCarlson,AdlaiFisher,andRonGiammarino TheUniversityofBritishColumbia December21,2009 SauderSchoolofBusiness,UniversityofBritishColumbia,2053MainMall,Vancouver,BC,V6T1Z2.Wethank fortheirhelpfulcommentsfelipeaguerrevere,leoncebargeron,sugatobhattacharya,michaelbrandt,alonbrav, IlanCooper,ThierryFoucault,FrancescoFranzoni,CamHarvey,UlrichHege,RobbieJones,PeteKyle,PierreMella- Barral,MurrayFrank,RonMasulis,MarkReady,AndrewRoper,EduardoSchwartz,PaulTetlock,SheridanTitman, BobWhaley,ToniWhited,andseminarparticipantsatAustralianNationalUniversity,DukeUniversity,HECParis, Queen'sUniversity,theUniversityofBritishColumbia,theUniversityofCalgary,theUniversityofMelbourne,the UniversityofMinnesota,theUniversityofPittsburgh,theUniversityofTexasatAustin,theUniversityofWaterloo, theuniversityofwisconsin-madison,vanderbiltuniversity,the2005bankofcanadaworkshopininternational FinancialMarkets,the2005NorthernFinanceAssociationMeetings,the2007HKUSTFinanceSymposium,andthe 2009WesternFinanceAssociationMeetings.SupportforthisprojectfromtheUBCBureauofAssetManagementis gratefullyacknowledged. 1

2 SEO Risk Dynamics Abstract We theoretically and empirically investigate rm-level risk dynamics around seasoned equity oerings.empirically,betaincreasesbeforeseosanddecreasesgraduallythereafter.usingrealoptionstheory,commitment-to-investgeneratesagradualpost-issuancebetadeclinewhereasinstantaneousinvestmentandtime-to-builddonot.inabehavioraltheory,systematicmispricingcan causeincreasingpre-issuanceanddecreasingpost-issuanceriskbutidiosyncraticmispricingcannot. Intheempiricalcross-section,investment,own-rmrunup,SEOproceeds,andprimaryissuance {associatedwiththerealoptionstheory{predictbetadeclines.sentimentproxieshaveweaker eects in the full sample, but are signicant in a post-1996 subsample. SEOs coincide with low rm-andmarket-volatility,suggestingvolatility-timingincorporatedecisions. JELClassication:G31,G32 Keywords:SeasonedEquityOering,RealOptions,DynamicRisk,DynamicBeta,Investment Commitment,Time-to-Build,VolatilityTiming

3 1 Introduction Thepatternofstockreturnsthroughseasonedequityoering(SEO)episodeshasattractedagreat deal of interest and research. Summarizing a large literature,1 Ritter (2003) reports an average returnofapproximately72%intheyearpriortoannouncement,atwo-daycumulativereturnof -2%aroundtheannouncementdate,andunderperformanceofabout5%peryearintheveyears subsequenttoissuance. Twoviewsofthesefactshaveemerged.Behavioraltheoriesexplainthatpre-issuancerun-up relatestooverweightingofpositivenews;thatmanagers(eitherdeliberatelyoralsothroughexcessiveenthusiasm)issueequitywhilestockpricesarehigh;andthatmarketsonlypartiallyreactto theseoannouncement,permittingslowlearningandlong-rununderperformance.2 Bycontrast, real options theories explain that seasoned equity oerings are associated with real investment, optimallytimedtooccuraftergrowthoptionsmoveintothemoneyandstockpricesincrease.since therealoptionstheoryincorporatesrationalexpectations,announcementofaseasonedoeringimpactspricesfullyandimmediately.apparentlong-rununderperformanceoccursbecauseexercising (ordeleveraging)agrowthoptioncausesanimmediatereductioninassetrisk.3 Thebehavioralandrealoptionstheoriesexplainthesamesetofaveragereturnfacts,buthave dierentimplicationsforrisk.inparticular,currentbehavioraltheorydoesnotaddresshowrisk shouldevolvethroughtheseoepisode.bycontrast,arealoptionsexplanationsuggeststhatrisk loadingsshouldincreasepriortoissuance,asoptimallytimedinvestmentapproachesandgrowth optionleveragerises.further,undertakinginvestmentshouldcauserisktodeclineasgrowthoption leveragefalls. Inthispaper,wepresentnewevidenceonthedynamicsofrmlevelriskthroughouttheSEO episode.ourprincipalempiricalndingisthatbetaincreasespriortotheseoannouncementand decreases after issuance. We document this result using a sample of over 5,700 seasoned equity 1Evidenceonlong-runperformanceisgivenbyBrav,Geczy,andGompers(2000),Clarke,Dunbar,andKahle (2001),Eckbo,Masulis,andNorli(2000),Jegadeesh(2000),LoughranandRitter(1995),Lyandres,Sun,andZhang (2008),MitchellandStaord(2000),andSpiessandAeck-Graves(1995).Announcementeectsarestudiedby AsquithandMullins(1986),MasulisandKorwar(1986),MikkelsenandPartch(1986),andothers.Evidenceofpre- SEOstockpricerun-upisgivenbyKorajczyk,Lucas,andMcDonald(1990)andLoughranandRitter(1995).Eckbo andmasulis(1995)surveytheearlierliterature. 2Daniel,Hirshleifer,andSubrahmanyam(1998)developacomprehensivebehavioraltheoryofSEOepisodereturns. LoughranandRitter(1995),BaylessandChaplinsky(1996),andBakerandWurgler(2000)givemoreinformaldiscussionsof\windowsofopportunity"and\markettiming."Baker,Ruback,andWurgler(2004)surveythebehavioral corporatenanceliterature. 3See,forexample,Carlson,Fisher,andGiammarino(2006),whodeveloparealoptionstheoryofSEOepisode returns.thistheoryisbroadlylinkedtocontributionsbyberk,green,andnaik(1999),brennanandschwartz (1985),Carlson,Fisher,andGiammarino(2004),Cooper(2006),Gomes,Kogan,andZhang(2003),Kogan(2004), Li,Livdan,andZhang(2009),LucasandMcDonald(1990),McDonaldandSiegel(1985),PastorandVeronesi(2005), andzhang(2005). 1

4 issuancesoveratwentyveyearperiod.ourbaseresultsusemonthlybetascalculatedfromdaily data,followingthehigh-frequencyor\realizedbeta"approach.4 Thepatternofaveragebetadynamicsdierssignicantlyfromthatfoundinsizeandbook-to-marketmatches.Weshowthatthe basicresultsarerobusttocalculatingbetaoverlongertimeperiods,tousingleadsandlagsofthe datatocontrolformicrostructureissuesasindimson(1979),andtoinstrumentingforconditional betaasinghyselsandjacquier(2006). OurndingthatbetadynamicsofSEOrmsareconsistentwiththepredictionsofrealoptions modelsisreenforcedinrecentworkbyhackbarthandmorellec(2008),whofollowasimilarempiricalapproachinthecontextofmergers,andbycooperandpriestley(2009)whouseinvestment basedportfoliostoexamineriskdynamics.ourstudyalsocomplementsrecentndingsbylyandres,sun,andzhang(2008),whoshowthatalong-shortportfoliobasedoninvestmentratesgives apricedfactorthathelpstoreduceseounderperformance. Although the pattern we nd in beta is generally consistent with the predictions of the real options theory, the existing stylized model predicts an immediate decline upon issuance, while wendagradualdeclineoveraperiodofthreeyears.themodelpredictionderivesfromastrong assumptionthatwhenagrowthoptionisundertaken,expansiontakesplaceinstantlyandisentirely nanced by an SEO that is registered and sold simultaneously. Recent research by DeAngelo, DeAngelo, and Stulz (2009), and Kim and Weisbach (2008), suggests that the relation between receipt of SEO proceeds and the timing of investment is more complex. Further, high levels of investmentcontinueintheyearsfollowingtheseo,andpreviousresearchsuggeststhatrmstake timetoplanandexecuteinvestment(e.g.,lamont,2000). Toreectricherassumptionsregardinginvestmentplanningandnancing,weextendthebasic real options model of SEO episode returns to include: 1) commitment-to-invest in the form of futurerequiredoutlaysrelatedtotheproject,2)atime-to-buildspecicationrelatedtokydland and Prescott (1982), and 3) nancing of follow-on investment through internally generated cash owsand/ornon-seoequitynancing.specically,weassumethatexpansionrequiresalumpy immediate investment, nanced by an SEO, and further commits the rm to invest at a xed rate over a xed period of time. Committing to future investment raises the risk of the rm. Intuitively,itengagestherminaswapwherethecashowstobereceived(futureprots)have muchhigherriskthanthecashoutowcommitment(capitalinvestmentcosts).5asthermpays 4RealizedbetasareusedbyAndersen,Bollerslev,Diebold,andWu(2005),GhyselsandJacquier(2006),and LewellenandNagel(2006),amongothers. 5Theeectofinvestmentcommitmentondiscountrateswasrstrecognizedinacapitalbudgetingcontextby RiceandBlack(1995)inanunpublishedworkingpaper.Subsequentresearchhasnotusedthisinsight. 2

5 downtheinvestmentcommitmentovertime,betagraduallydrops.thus,evenwithoutnewequity issuances,riskgraduallyfallsasthermplowsbackoperatingcashowstopaydownexpansion costs.followingourwork,kuehn(2008)investigatesthegeneralequilibriumeectsofinvestment commitment. Theexistingbehavioralliteraturedoesnotmakeanydirectpredictionsaboutsecondmoments inrelationtoseos.onewaytoconstructsuchalinkistoconsiderthatsentimentwavesmight jointly drive both market runups and SEO issuance.6 Under such an assumption, as sentiment becomesamoreimportantpartofvaluationsduringamarketrunup,rmswithhighsentiment exposuresshouldexperiencebetaincreases. Aftertheburstingofabubble,thesesamermsshould thencovarylesswiththemarket.weformalizetheseideasinamodelthatextendstheexisting behavioral literature by considering that sentiment or temporary mispricing may impact either systematic or idiosyncratic components of rm value. The model predicts that overpriced SEO rmswillhavehighbetasthatdeclineafterissuanceonlywhenasystematiccomponentofreturns isaectedbysentiment. Ourextensionsoftherealoptionsandbehavioraltheoriesarethusbothcapableofexplainingthe patternofaveragebetadynamicsaroundseos.theydo,however,deliverdistinctcross-sectional implications that we empirically investigate. Three variables closely related to the real options theory, i) investment rate relative to a match, ii) issuance proceeds as a percentage of market capitalization,andiii)primaryissuancepercentage,signicantlynegativelypredictpost-issuance returns,andequity-andasset-betachanges,relativetomatches.afourthvariableassociatedwith the real options theory, own-rm runup, also signicantly negatively predicts post-issuance beta changes.twovariablesrelatedtothebehavioraltheory,i)marketrunup,andii)thesentimentindex ofbakerandwurgler(2007),donotpredictpost-issuanceperformance.sentimentalsodoesnot predictbetachangesinthefullsample.moreinterestingresultsemergefromasubsampleanalysis. Neitherofthebehavioralvariablesaresignicantforreturnsorbetasinthe subsample. However,inthe subsample{closelyassociatedwiththeDotComera{bothvariables negativelypredictpost-issuancereturnsandbetachanges;theseresultsarehighlysignicantfor marketrunupinthevastmajorityofregressions,andconsistentlysignicantforsentimentinthe asset-betachangeregressions. The third major empirical issue we address is whether volatility dynamics around the SEO areconsistentwithrealoptionstheories.sincerealoptionleverageappliesequallytopricedand 6Barberis,Shleifer,andVishny(1998)provideamodelofinvestorsentiment.AlthoughnotintheSEOcontext, Barberis,Shleifer,andWurgler(2005)discusscomovementasaconsequenceofsentiment. 3

6 unpriced risk, predictions about risk dynamics carry through to total volatility. We thus expect thattotalvolatilityshouldincreasepriortoseoannouncementanddecreaseafterissuance.we calculatemonthlyrealizedvolatilitiesusingdailyreturns,followingschwert(1989),andndthat thesedecreasepriortoissuanceandincreasethereafter,overaperiodofseveralyears.volatility dynamicsthuscontradictthebasicrealoptionsmodelofseasonedoerings. Tobetterunderstandthesevolatilitydynamics,weexaminethevolatilitiesofmatchedrms aswellasmarketaggregates,andndthatequityissuestendtooccurduringtimesofrelatively lowmarketvolatility.this\volatilitytiming"phenomenonhasatleasttwopotentialexplanations. First, issuers may prefer to come to market during times of relative stability, in order to face less uncertainty regarding the nal pricing of the issue. An alternative is that the volatility of fundamentals timeissuanceatpointsoflowvolatility,sincetheoptionvalueofwaitingisthensmaller.7 is stochastic, in which case managers have a rational motivation to endogenously Ourworkrelatestopreviousstudiesthatexaminewhetherriskchangesdiscretelyatthetime ofequityissuanceduetonancialleverage,assuggestedbyhamada(1972).forinstance,healy and Palepu (1990) nd that beta increases after an SEO, while Denis and Kadlec (1994) argue thatafteraccountingforpotentialmicrostructureeects,riskfallsslightlyfollowinganseo.the focusofthesepapersismuchdierentthanours,becausenancialleveragesuggestsaone-time changeinrisk.thesestudiesthusexamineonlythechangeinbetafrompre-topost-issuanceover relativelyshortone-yearwindows.ouranalysisusesamuchlargersample,andanalyzesdynamics throughout a variety of windows. We robustly nd an increase in beta prior to the SEO and a decreasethereafter. Another related literature examines the link between real investment and expected returns. AuthorsincludingAndersonandGarcia-Feijoo(2006),Lamont(2000),PolkandSapienza(2009), Titman,Wei,andXie(2004),andXing(2008)showthatrmswithhigherinvestmentratestend to experience lower subsequent stock market returns. Many authors attribute these ndings to inecientinvestmentcausedbymanagerialempire-buildingormanagerialoveroptimism.theories ofoptimalrealinvestment(e.g.,carlson,fisher,andgiammarino,2006;li,livdan,andzhang, 2009)haverecentlyarguedtheabilitytoaccountforthesamefacts. Several recent studies complement our ndings. Campbell, Polk, and Vuoltenahu (2009) and Taliaferro(2006)showthatbetaislowerafterperiodsofhighcorporateinvestment.Brav,Michaely, 7Alinkbetweenuncertaintyandinvestmentisimplicitinstandardrealoptionsmodels,asdiscussedforexample bybernanke(1983)andpindyckandsolimano(1993).empirically,leahyandwhited(1996)ndthatcorporate investmentisnegativelyrelatedtouncertainty. 4

7 Roberts,andZarutskie(2009)ndthatbankloanspreadsdecreasefollowingseasonedoerings.8 Lyandres, Sun, and Zhang (2008) show that using an investment-based factor to adjust for risk reduces SEO underperformance. These results are consistent with the real options theory that helpstomotivateourempiricalwork. Thepaperisdividedintothreemajorsections,eachofwhichcanbereadseparatelydepending ontheinterestsofthereader.section2discussesriskimplicationsofrealoptionstheory.wedevelop ageneralframeworkthatnestsimportantpriorspecicationsfromtheliteratureandextendsthe analysis of risk dynamics to demonstrate the impact of i) time-to-build, and ii) commitmentto-invest. We show that investment commitment predicts a slow post-issuance decline in risk as investmentoccurs,whereastime-to-builddoesnot. Section3discussesbehavioraltheories.Existingmodelsprovidepredictionsformeanreturns butnotriskdynamics.weaddtotheliteraturebydevelopingamodelthatdeliversimplications forriskwhenstockpricesaresubjecttotemporarymispricing. Section4containsourempiricalanalysis.Wedocumentourmainndingsregardingdynamics inreturnsandbeta,examinepost-seounderperformanceandbetadynamicsinthecross-section, andnallydemonstratethedynamicsofvolatilityaroundseos.section5concludes. 2 Real Options Theory Recentliteraturelinksrealoptionstheoriestopatternsinnancialreturns.Inthespeciccontext ofseasonedequityoerings,lucasandmcdonald(1990)modelreturnsinthepre-seowindow andannouncementdate,whilecarlson,fisher,andgiammarino(2006)considerriskandreturn dynamicsthroughouttherunup,announcement,andpost-issuanceperiod. Inthissection,weextendthepriorliteraturebyconsideringthatadecisiontoinvestentailsnot onlyacurrent expenditureandincreaseinphysicalcapital,butalsoacommitmenttocontinueto investatacertainrateforaxedperiodoftime.thiscommitment-to-investextensionisrelatedto theideaoftime-to-build,butdiersinanimportantway.inastandardtime-to-buildmodel(e.g., KydlandandPrescott,1982),aninvestmentoutlayatdate productivecapitaloroutputuntilsomefuturedate+t doesnotresultinanincreaseinfully >.MajdandPindyck(1987)andDixit andpindyck(1994)incorporatethisaspectoftime-to-buildintoarealoptionscontextbyassuming thatarmcaninvestatamaximumrateperunittime,andthattotalinvestmentmustaggregate 8Otherauthorshavegivensomeevidenceofchangesinriskaroundothertypesofsecuritiesissuance.Forexample, Lewis,Rogalski,andSeward(2002)ndthatassetrisktendstodecreaseafterconvertibledebtissuances.Loughran andritter(1995)ndthatbetadeclinesforthreeyearssubsequenttoanipo. 5

8 toapredeterminedquantitybeforetheprojectiscompletedandacorrespondingincreaseinoutput occurs.however,time-to-buildmodelsgenerallydonotinvolveanexplicitcommitmenttocontinue toinvestinthefuture.9wedistinguishtheideathatinvestmentaectsproductivecapacitywitha lag(\time-to-build")fromtheideathatexpansiondecisionscreateirreversiblefutureexpenditures (\investmentcommitment"). Weshowthat,unliketime-to-build,commitment-to-investcreatesapayostreamlikeaswap, which increases risk because the value of capital to be installed is risky while the committed paymentsarexed.10astheprojectiscompletedandfutureinvestmentcommitmentsarereduced, riskfallsaswell. Ourframeworknests1)astandardmodelofinstantaneousinvestment,2)time-to-build,and 3) investment commitment, allowing us to show their distinct risk implications. The subsequent empiricalanalysisshowsthatseoriskdynamicsaremoreconsistentwithinvestmentcommitment thanstandardmodelswithorwithouttime-to-build.theimportanceofinvestmentcommitment is consistent with prior empirical research by Loughran and Ritter (1997) and Lyandres, Sun, andzhang(2008),whodocumentabnormallyhighpost-seoinvestmentexpendituresthatpeaks aroundthetimeofissuanceanddeclinesslowlyafterwards,andalsoconsistentwithlamont(2000), whoshowsthatcorporateexpansionscantakeseveralyearstocomplete. 2.1 Operating Cash Flows, Production, and Investment Fort0,letQtdenotetheinstantaneousoutputrateofasingleallequityrm.Thermgenerates operatingcashowsxtqt,where dxt=gxtdt+xtdzt; g=r istheconstantdriftundertherisk-neutralmeasure,ristherisk-freerate,>0isthe constant amount by which the risk-free rate exceeds the growth rate g, is volatility, and zt is 9ForexampleinMajdandPindyck(1987)thermmaystopinvestingwheneveritlikes,andcontinueinvestingat sometimeinthefutureuntiltheprojectiscompleted.inkydlandinprescott(1982),adecisiontoexpandatdate tisassociatedwithpaymentsatdatet,t+1,t+2,t+3.however,previouslyscheduledoutlayscanbereversedby choosingfutureprojectstohavenegativesizes(disinvestment). 10Inthelargerrealoptionsliterature,standardinvestmentanddisinvestmentdecisionsarecommonlyrelatedto callsandputs(mcdonaldandsiegel,1985,1986;brennanandschwartz,1985)leadingtocharacteristicpatterns inriskdynamics(carlson,fisher,andgiammarino,2004,2006;cooper,2006).followingthislogic,hackbarthand Morellec(2008)observethatanoptiontomergecanbeequatedtoacallor,whenequityisthemethodofpayment, anoptiononanassetexchange,leadingtouniquepredictionsforriskdynamics.buildingonthislineofresearch, commitment-to-investcaninsimplesttermsbeunderstoodasanoptiononaforwardcontract,ifthefutureinvestment commitmentconsistsofasinglexedpayment,ormoregenerallywhenthecommitmentistoastreamofpayments, asanoptiononaxed-for-oatingswap. 6

9 astandardbrownianmotion.theseassumptionscanbemotivatedforexamplebyassumingthat thermfacespricesof Xt perunitsoldandhaszeromarginalcostsofproduction.underthese assumptions,aprotmaximizingrmwillalwaysproduceatfulloutput,andhenceqtisequivalent tothemaximumoutputrateoftherm. Thermbeginsatt=0withproductiveassets0,andhasaone-timeopportunitytoexpand. Letdenotetherandomtimeatwhichthermexercisesitsgrowthoption.Asinstandardmodels ofinstantaneousinvestment,thermpaysadiscreteamounti 0at.Inaddition,theinvestment decisionrequiresacommitmentfromthermtocontinueincurringoutlaysrelatedtotheinvestment thatgrowatarate0throughouttheinterval to+t,wheret isaconstantgreaterthan zero. Hence, in this environment, an expansion option has two components, the rst related to lumpyup-frontcostssuchasconstructiondown-paymentsorbuildingdesigncosts,andthesecond relatedtocontinuousowsofinvestmentexpenditures.thecapitalleveloftherm,equivalentto itsbookvalue,issummarizedby 8 Kt= >< 0 ift< 1e(t ) if t+t ; (1) >: 2 ift>+t where1 0+I,and2 (0+I)eT. Theparticularfunctionalformofthecommitment-to-investisnotessential.Forexample,we couldassumethatcommittedfutureinvestmentmustbepaidataconstantrategivingalinear specication,andourresultsbelowwouldnotchangesubstantially.theexponentialspecication correspondstoasettingwhereinvestmentspendingisproportionaltosize. Theoutputlevelofthermatanydatetisgivenby 8 Qt= >< Kt ift< Kt b(kt 0) if t+t ; (2) >: Kt ift>+t where0b1.theparameterbcontrolstime-to-build.whenb=0,eachunitofcapitalstock producesoneunitofoutputatallpointsintime.ifb>0,thennewcapitalacquiredduringthe interval(;+t)doesnotachieveitsfullproductivityq=kuntil+t,reectingtheideathat newinvestmentsmayrequiretimetobecomefullyproductive. Wenowdiscussimportantspecialcasesofthemodelabove,someofwhichhavebeenstudiedin 7

10 thepriorliterature.theinstantaneousinvestmentmodelofmcdonaldandsiegel(1986)iscaptured whencapitalandoutput discretelyincreaseatthe momentofoptionexercise andnowhereelse, hence I >0and =b=0.bycontrast,theideathatcurrentperiodinvestmentoutlayscause outputtoincreasewithadiscretedelay,asinkydlandandprescott(1982)andmajdandpindyck (1987),canbeachievedwhenI>0,=0,andb=1.Partialtime-to-buildiscapturedbyI>0, 0<b<1. Distinctfromtime-to-build,thekeyparametercontrollingcommitment-to-investis.If=0, thenthereisnocommitment-to-investeventhoughtime-to-buildmaybeaccommodatedwithb>0 asdiscussedabove.conversely,if >0,thentheexpansiondecisioninvolvesfutureinvestment commitment.wenotethatif>0andb=0,thenwecanhavecommitment-to-investwithno time-to-build:eachdollarofinvestmentexpenditureresultsinanimmediateincreaseinoutputat aone-to-oneratio. 2.2 Financing and the Investment Decision Followingstandardpractice,denefreecashowsasoperatingcashowslessnetcapitalexpenditures.Weassumethatthermmaintainszerocashbalancesatalltimes,implyingthatpositive freecashowsarepaidoutimmediatelytoinvestorsasdividends,whereasnegativefreecashows mustberaisedfrominvestorsthroughequityissues.weinterpretthelumpyinitialinvestmentof I asanseo.duringtheexpansionperiod(;+t]thatfollowstheseothermnancesthe ongoinginvestmentrstfromoperatingcashows.ifoperatingcashowsarenotsucientatany instant,weinterpretthenon-seofundsraisedascomingfromemployeenancingthroughstock oroptionbasedcompensationorconversionofemployeeoptions.11 Themanager'sonlydecisioniswhentoundertaketheinvestmentopportunity.Weassumethat theobjectiveofthemanageristomaximizethefundamentalvalueoftherm.12giventhemarkov structureoftheproblem,theoptimalpolicyisastoppingtimeassociatedwiththerstpassageof thestatevariablexttoacriticalboundaryx.optimalbehaviorisfullycharacterizedbystandard value-matchingandsmooth-pastingconditionsattheinvestmentboundary. 11Recentliteraturediscussestheimportanceofnon-SEOequitynancing.SeeforexampleFamaandFrench(2005) andbabenko,lemmon,andtsurlukevich(2008).ofcourse,othersourcesofinvestmentnancingsuchasretained cashbalancesordebtmaybeutilizedbutthesealternativesproducedierentriskdynamicsfromthosedescribedin thissection.forexample,thepresenceofrisklesscashbalanceswillosettheleverageeectofgrowthoptions.we leavethedetailedstudyoftheriskdynamicsassociatedwithnon-equitynancingtofutureresearch. 12Byassumingvaluemaximizationweeliminateconictsofinterestthatwouldariseifthemanagerwasconcerned withexistingshareholdersasin,forexample,myersandmajluf(1984). 8

11 2.3 Valuation and Optimal Investment Weusebackwardrecursiontoderivermvaluesandoptimalinvestmentpolicy.Armthathas completeditsexpansionismature,anditsvalueisgivenby V2t=Xt2 : (3) Thisequationcorrespondstotheperpetuityvalueofrevenues,andcanberecognizedastheGordon growthformula. Thevalueofarmundergoinganexpansion,anadolescent rm,is: V1t = Xt0 b 1 e (+T t) +Xt1e(t ) (1 b) 1 e ( )(+T t) +Xt 2e (+T t) 1e(t ) r 1 e (r )(+T t) : (4) Thersttwotermsaccountforoperatingcashowsgeneratedduringtheinterval[t;+T],the thirdtermcapturesoperatingcashowsoccurringaftertheinvestmentintervaliscompleted,and thenaltermreectsremainingcommittedcapitalexpendituresduringtheinvestmentinterval.to reectthedecompositionofadolescentvalueintooperatingcashowsandcommittedexpenditures, wewrite V1t=XtvA1t VC 1t; (5) where VC 1t 1e(t ) r 1 e (r )(+T t) (6) andva1t V1t VC 1t =Xt. Wenowturntotheoptimalinvestmentpolicyandvaluationforarmthathasnotyetinvested, thejuvenilerm.itisstraightforwardtoshow: 1:Theoptimalinvestmentstrategyforajuvenilermis Proposition x= 1 I+V 1 C va1 0=; andthevalueofajuvenilermis V0(Xt)=Xt 0+Xt x " ; 9

12 where = q (12 r 2)2+2r 2+12 r 2 >1and "= C I+V1 ( 1). Hence, costs,i+vc with commitment-to-invest the entire discounted value of current and future investment 1,motivatesthermtowaittoexerciseitsgrowthoption.Thisaectstheinvestment boundaryx,butotherwisethevaluationequationissimilartothecasewherethereisnoinvestment commitment. 2.4 Risk Dynamics Denebetaastheloadingofarm'sinstantaneousreturnondXt=Xt,i.e.it=Cov(dVit=Vit;dXt=Xt)=2. Thematurerm'sbetaisthus2t=1andthejuvenilerm'sbetais 0t=1+VG V0t ( 1) (7) wherethevalueofthegrowthoptionisvg 0t Xt x. " Fortheadolescentrm,commitment-to-investhasanimportanteectonriskduringthecommitmentinterval.Thebetacanbeexpressedas 1t=1+VC V1t ; (8) for <tt,afunctionthatisstrictlydecreasingint,fallingtooneat+t.followingequations (8) and (6), the parameter > 0 (commitment-to-invest) generates non-trivial beta dynamics in the post-seo period regardless of the value of b (time-to-build). In comparison, when = 0 (nocommitment-to-invest),theparameterbhasnoinuenceonpost-seobetadynamics.hence, commitment-to-invest,distinctfromtime-to-build,isthekeydriverofpost-seobetadynamics. Ourmodelassumesthatcommitment-to-investisabsolute,butonecanweakenthisassumptionandstillmaintainnon-trivialpost-SEObetadynamics.Forexample,themodelofMajdand Pindyck(1987)canbeapproximatedbyourframeworkwhenI=0,>0,andb=1.LikeMajd and Pindyck, this specication entails no lumpy up-front costs (I continuousinvestmentmustbecompletedbeforenewcapitalbecomesproductive( = 0), and a nite amount of >0,b=1). AnimportantdierenceisthatMajdandPindyckallowcostlesstemporarysuspensionofinvestmentactivityatanypointintime,whereasweabstractfromthecomplicationsassociatedwiththe optiontotemporarilymothballaprojectinordertoachieveclosed-formexpressions.nonetheless, theoptiontotemporarilysuspendwillnoteliminatethepost-seodeclineinbetathatoursimpler 10

13 modelcaptures.13 WecannowsummarizebetadynamicsforanyrmthatundertakesanSEO.Priortoissuance, rmriskdependsontherelativevalueofthegrowthoption.thisoptionhasmaximalvalueatthe commitmentdate.betasofseormsthusriseinthemonthsprecedinganseoannouncement. OurmodelthenpredictsadropinbetaontheSEOissuedatethatisproportionaltotheamount ofproceedsi.riskthencontinuestofallthroughoutthecommitmentintervaltoitslong-runpost- SEOvalueofoneasfundsfromoperationsandothersourcesextinguishtheexpansioncommitment. Therelativemagnitudesoftheseeectsdependsontheparameterizationofthemodel. Figure1comparesbetadynamicsfordierentvaluesoftime-to-build bandcommitment-toinvest.panelashowsthatforthestandardinstantaneousinvestmentrealoptionsmodel(=0 and b=0),betarisespriortoequityissuanceandthendropsimmediatelytoequalthebetaof assets-in-place.panelbshowsthatwithstandardtime-to-build(b=1)andnocommitment-toinvest(=0,solidline),betadynamicsarenearlyidenticaltothoseproducedbythestandard instantaneousinvestmentrealoptionsmodelasinpanela.however,whenthereisacommitment to future investment involving continuing expenditures ( > 0, dashed line), beta remains high followingtheseodateandthendeclinesasinvestmenttakesplaceandthecommitmentlevelfalls. Hence,investmentcommitmentplaysakeyroleindeterminingthedynamicsofpost-issuancebeta. Inadditiontothebetadynamicssetoutabove,thisrealoptionsmodelhasimplicationsfor totalvolatility.inthetheory,themarket-modelbetadoesnotplayanyspecialrole.instead,risk (beta)canbeviewedastheloadingonanecientportfolioinanypricingenvironment.moreover, sincerealoptionleverageappliestounpricedaswellaspricedrisk,alloftherealoptionresultsfor dynamicriskloadingsapplyequallytototalvolatility.thebehavioroftotalvolatilitythusprovides atestofthebasicrealoptionstheorythatisrobusttoanypricingenvironment. 13Toseethis,notethatathighlevelsofdemand,evenwhenarmisnotexplicitlycommittedtocontinueinvesting, itwilloptimallycontinuetodosowithveryhighprobability. risk,whichwilldeclineasinvestmentoccurs.asimilarlinkagebetweenthelikelihoodoffutureinvestmentandrisk Thehighlikelihoodoffutureinvestmentwillelevate ispresentinkogan(2004).inhismodel,rmsfacingcappedinvestmentrateshaveelevatedriskwhenplantsizeis belowoptimal,motivatingahighprobabilityofnear-terminvestment.similaranalogiescanbedrawnwithmodelsof stagedinvestment(see,e.g.,schwartzandmoon,2000;berk,green,andnaik,2004;garlappi,2004;andhackbarth andmorellec,2008). 11

14 2.5 Cross-Sectional Implications Wederiveimplicationforriskandreturndynamicsfromcross-sectionaldispersioninthevalueof thegrowthoptionvg 0t.Formally,dene t2t 0t,andfromequation(7)notethat VG t= V0t ( 1); implyingthatthedecreaseinbetaislargerforlargergrowthoptions.moreover,returnswillbe proportionaltobetasothatthelargerthepricerunup,thelargerthedecreaseinreturnaround theseo. Cross-sectionaltestsofthemodelrequiresimpleempiricalproxiesforgrowthoptionvalue.The followingvariablesarenaturalcandidates. 1. Investment:Priorinvestmentcommitmentdrivesuprisk,andtheactofinvestmentdeleveragesthisrisk. 2. Pre-issuancerunupintherm'sownstockprice:Largerrun-upsareassociatedwithgreater growthoptionleverageandhenceshouldpredictgreaterdeclinesinriskandreturnfollowing anseo. 3. Proceeds: Proceeds relate to I, the size of the initial investment. Hence, greater proceeds shouldimplylargerriskandreturnreductions. 4. Primaryvs.secondaryissuance:Puresecondaryissuesdonotgeneratenewfundsfortherm andhencetheseshouldnotbeassociatedwithunderperformanceorbetadynamics. Weusetheseinstrumentsincross-sectionaltestsofthemodelinSection The Case of Starbucks Toprovideaperspectiveonthedegreetowhichourmodelcapturestheactualinvestmentprocess, consideronerminoursample.starbucksundertookanipoin1992whenithad165stores.on November 8, 1994, the company announced a public SEO of 5.5 million shares. This took place onemonthafterthermannounceddetailedplanstoopen\atleast"200newstoresinscal1995. Since that time the company has not raised funds through an underwritten equity issue though itdoescontinuetoretainearnings,issuestockoptionsandissuesharestoemployees.ithasalso repurchasedsharesonseveraloccasions.atyearend2004thecompanyhadover8,500stores,20 timesthenumberofstoresthatithadaftercompletingitsseo. 12

15 Figure2presentsatimelineofinvestment(changeinnetplant/plant),andofnewequityand debtissues.wealsoplotourestimateofstarbucks'betathroughthisperiod.itcertainlyseems thatstarbucksexercisedagrowthoption,oraseriesofgrowthoptions,andthattherm'sipo andseoswereimportantpartsofthisoptionexercise.butitisalsoclearthatthegrowthoption exerciseandbetadeclinewerenotinstantaneous.starbucksannouncedatimetableandalocation forstoreopeningsjustpriortotheseo,sowecaninferthatitplannedanexpansionthatwouldlast foratleastoneyear.whileitmayhavebeenpossibletostoporscalebacktheseplans,signicant non-sunkcostswouldlikelybeincurred.tosomeextent,then,inadditiontoexercisingoptionsto expandimmediately,rmssimultaneouslyenterintocommitmentsforfurtherexpansion.wealso observethatfollowingitsseo,muchofstarbuckscontinuinginvestmentwasfundedinternallyby operatingcash-ows,andexternallybynon-seoequityissues,asintheassumptionsofourmodel. 3 Behavioral Theory TheleadingbehavioraldescriptionsofSEOunderperformanceincludeDaniel,Hirshleifer,andSubrahmanyam(\DHS",1998)andthewindowsofopportunityandmarkettimingtheoriesofLoughran andritter(1995)andbakerandwurgler(2000).thesemodelsrelyoncognitivebiasesandpersistentmispricingtoexplainseoreturnpatterns. Theintuitionsupportingbehavioralmodelsiscompelling.Researchinpsychologyestablishes thatindividualstendtobeovercondentabouttheirownabilities.researchalsoshowsthatindividualsoverweightevidenceconrmingtheirpriorbeliefs,andunderweightcontradictoryevidence. This is called biased self-attribution. DHS present a rigorous and complete theory of mispricing basedonthesendings.overcondenceismodeledasabeliefthattheprecisionofprivatesignals ishigherthanitactuallyis.biasedself-attributionisintroducedbyassumingthatovercondence increasesafteraninvestorreceivesapublicsignalthatisconsistentwiththeirprivatesignal.asa result,pricesoverreacttoprivatesignals,andfurtheroverreactionoccurswhenconrmatorypublic informationisreleased. DHSalsoderiveimplicationsforeventstudies.Theyallowaninformed,rationalmanagertotake advantageofovervaluedsharesthroughshareissues.aswithprioradverseselectionmodels(e.g., MyersandMajluf,1984),DHSassumethatinvestorsareawareofthemotivesofmanagers.The SEOepisodeascharacterizedbythistheorythusconsistsofthefollowing:SEOsareprecededby investorsreceivingpositiveprivatesignalsandconrmatorypublicsignalsthatcauseoverreaction andinatedstockprices.henceapre-seopricerunupispredicted.managersthensellshares, 13

16 butbecausethisiscontradictorypublicinformation,investorsunderreacttoitduetobiasedselfattribution.pricesthusremainhigherthantheirfundamentalvalueevenafterthepublicissuance decision, and investors then learn slowly about the overvaluation through subsequent private or publicsignals.theprocessoflearningtendstodrivepricesbackdowntotheirfairvalueovertime. Tosummarizethedynamicimplications,behavioralexplanationsofSEOsimplythatreturns willbehaveinawaythatissimilartotheimplicationsofrealoptionstheories:pricesrisethroughthe pre-seostage,seoannouncementsbringanegativeannouncementeect,andpost-seoreturns arelowerthanpre-seoreturns.however,existingbehavioralmodelsdonothaveimplicationsfor riskdynamicsthroughanseoepisode.wenowprovideamodelofriskdynamicsundertemporary mispricingthatllsthisgapintheliterature. 3.1 An Extension of Behavioral Theories to Beta Dynamics Denotethecum-dividendgrossreturnofsecurityiattimetasRit (Pit+dit)=Pi;t 1.Wedecomposedividendsintoasystematiccomponentdtandanidiosyncratic,zero-mean,IIDcomponentit. Assumethatforeachstockithereisatime-independentloadingbiF onthefundamentalsourceof value.dividendscanthusberepresentedasdit=bifdt+it.wedenotethefundamentalvalueof aunitclaimonaggregatedividendsdtbyftanditsassociatedreturnbyrft=(ft+dt)=ft 1.To modelmispricing,weallowstockpricestoalsodependonmarket-wideandstock-specicmispricing: Pit=biFFt+biS(St+uit); wherebisistheloadingonasentimentfactorstanduitisanidiosyncraticcomponentofpricethat mayalsobesubjecttomisvaluation.thefactor St isunrelatedtoanyfundamentalinformation regardingcashowsandhasalong-runmeanofzerobutmaytemporarilydeviate.asaresult,the returnonthisfactorrst=st=st 1ispartiallypredictable. TomakethedistinctionbetweenFt andst concreteconsiderthefollowingexample.letdividendsbedrawnindependentlyeachperiodfromanormaldistributionwithmeandandvariance 2d,andassumeaconstantrequiredrateofreturnr.Thefundamentalfactorthenhasvalue Ft=F =d r forallt.returnstothefundamentalfactoraredrivensolelybystochasticvariationindividends. Tocapturesentiment,let St=eS t 1; 14

17 where S t =S t 1 +St; 0 < 1, S 0, and the innovation t is an independent unit normal random variable. The ideaofafundamentalfactorandameanrevertingpricedeviationiscommonintheliteratureon stock-pricebubbles(e.g.,blanchardandwatson,1982). ForconveniencelettheprocessesF ands beindependent,andassumealargenumbern of individualstockswithindependentandpotentiallymean-revertinguit,topermitthepossibilityof idiosyncraticmispricing,suchthat Ni=1uit=N 0.Wenormalize P Ni=1biF = P Ni=1biS =1.The priceofthemarketatanypointintimeishence PMt=Ft+St andtheassociatedmarketreturnisrmt=(pmt+dt)=pm;t 1.Giventhisformformarketprices andreturns,itisconvenienttorenormalizeindividualsecuritypricesas Pit=biFt+St+uit wherebi=bif=bis isasingleparametersummarizingtheimportanceoffundamentals,withlevels of the parameter bi < 1 indicating a stock is relatively more exposed to sentiment than is the market.notethatthisnormalizationiswithoutlossofgeneralitytothepropertiesofreturnssince bif and bis are assumed to be time independent. Individual stock beta is dened by the ratio i;t 1 Covt 1(Rit;RMt)=Vart 1(RMt). ThefollowingpropositionrelatesstockbetatocurrentlevelsofsentimentSt 1. 2:Thebetaofstock iconditionalonthecurrentlevelofsentimentisgivenby Proposition i;t 1= bi+t 1+t 1+ui;t 1 1=Ft 1 b i2f +2t 1 2S +2t 1 (9) 2S where t 1St 1=Ft 1,2F Vart 1(RFt),and 2SVart 1(RSt). ThisformulaforbetacanbemosteasilyunderstoodbyconsideringthespecialcaseswhereF=S= 1anduit=0.WewishtoconsiderthebetadynamicsofstocksundertakingSEOs,whicharelikely tohaverelativelyhighexposurestosentiment.furthermore,wewouldexpectthisactivitytooccur afterarunupinthemarketpriceduetothefactorst.tofurtheraiddiscussion,therefore,consider 15 2F

18 astockwithbi=0sothatitspricedependsonlyonsentiment.undertheserestrictionsthestock betais i;t 1=t 11+2t 1+ t 1 : This expression can easily be shown to be increasing on t 2 (0;1+ p 2). Beta is zero when market-widemispricingst=0andthenincreasesaspricesreachsomehighlevelwhereseosare undertaken.underthisscenario,equityissuerswouldexhibitarunupinmarketprice,arunupin own-stockprice,andarunupinbeta.followingtheseo,meanreversioninsentimentwillcause marketprices,stockprices,andbetastofallonaverage. Itisinterestingtocomparethesereturndynamicswiththoseofarmwherethemispricing isduesolelytotheidiosyncraticfactoruit>0.stockpricesofsuchrmswouldincreasepriorto SEOs,buttherunupwouldnotbeassociatedwitharunupinthemarket.Inspectionofequation (9)clariesthatthebetasofsuchrmswouldfallratherthanrisepriortoequityissuance.Thus, onlywhenmispricingisdrivenbymarket-widesentimentcanthemodelpredictariseandfallin betaaroundtheseodate. Figure 3 graphically depicts the dynamics of risk due to variation in systematic sentiment, ascapturedbyequation(9).weassumetheidiosyncraticcomponentofpricesui;t 1 iszeroand consider two securities: the \sentiment" stock (bi = 0, solid line), and the \fundamental" stock (bi = 1, dashed line). The sentiment stock beta approaches zero when sentiment St 1 is small relativetofundamentals(t 1 =0).Assentimentincreases,thereturnon St 1 becomesamore importantcomponentofmarketreturns,causingthesentimentstockbetatorise.bycontrast,the fundamentalstockbetaapproachesonewhensentimentislow.anincreaseinsentimentinitially causesthefundamentalstockbetatorisewhensentimentislow.tounderstandthisresult,notethat fundamentalsandsentimentareuncorrelated,andhenceforlowvaluesofsentiment,anincrease insentimentcausesmarketvariancetofall.thisvarianceeectdominatesthereducedcovariance betweenthemarketandpurefundamentalsstockwhent 1islow.Covarianceisthedominating factor for fundamental stock betas when t 1 is large, and betas therefore eventually decline to zero.thetwocurvesdepictedinfigure3provideupperandlowerboundsforthebetaofastock thatisimpactedbybothfundamentalsandsentiment0<bi<1,sincesuchastockcanatany instantbereplicatedasaportfoliocomprisedofthetwostocksinthegure. We conclude that when SEO issuance is driven by overvaluation related to an increase in systematic sentiment, the SEO rm beta is likely to decline after issuance. By contrast, SEO's drivenbyidiosyncraticovervaluationwillnotproducethiseectinthepost-issuancebeta. 16

19 4 Empirical Analysis This section documents the dynamics of risk around SEOs, and relates our ndings to the real optionandbehavioraltheories.werstsummarizethepredictionsofthetwomodelsandexplain ourchoiceofinstruments. 4.1 Predictions of the Real Options and Behavioral Theories Thebehavioralandrealoptionstheoriesbothpredictarunupinreturnspriortoequityissuance, andlowerreturnsfollowingissuance.thetheoriesalsosimilarlypredictthatlargerrunupsshould lead to greater underperformance, in the real options theory due to exercise of a larger growth option,andinthebehavioraltheoryduetogreatermispricing. Thetwoframeworksdiermoreintheirimplicationsforrisk.Inpreviousliterature,thereal optionstheorypredictsarunupinbetapriortoissuance,whereasnopriorbehavioraltheoryof SEOriskdynamicsexists.Thus,withonlypriorresearchframingourinitialapproachtothedata, ourrsthypothesesare: H0:AssetbetaisconstantthroughouttheSEOepisode,andtheonlychangeinequitybetaoccurs atthetimeofissuanceforleveredrms,aspredictedbyhamada(1972). HA: (Standard Real Options): Asset beta increases prior to the SEO due to real option leverage, anddecreasesdiscretelyatthetimeofissuance/investment,remainingconstantafterissuance. ThehypothesisH0 hasbeentheobjectofconsiderablepriorresearchinthenanceliterature,e.g., HealyandPalepu(1990),DenisandKadlec(1994).Ourpaperisthersttodirectlyexaminethe riskimplicationsoftherealoptionstheory. We foreshadow the results of future empirical sections by stating that we nd considerable evidenceofarunupinbetapriortoissuance,assuggestedbytherealoptionstheory,butwealso ndaslow,ratherthaninstantaneous,declineinbetaafterissuance,whichisnotconsistentwith anypriortheory.thisndingmotivatedustodevelopthetheoreticalextensionsoftherealoptions andbehavioraltheoriespresentedinsections2and3. Consideringtherealoptionsandbehavioralmodelsdevelopedinourpaper,bothcangenerate highriskaroundthetimeoftheseo,decliningafterwards.intherealoptionsmodel,riskdeclines astherminvestsandreducesitsfutureinvestmentcommitment,whereasinthebehavioralmodel, marketbetatendstodeclineafterissuancebecauseofmean-reversioninasystematicsentiment 17

20 factor. Hence, a sharp distinction between the theories relates to instruments that predict the magnitudeofbetachangesaroundissuance: 1. Investment:Intherealoptionstheory,priorinvestmentcommitmentdrivesuprisk,andthe actofinvestmentdeleveragesthisrisk. 2. Pre-issuancerunupintherm'sownstockprice:Inthereal-optionstheory,largerrun-upsare associatedwithgreatergrowthoptionleverage,andthesourceoftherun-up(systematicvs. idiosyncratic)doesnotaltergrowthoptionorinvestmentcommitmentleverage.bycontrast, inthebehavioraltheoryidiosyncraticovervaluationdoesnotleadtoanincreaseinmarket betas. 3. Sentiment:Inthebehavioraltheory,themarketbetaofanissuerrisesandthenfallsifthe rmisovervaluedbecauseofanincreaseinsystematicmispricing. 4. Proceeds: In the real options theory, proceeds relate to the size of the initial investment. Hence,greaterproceedsshouldimplylargerriskandreturnreductions. 5. Primaryvs.secondaryissuance:puresecondaryissuesdonotgeneratenewfundsfortherm andhenceintherealoptionstheorytheseshouldnotbeassociatedwithunderperformance orbetadynamics.bycontrastinmanybehavioraltheories,e.g.,dhs,insidersareassumed totakeadvantageoftemporarymisvaluationswhichcouldoccurthroughsecondaryissuances aswellasprimaryissuances. Theseadditionalpredictionsprovideguidanceforourempiricalinvestigationbeyondtheformal statementsinhypothesesh0 andha,andthefollowinghypothesissummarizestheimplications oftheextendedtheories: HA1:(ExtendedRealOptionsandBehavioralTheories):Assetbetamayincreasepriortoissuance anddeclinegraduallythereaftereitherduetoexerciseofagrowthoptionwithcommitment-to-invest (RealOptions)orwhentimingsystematicsentiment(Behavioral). 4.2 SEO Data and Average Returns WeconstructoursamplefromtheSDCNewIssuesdatabasecommonstockissuestradedonNYSE, AMEX,orNasdaqbyU.S.companies,andnotcodedasIPO's,unitissues,ADR'sorADS's.14We 14OurunitofobservationisanequityissueandwetreatrmsthatundertakeanSEOmorethanonceasseparate observations. 18

21 includeissuancesoccurringafterjanuary1,1980,whenlargescalecoverageofcorporatenewson Lexis/NexisandFactiva(\newssources")becomesavailable,andbeforeDecember31,2005,which permitsthatthreeyearsofpost-seoreturnsmaybeavailable.wealsoapplythefollowingscreens, detailedintheappendix: AuniquematchingCRSPPERMNOfortherelevantdatecanbeidentiedusingtheSDCi) CUSIP,ii)TickerSymbol,oriii)CompanyName. TheCRSPexchangecodeisNYSE,AMEX,orNASDAQontheissuancedate. TheCRSPsharecodeis10or11,indicatingthattheissuanceiscommonstock. A valid announcement date for the issuance is available, identied as the earlier of i) the SDC-reportedlingdate,orii)theearliestnewsreportornewswirementioningtheissue, obtainedbysearchingthenewssources. Validdataforcomputingmarketcapitalization(\size")andbook-to-marketequity(\B/M") oftheissuerisavailablefromcrspandcompustat,asoftwodayspriortotheannouncementdate. TheCRSPindustrycodeonthedateofissuanceisnotautility(SIC=49XX)ornancial (SIC=6XXX). Atleast63validdailyreturnsareavailableonCRSPinthe252tradingdayspriortoannouncementoftheSEO. Thenalsamplesatisfyingthesecriteriaconsistsof5,740uniqueseasonedequityissues. FromtheSDCdata,werecordthesizeoftheissuanceindollars(\proceeds"),thedollarvalue of the issuance raised directly by the rm (\primary"), and the dollar value of sales by other shareholders(\secondary").thedistinctionbetweenprimaryandsecondaryisusefulbecausethe realoptionstheoryisnaturallyassociatedwithprimaryissuance,whereasbehavioraltheorycould applytoeitherprimaryorsecondaryissues. WefurthercategorizeSEO'sthathavesomeprimaryproceedsbytherm'sstateduse-of-funds ontheannouncementdate.wefocusonpubliccommunicationsthroughtraditionalmediaoutlets, searching the business news wire and major newspaper segments of our news sources. To link withthesdcnewissuesdatabase,wesearchedthenewssourcesinaoneyearwindowcentered aroundtheissuancedateforacombinationofthecompanynameandanyofthekeywords\stock", 19

22 \equity",or\issue".allreturneddocumentswerethenmanuallyscannedforinformationregarding 1) The rst announcement date of the issuance, and 2) the stated use-of-funds. Any potentially usefulportionsofthenewsreleaseswererecordedintoadatabase. WerstusethisnewdatatorenetheSDCannouncementdateoftheissuanceasdescribed previously.second,wecreateanewdataitemforthestateduseoffunds.togeneratethisvariable, wedenedthefollowingsixcategoriesandassociatedkeywords(initalics): CapitalInvestment(INV):research,expan,propert,expenditure,construction,develop,build, equip; Acquisition(ACQ):merge,acqui; WorkingCapital(WC):working,inventory,receivable; GeneralCorporatePurposes(GCP):generalcorporatepurpose; Debt(D):debt,loan,credit,bank,repay,note,bond,borrow,debenture,redeem; NoInformation(NI):noneoftheabove. Observationsmaybelongtomorethanonecategory. Table1providesabriefsummaryofthesample.Themajorityofthe5,740issueshavesome componentoftheissuanceprimary,with1,073puresecondaryissues.oftheprimaryissues,substantialnumbersfallintoeachoftheuse-of-fundscategories.theaveragemarketequitydecileof theoverallsample(4.2)indicatesthatthermsareslightlysmallerthanthemediannyserm, withpuresecondaryissuesnotablylarger(5.9)thanissuescontainingaprimaryportion.theaverageb/mdecile(3.5)indicatesthatissuersaregrowthrms,withpuresecondaryissuersslightly morevalue-oriented(4.0).themeanratioofprimaryissuancetototalissuanceis0.71fortheentire sample,andtheaverageissuanceisapproximately21%ofpre-issuancemarketcapitalization.pure secondaryissuestendtobeasmallerfractionofoutstandingequity(12%)thantheoverallsample. characteristics.15 WefollowcommonpracticeandobtainmatchesforoursamplermsbasedonsizeandB/M Specically, for each seasoned issuer we identify the PERMNO on CRSP that belongstothesameb/mdecileastheissuer,hasnotissuedequityinthepreviousveyears,and 15TomeasuretheB/MratiowerstobtainthebookvalueofequityfollowingBrav,Geczy,andGompers(2000) usingthequarterlycompustatlingtwoquarterspriortotheannouncementdate.ifthisquarterlylingisnot available,weinsteadobtainthebookvalueofequityfromtheannualling,followingtheprocedureofdavis,fama andfrench(2000).wedividethebookvaluebythemarketvalueofequityontherecordedbook-valuedate.our marketvalueofequity(me)isobtainedtwodayspriortotheannouncementdate.weassignmeandb/mtodeciles bynysebreakpointsonthedaythatthevariablesaredened. 20

23 istheclosestsizematchsatisfyingthesecriteria.anymissingdatainthematchreturnseriesis replacedwithreturnsfromthenextbestmatch,iteratively,untilacompleteseriesofvalidmatch returnsisachieved.finally,ifthesamplermhasanymissingreturns,theinvaliddataarereplaced withdatafromthematchseries,whichisguaranteedtobecomplete. Table2presentsaveragereturnsaroundtheSEOdate.Wemeasureannouncementeectsusing threedierentdates.ourbaselinechoiceofannouncementdateistheearlierofthei)lingdate recordedbysdc,andii)theearliestdatefromoursearchofnewssources(the\wiredate").the wiredateisavailablefor3,966rmsandprovidesanearlierannouncementdatethansdcfor493 rms. Using the earliest date gives an announcement eect for the entire sample of -2.00% in a three-daywindowcenteredontheannouncementdate.usingonlythesdcdate,whichisavailable foralmostallofoursamplerms(5,717of5,740)givesalessnegativeannouncementeectinthe entiresample(-1.89%),indicatingthatreningtheannouncementdatesusingthehand-collected newsdataprovideseconomicallyrelevantinformation.mostoftheimpactofusingthewiredateis concentratedintheearlysubsample,forexampleduring wheretheannouncementeect usingtheearliestdateis-2.05%,relativeto-1.70%usingthesdcdate.byuse-of-fundscategory, puresecondaryissuanceshavethesmallestannouncementeects(-1.70%),andthelargestisfor generalcorporatepurposes(-2.20%).16theaverageone-yearrunuppriortoannouncementislarge inthefullsample(106%),andparticularlypronouncedinthe subsample(144%).the returnsofsizeandbook-to-marketmatchesarealsohighinthepre-announcementwindow(48%), althoughnotaslargeasfortheissuers. Thepost-issuanceunderperformanceinoursampleisconsistentwiththepriorliterature.The averagethree-yearbuy-and-holdreturnofissuersis10%lowerthanforsizeandbook-to-market matches(28.6%vs.38.6%). Consistentwiththepriorliterature(e.g.,Eckbo,Masulis,andNorli, 2000;Brav,GezcyandGompers,2000),theunderperformancewhencontrollingforbothsizeand book-to-marketissmallerthandocumentedbyloughranandritter(1995),whocontrolforsize only.theunderperformanceissimilaracrosssubperiods,withthenotableexceptionof issues,whichperformmuchworserelativetomatches(3.1%vs.21.2%)and ,whereunderperformanceisnegligible(35.7%vs.35.8%).byuse-of-funds(panelc),thethree-yearpost-issuance buy-and-holdreturnsarelowestfortheinvestmentcategory(13.8%).thethree-yearunderperformancerelativetomatchesisinterestinglylargestfortheno-informationcategory(18%),acquirers 16Forcomparison,HeronandLie(2004)reportameanthree-dayabnormalreturnfor3658SEOswithsome primaryproceedsofabout-2.5%duringa samplingperiodthatiscontainedinours.ourndingofalower announcementeectforpuresecondaryoeringsthanmixedorpureprimaryoeringsisalsoconsistentwiththeir results. 21

24 (15%),andrmsissuingtoinvest(13%).17 Thegroupofpuresecondaryissuers(PS)doesnotunderperformatanyinvestmenthorizon, consistent with the ndings of Lee (1997). Pure secondary issuances are often used to sell the sharesofinsiders,hencethelackofunderperformanceinthiscategoryindicatesthatinsidersdo not on average use this process to sell overvalued equity. The real options theory predicts no underperformanceforpuresecondaryissues,consistentwiththisempiricalresult. As in Loughran and Ritter (1995), for the rst six months after the SEO, the sample rms outperformthematchesbyasubstantialmargin(8.1%to4.0%),andthisresultisrobustacross alltimeanduse-of-fundssubsampleswiththeexceptionof afteroneyear,thereturns areclosertothematcheswiththeseormsstilloutperforming(11.2%vs.9.3%).themeasured underperformanceseemsstrongestthreeyearsafterissuance,anddoesnotincreasesubstantially overyears3-5fortheoverallsample.combiningthissetoffacts,mostoftheseounderperformance takesplacebetweensixmonthsandthreeyearsaftertheissuancedate. Table3showsinvestment,capitalstructure,andworkingcapitaldynamicsaroundtheseasoned equityissue.consistentwiththepriorliterature,seormsinvestheavilyrelativetosizeandbookto-marketmatches.theirlevelofexcessinvestmentishighestinthethree-yearwindowsurrounding theseo,anddeclinessteadilythereafter.thelevelofexcessinvestmentisbyfarhighestforthe use-of-fundsgroupinv(18.2%theyearafterissuancerelativeto11.1%formatches),followedby ACQ,GCP,NI,andWC.Bycontrast,thepuresecondaryissuersinvestlessthantheirmatches (9.5%vs.10.2%). Thelong-termdebt/bookassetsratioisrelativelystableforSEOrmspriortoissuance,drops intheyearofissuance,andincreasesthereafter.relativetomatches,seormshavehigherbook leveragepriortoissuance,withthedierenceespeciallylargeforthedebtsubgroup.thedierence relativetomatchesdropssubstantiallyintheissuanceyearandthenincreases. Theratioofcurrentassetstocurrentliabilitiesisstableatabout2.05forallSEOrmsinthe threeyearspriortoissuance,increasesto2.30intheyearofissuance,andthendeclinessteadily to2.09threeyearsafterissuance.short-termliquidityishighestforthesubgroupsinv,wc,and GCP and lowest for DEBT and pure secondary issuers. The dierences relative to matches are largestforinv,wc,andgcpintheyearofissuance,anddeclinethereafter. 17Theve-yearunderperformanceisremarkablystrong(34.3%)forthe\noinformation"categoryofrmsthatdo nothaveastatementinoursearchofpublicnewssourcesabouttheuseofissuanceproceeds,andhaveissuedsome primaryshares. 22