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Secondary Stock Market Liquidity and the Cost of Issuing Seasoned Equity – European Evidence

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Secondary Stock Market Liquidity and the Cost of Issuing Seasoned Equity – European Evidence Secondary Stock Market Liquidity and the Cost of Issuing Seasoned Equity – European evidence Finance Master’s thesis Pages: 117 (257,556 characters) Kristian D. Bundgaard MSc. in Finance and Accounting Jonas Ahm MSc. in Applied Economics and Finance August 20212 Advisor Lasse Heje Pedersen Professor at the Department of Finance at Copenhagen Business School & The John A. Paulson Professor of Finance and Alternative Investments at the NYU Stern School of Business Department of Finance Handelshøjskolen København Copenhagen Business School Executive summary This thesis finds that secondary market liquidity is an important and significant predictor of the combined cost of issuing seasoned equity. Firms with more liquid shares are on average able to issue new equity at lower costs than their less liquid counterparts. This relation is interpreted as economically meaningful and important. The intricate and multifaceted concept of market liquidity is explained and discussed along with the wide variety of measures in existence to capture and quantify it. The total costs of a seasoned equity offering (SEO) are argued to consist of direct and indirect costs. The direct cost refers primarily to the gross fees paid to the investment bank which, along the lines of Butler et al. (2005), are argued to be significantly related to the secondary market liquidity of the issuing firm. This insight is confirmed in an empirical analysis of a sample of 145 European SEOs. The analysis finds that gross fees are significantly lower for more liquid issuers, controlling for confounding effects. The indirect costs of an SEO largely derive from the well documented SEO discount. This discount has historically been explained with adverse selection stemming from asymmetric information. Empirically the SEO discount has been found to be positively related to firm risk, as well as the relative size of the offering. These insights are consistently confirmed in this study. Controlling for these and other relevant variables, in the small as well as the large sample (consisting of 2,065 SEOs), the SEO discount is found consistently and significantly negatively related to the secondary market liquidity of the issuing firm. This effect is closely related to the insight of Amihud and Mendelson (1986) that illiquidity is priced in the market, which leads illiquid assets to trade at a discount. Finally, it is argued that neither direct nor indirect costs should be viewed in isolation when analyzing the decision to issue equity. Rather it is the combined cost that an owner of a firm will incur if he does not subscribe to the issuance on a pro rata basis. These total costs are found to be significantly related to the secondary market liquidity of the issuing firm in an economically important way. Together these findings suggest that secondary market liquidity is a significant and important predictor of the combined cost of issuing seasoned equity and that firms should have a great interest in the market liquidity of their shares, as this may substantially affect the costs at which they can obtain additional equity. Contents 1 Introduction .............................................................................................................................. 1 1.1 Problem statement ......................................................................................................... 3 1.2 General methodology .................................................................................................... 4 2 Why liquidity matters ............................................................................................................... 5 2.1 A brief history of asset pricing theory ........................................................................... 6 3 Liquidity ................................................................................................................................. 14 3.1 Introduction ................................................................................................................. 14 3.2 Grouping of liquidity measures ................................................................................... 17 3.2.1 Backward versus forward looking liquidity measures ............................................ 17 3.2.2 High-frequency versus low-frequency liquidity measures ...................................... 18 3.2.3 Percent-cost measures versus cost per-volume ....................................................... 18 3.2.4 One-dimensional versus multi-dimensional measures ............................................ 19 3.3 Liquidity measures ...................................................................................................... 19 3.3.1 One-dimensional liquidity measures ....................................................................... 20 3.3.2 Multi-dimensional liquidity measures ..................................................................... 25 3.3.3 Other measures of liquidity ..................................................................................... 31 3.4 Liquidity index ............................................................................................................ 34 3.4.1 Data availability for liquidity measures................................................................... 34 3.4.2 Measures included in the liquidity index ................................................................. 34 3.4.3 Liquidity index description...................................................................................... 35 4 Seasoned equity offerings ...................................................................................................... 36 4.1 What is a seasoned equity offering.............................................................................. 36 4.1.1 Seasoned public offerings........................................................................................ 38 4.1.2 Rights offers ............................................................................................................ 40 4.2 The process of a seasoned equity offering .................................................................. 44 4.2.1 The role of the investment bank .............................................................................. 44 4.3 Flotation methods for a seasoned equity offering ....................................................... 46 4.3.1 Fully marketed offerings ......................................................................................... 47 4.3.2 Accelerated offerings............................................................................................... 48 4.3.3 Accelerated bookbuilt offerings .............................................................................. 48 4.3.4 Bought deal .............................................................................................................. 49 4.3.5 Other flotation methods ........................................................................................... 49 5 The direct cost of issuing equity – the Gross fee ................................................................... 50 5.1 Empirical findings of the Gross fee ............................................................................. 50 6 The indirect cost of issuing equity – the SEO discount ......................................................... 55 6.1 Introduction ................................................................................................................. 55 6.2 Capital structure theory – a brief overview ................................................................. 56 6.2.1 Modigliani and Miller.............................................................................................. 56 6.2.2 The Static Trade Off Theory of Capital Structure ................................................... 57 6.2.3 The Pecking Order Theory ...................................................................................... 57 6.3 Theoretical foundation of the SEO discount ............................................................... 58 6.4 Empirical findings of the SEO discount ...................................................................... 62 6.5 A relation between the SEO discount and market liquidity ........................................ 66 7 Data ........................................................................................................................................ 69 7.2 Summary statistics of small dataset............................................................................. 74 7.3 Summary statistics of large dataset ............................................................................. 76 7.4 Comparison of small and large dataset........................................................................ 78 7.5 Econometric methodology .......................................................................................... 79 8 Results – direct and indirect cost ........................................................................................... 80 8.1 Empirical analysis of the Gross fee – small sample .................................................... 80 8.1.1 Univariate results – Gross fee .................................................................................. 81 8.1.2 Multivariate results – Gross fee ............................................................................... 86 8.2 Empirical analysis of the SEO discount – small sample ............................................. 90
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