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Credit Ratings and the Cost of Issuing Seasoned Equity† Garrett A

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Credit Ratings and the Cost of Issuing Seasoned Equity† Garrett A Credit Ratings and the Cost of Issuing Seasoned Equity† Garrett A. McBrayer* Abstract This study examines the effects of issuer credit ratings on the underwriting costs incurred in seasoned equity offerings (SEOs). The evidence from a panel of common stock SEOs from 1990-2014 shows that when firms issue seasoned equity, those with issuer credit ratings pay significantly reduced investment banking fees. Recognizing the potential endogeneity, I confirm these results by conducting a matched sample analysis of firms who obtain new, long-term issuer credit ratings to an unrated control group. Controlling for factors identified in prior literature as determinants of SEO issuance and of SEO fees, I find that firms who obtain a new credit rating are more likely to issue seasoned equity and pay reduced investment banking fees in doing so. The findings suggest that firms can reduce their costs to issuing equity by actively seeking to mitigate issues of value uncertainty prior to a seasoned equity offering, i.e., obtaining a credit rating prior to initiating a SEO. JEL Classification: D82, G14, G24 Keywords: credit ratings, seasoned equity offerings, information asymmetry Draft Version: May 2017 v5.5 †I am grateful for the invaluable comments and suggestions of Josh Filzen, Wayne Lee, Alexey Malakhov, Tim Yeager, Pu Liu, as well as to the seminar participants at the University of Arkansas and Boise State University. *Assistant Professor of Finance, College of Business and Economics, Boise State University, Boise, ID 83725. [email protected]. Credit Ratings and the Costs of Issuing Seasoned Equity 1. Introduction Information asymmetries pertaining to the valuation of a firm’s assets have direct effects on the risks inherent in investing in the firm’s financial claims. In secondary equity markets, the adverse selection costs associated with an investment in a firm’s equity are a positive function of information asymmetry (Benston and Hagerman, 1974; Kyle, 1985; Glosten and Harris, 1988; Stoll, 1989; Huang and Stoll, 1997; Lin, Sanger, and Booth, 1995; among others). Investors account for the potential losses faced when trading with an information-motivated trader. In primary markets, the observed underpricing of initial public offerings (IPOs) has been attributed, in part, to information asymmetry. Rock (1986) argues that the observed underpricing results from a winner’s curse problem where information heterogeneity induces informed investors to bid on only the best IPOs leaving less-informed investors with only the overpriced issues. Habib and Ljungqvist (2001) show that issuing firms take costly action to reduce information asymmetry prior to IPO issuance, e.g., hiring a reputable, more expensive underwriter for their certification ability. Mechanisms which ameliorate the adverse selection costs of equity issuance serve to improve the efficiency of primary equity markets. In this paper I explore one such mechanism, specifically the presence of an issuer credit rating. Credit rating agencies play critical roles in alleviating the information asymmetries that exist between borrowers and lenders and in apportioning risks in financial markets. In debt markets, firms who obtain credit ratings from Standard and Poor’s and/or Moody’s have increased leverage (Faulkender and Petersen, 2006), are able raise more funds in syndicated debt financing (Sufi, 2009), and suffer less from underinvestment due to capital constraints (Harford and Uysal, 2014). What is it, then, that makes credit ratings a mechanism for a reduction in information asymmetry? Boot, Milbourn, and Schmeits (2006) argue that credit ratings serve as a coordinating mechanism. The 1 threat of adverse rating changes motivates firms to take corrective actions. Thus, in the model of Boot et al. (2006), this threat leads to homogeneity in investor beliefs. The literature on the role of credit ratings in debt markets is well developed. As for the role of credit ratings in equity issuances, An and Chan (2008) find that credit rated firms exhibit reduced underpricing at IPO relative to unrated issuers. When they examine credit rating levels, i.e., the rating obtained by the firm, they do not find an association between the level obtained and IPO underpricing. An and Chan (2008) conclude that the credit rating itself conveys useful information in reducing value uncertainty of the issuing firm, i.e., credit ratings serve to reduce information asymmetry. One methodological challenge recognized in An and Chan (2008) is the potential problem of endogeneity. For example, a firm would choose to become rated when the benefits to doing so, such as reduced equity issue costs, outweigh the costs of the rating. As such, the decision to become credit rated is endogenous to the decision to issue equity. In this study, I examine the SEO underwriting costs for credit rated firms relative to their unrated contemporaries. Using a sample of U.S. common share SEOs from 1990-2014, I document two main results. First, I advance the literature exploring the investment banking fees associated with issuing seasoned equity. I find that the fees paid by credit rated firms are significantly reduced relative to their unrated contemporaries. The presence of a credit rating mitigates the issues of information asymmetry thus lessening the value uncertainty regarding the issuing firm’s assets resulting in a reduction of the fees charged by the underwriting investment bank. This finding contributes to the results of An and Chan (2008) as it provides evidence that credit ratings reduce value uncertainty for firms who are, relatively speaking, better known to financial markets. The reduction in SEO underwriting fees for rated firms suggests that the benefits to rated firms when issuing equity extend beyond the IPO. 2 Secondly, I address the potential endogeneity problem noted in An and Chan (2008) by examining the differential effects that becoming credit rated imparts on the SEO activity and underwriting costs of issuing firms. The decision to become credit rated and the decision to issue seasoned equity may be endogenous to each other when firm characteristics affecting SEO behavior also affect the decision to be rated. To alleviate this concern, I employ a propensity-score, matched- sample approach wherein I identify previously unrated firms who obtain a credit rating and compare their SEO activity and characteristics to an unrated, propensity-score matched control group. Using a unique dataset from Bloomberg Data Services, I identify 738 instances of credit rating initiations (i.e, instances where a previously unrated firm obtains a Standard and Poor’s long-term issuer credit rating) over the period 1990-2014. Credit rating initiation firms are matched to an unrated, propensity matched control group following the methodology of Faulkender and Petersen (2006). I then examine the SEO activity of the matched-sample exploring both the likelihood that a firm issue an SEO and their costs to doing so. Controlling for the factors identified in prior literature as determinants of SEO issuance, I find a 12.47 percentage point increase in the likelihood of SEO issuance for credit rating initiation firms. Additionally, I document a reduction in the investment bank fees paid by newly rated firms who choose to issue seasoned equity. Obtaining a credit rating prior to an SEO issue is associated with an economically significant reduction of between 4.88% and 8.12% in the gross fees charged by the underwriting investment bank. The results suggest that the adverse selection costs faced by a firm for issuing seasoned equity are not wholly exogenous to the firm. Improving the information environment in which the firm’s secondary market equity trades mitigates the costs associated with add-on equity issues. Specifically, obtaining a credit rating prior to the issuance of seasoned equity reduces value uncertainties and information asymmetries thus leading to a reduction in underwriting fees. The findings provide support to prior literature documenting the economic importance of credit ratings. 3 The identification, certification, and validation that occur with an existing, or new, credit rating seems to affect the information environment with which the rated firm’s equity trades. Credit ratings serve to mitigate problems of uncertainty regarding asset valuations enabling less-costly placements of seasoned equity issues. The remaining sections of this paper are organized as follows. Section 2 reviews the related literature and develops the concept. Section 3 discusses the sample used in the panel analysis and provides evidence on the relation between credit ratings and SEO costs. The results of the examination of the association between the credit rating initiations and firm SEO characteristics are provided in Section 4. Section 5 concludes. 2. Related Literature and Concept Development The purpose of this study is to examine the impacts of credit ratings on the costs associated with SEO issuance. More precisely, I test the relation between credit ratings and the underwriting fees charged by the associated investment bank(s). As such, this paper relates two strands of literature. The first examines the effects of credit ratings on information asymmetry. And the second, the primary market costs associated with the issuance of equity. 2.1 Credit Ratings and Information Asymmetry Prior literature suggests that credit ratings convey information beyond that which is incorporated in the observed prices of financial claims. Credit ratings and credit rating changes inform markets as to the economic prospects of the rated firm (Holthausen and Leftwich, 1986; Ederington and Goh, 1998; Dichev and Piotroski, 2001). Norden and Weber (2004) show that credit default swap (CDS) and equity markets respond to the news of rating downgrades or reviews for downgrade as the news reveals private information to markets. Information asymmetry is reduced when the assessment and monitoring expertise of credit rating is engaged (Boot et al., 2006; Odders- White and Ready, 2006; He, Wang, and Wei, 2010). Odders-White and Ready (2006) document 4 improved secondary market liquidity for higher credit quality firms.
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