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Seasoned Equity Offerings and Agency Problems: Evidence from a Quasi-Natural Experiment in China

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Seasoned Equity Offerings and Agency Problems: Evidence from a Quasi-Natural Experiment in China Seasoned Equity Offerings and Agency Problems: Evidence from a Quasi-Natural Experiment in China E. Han Kim, Heuijung Kim, Yuan Li, Yao Lu, and Xinzheng Shi† Abstract We find that agency problems become more severe following seasoned equity offerings. We examine publicly-listed Chinese firms over the period 2000 to 2012, which contains exogenous regulatory shocks on the eligibility of SEOs. The data reveal that during the year of SEO and the following year, overinvestments increase, acquisitions yield lower shareholder returns, director and officer compensation increases with lower sensitivity to performance, and tunneling increases. Cross-sectional differences in SEO announcement returns suggest that investors partially anticipate some of the post-SEO changes. The agency costs stemming from SEOs are negatively related to ownership concentration and growth opportunities, but are unrelated to higher percentage of independent directors on the board or to closer monitoring by regulators. This Draft: April 19, 2015 Keywords: Equity Issuance, Agency Problems, Corporate Investment, Managerial Compensation, Tunneling. JEL Classifications: G32 G34 †E. Han Kim is Everett E. Berg Professor of Finance at the University of Michigan, Ross School of Business, Ann Arbor, Michigan 48109: [email protected]. Heuijung Kim is a doctoral candidate at Sungkyunkwan University, SKK Business School, Seoul, Korea: [email protected]. Yuan Li is a graduate student at University of South California, US: [email protected]. Yao Lu is Associate Professor of Finance at Tsinghua University School of Economics and Management, Beijing, China: [email protected]. Xinzheng Shi is Associate Professor of Economics at Tsinghua University School of Economics and Management, Beijing, China: [email protected]. We are grateful for helpful comments and suggestions by Hongbin Li, Chen Lin and Gordon Philips and seminar participants at Tsinghua University, Sungkyunkwan University, and participants at 2014 China Finance Review International Conference, 2014 China Finance and Accounting Conference, the 2014 Conference on Asia- Pacific Financial Markets, 2014 World Banking and Finance Symposium, Singapore, the 2nd IFMA International Conference on Finance, 2014 Corporate Governance Conference at Renmin University, and 2014 Finance Conference at University of International Business and Economics. This project received generous financial support from Mitsui Life Financial Research Center at the University of Michigan. Yao Lu acknowledges support from Project 71202020 of National Natural Science Foundation of China. 1 I. INTRODUCTION Seasoned equity offerings are an important source of external financing, bringing in a large amount of potential free cash flows. Relying on Jensen‘s (1986) hypothesis that free cash exacerbates agency problems, Jung, Kim, and Stulz (1996) argue that investors‘ concern with unproductive use of SEO proceeds is an important reason for the well- documented negative stock market reaction to the announcement of SEOs. They provide evidence of less negative market reaction to SEO announcements by firms with higher market to book ratios, arguing high growth firms are less likely to waste newly raised funds. Kim and Purnanandam (2014) go a step farther: They argue that misuse of SEO proceeds is due to weak governance, providing evidence that the previously documented negative investor reactions to the announcement of primary SEOs are limited to firms with weak governance.1 Although this link between SEO announcement returns and agency problems is informative, there is little direct evidence on how firms‘ real activities and agency costs are jointly affected by SEOs, leaving several questions unanswered. Are SEO proceeds indeed used less productively? If so, what are the specific channels through which shareholder value gets damaged? What can be done to reduce the damages? We investigate these issues by examining how SEOs affect corporate investments, managerial compensation, and tunneling. We also relate the post-SEO changes in these variables to stock market reaction at the time of SEO announcement. We focus on 1 Primary offerings are distinct from secondary offerings. Proceeds of shares sold through primary offerings go to the firm, making them susceptible to misuse by the management. Secondary offerings, by contrast, are sales of shares owned by corporate insiders and block-holders, so the proceeds do not go to the firm. Kim and Purnanandam (2014) show that investors react negatively to the announcement of secondary offerings because of the negative signal transmitted by better informed investors (Leland and Pyle, 1977). They also show that the market does not react negatively to the announcement of primary offerings unless the issuer has weak governance. Their evidence is based on difference-in-differences in the market reaction to an external shock weakening corporate governance. 2 investments, managerial compensation, and tunneling because they are discretionary and susceptible to managerial self-serving behavior. Our investigation is based on Chinese SEOs. The main motivation for studying the Chinese case is endogeneity issues in the choice of SEOs. The decision to issue an SEO is associated with a number of firm level factors such as internal funds, debt issuance, the market-to-book ratio, stock returns, and firm age and size (Alti and Sulaeman, 2012; Baker and Wurgler, 2002; Jung et al., 1996; DeAngelo et al., 2010; Hovakimian, Opler, and Titman, 2001), as well as other unaccounted time varying factors affecting corporate activities and performance. These factors cannot be controlled by firm fixed effects. China's Securities Regulatory Commission (CSRC) enacted two regulations that became effective in 2006 and 2008, each imposing greater restrictions and higher standards on the eligibility to issue SEOs. These regulatory changes provide exogenous shocks that can be used to construct instruments to study causal effects. In addition, China is the world‘s second largest economy attracting much attention from practitioners and scholars in recent years. SEOs in China have grown over time, making them one of the main sources of external financing. Chinese firms rely more heavily on SEOs relative to US firms. Over the period 2010 through 2012, for example, the ratio of capital raised through SEOs by non-financial Chinese firms to their market capitalization was about 2.18%; the same ratio for US counterparts was about 0.6%. (Source: http://data.worldbank.org and SDC) China has relatively weak corporate governance and legal system (e.g., Allen, Qian and Qian, 2003, Aharony, Lee and Wong, 2000), providing more latitude for managers and controlling shareholders to derive private benefits of control. Hence, agency problems associated with SEOs, if any, would be more noticeable in China. The 3 type of SEOs available and the underwriting practices in China follow the international standard, which allows generalization of findings based on Chinese SEOs. Finally, in contrast to SEOs in the US, secondary offerings—sales of shares held by insiders and block holders—are virtually non-existent in China. 2 Proceeds of secondary offerings do not go to the firm; hence, the proceeds are not subject to managerial discretion or self-serving. But they transmit negative signals from better informed insiders and block holders, causing negative investor reaction (Leland and Pyle, 1977). Hence, studying Chinese SEOs helps avoid confounding effects associated with secondary offerings that are unrelated to agency costs. We define the year of an SEO and the year after as SEO years. We observe more over-investments during SEO years relative to non-SEO years. Corporate acquisitions also yield substantially lower shareholder value. In addition, D&O (director and officer) compensation increases with lower pay for performance sensitivity. An illegal and yet pervasive form of private benefits in emerging Asian economies is tunneling by controlling shareholders and managers (Johnson, La Porta, and Lopez-de-Silanes, 2000; Bertrand, Mehta, and Mullainathan, 2002; Lemmon and Lin, 2003). Obviously those engaged in tunneling have every incentive to hide it; hence, it is difficult to accurately quantify the magnitude. However, money has to change hands in tunneling SEO proceeds, and for financial reporting, the funds siphoned off have to be hidden in the balance sheet under asset accounts that appear less culpable. Our private, 2 There were three mixed offerings containing secondary offerings of state-owned shares during June 2001 and October 2001 when China Securities Regulatory Commission (CSRC) required that if a firm plans to issue N new shares through an underwritten offering and the firm has state-owned shares (which were non- tradable at the time), then the offering must contain 10% of N state-owned shares. This means the firm will issue 1.1N shares in total, with 0.1N shares being state-owned shares. Such secondary offerings of state- owned shares are unlikely to transmit the type of negative signals associated with secondary offerings in the US. The regulation was effective for only four months, and only three SEO cases were completed during that time. 4 confidential conversations with top Chinese executives and other informed sources suggest that the siphoned funds usually end up with debit to account receivables or prepaid expenses. If they are debited to accounts receivable, our sources say, the accounts receivable soon become uncollectable. Thus, we employ
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