Cross‐Country Variability in Cost of Raising Equity: Evidence from Seasoned Equity Offerings

• Author: Puneet Prakash,Nanda K. Rangan,Manu Gupta
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/irfi.12201
• Published date: 01 December 2019

Cross-Country Variability in Cost of

Raising Equity: Evidence from

Seasoned Equity Offerings

MANU GUPTA

†

,PUNEET PRAKASH

‡

AND NANDA K. RANGAN

†

†

Finance Insurance and Real Estate, Virginia Commonwealth University, Richmond,

VA and

‡

Finance and General Business, Missouri State University, Springfield, MO

ABSTRACT

We examine how county-level governance affects the cost of raising equity.

Using data on seasoned equity offerings, we find that the underwriting

spread is determined by the litigation risk of issue certifiers, and offer under-

pricing is largely determined by the investment risk of the equity issue.

Underwriting spread increases with enhanced legal enforcement, offsetting

the reduction in underpricing associated with strong legal enforcement. Our

study offers insight into the effect of legal enforcement and regulatory policy

on the cost of raising equity.

Accepted: 8 May 2018

I. INTRODUCTION

The link between country-level corporate governance (legal systems) and the

development of financial markets is well established in the law and finance

literature—yet the cost of raising equity capital across nations has received little

attention.

1

Seasoned equity offerings (SEOs), a significant proportion of the

total equity raised by corporations,

2

clearly have noteworthy implications for

firms’cost of capital, and as a consequence, strongly influence firms’compe-

tiveness in product markets that are essentially global in nature. We examine

how country-level governance affects the cost of raising equity capital

through SEOs.

The two major cost components of raising SEOs that we examine are the

offer underpricing (percentage change in a security’s price from offer price to closing

price on the first day after offer) and the underwriting spread (difference between

the price paid by underwriters and the offer price). Within the context of our exami-

nation, we define investment risk as the risk of loss to investors participating in the

1 See Gupta et al. (2011, 2013) for a review of this literature.

2 Kim and Weisbach (2008) report that across the world, a little more than $1 trillion was

raised though SEOs between 1990 and 2003, and $620 billion through IPOs during the same

period.

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 19:4, 2019: pp. 821–850

DOI: 10.1111/irfi.12201

equity issue, and litigation risk as the risk faced by issue certifiers (e.g., issuers and

underwriters) of being sued by investors.

The subscribers or outside investors of SEOs face the risk of investment loss,

either because the project in which the equity is invested will result in wealth

loss (negative net present value) or the firm’s controlling insiders will extract all

the benefits that arise from the project. In either case, subscribers or outside

investors of the SEOs, anticipating such potential outcomes, will demand a

higher discount to compensate for this risk, and thus the issue will be

underpriced.

The underwriter, who markets the equity issue, may also be exposed to

potential investment loss if the issue is offered through a firm-commitment

underwriting process. In this scenario, the underwriter faces an under-

subscription risk that will result in loss to the underwriter from unsold securi-

ties. The underwriter can manage this risk through a lower offer price set after a

roadshow, which allows the underwriter to match the demand for the issue. In

addition, the period for which the underwriter holds the security is much

shorter than that of the final investors, which further reduces the underwriter’s

exposure to investment risk.

The more significant risk for underwriters is that of exposure to litigation

from investors. As certifiers of issue quality, underwriters can be sued by inves-

tors who suffer a loss. Investors’ability to sue an underwriter, however, depends

on whether the country’s legal system recognizes the investors’right to sue the

underwriters and how well these laws are enforced. Underwriters can mitigate

the risk of litigation by demanding up-front compensation in the form of

higher underwriting spreads.

There is considerable dis agreement in the literatu re regarding the role

played by investment risk a nd litigation risk in determ ining the underwriting

spread and issue underpri cing. Prior studies of SEOs t hat examine investors’

investment risk and underw riters’litigation risk have mostly been confined

to within-country samples, thereby limiting their generalizability to cross-

country analysis of SEO s. Our study fills this gap in th e literature and pro-

vides empirical evidenc e on cross-country variat ion in SEO spreads and

underpricing.

Evidence from the literatu re suggests that equity i ssue spread increases

with a security’s investment risk (e.g., Booth and Smith 1986 ; Carter and

Manaster 1990; Chemmanu r and Fulghieri 1994; Altınkılıç a nd Hansen 2000;

Eckbo et al. 2007 and Lee and Masulis 2009).

3

The equity issue spread has

also been linked to equit y issue underpricing in t heoretical models dev eloped

by Tinic (1988) and Yeoman (2 001) and empirically eva luated by Kim

et al. (2010). In Tinic (1988 ), investment banks are as sumed to utilize both

3 Booth and Smith (1986), Carter and Manaster (1990), and Chemmanur and Fulghieri (1994)

argue that underwriters provide implicit quality certification for security issues and therefore

put their reputations at stake. Underwriting spread thus increases as the uncertainty about

the intrinsic value of the security being issued increases.

© 2018 International Review of Finance Ltd. 2018822

International Review of Finance