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

AuthorPuneet Prakash,Nanda K. Rangan,Manu Gupta
Date01 December 2019
Published date01 December 2019
Cross-Country Variability in Cost of
Raising Equity: Evidence from
Seasoned Equity Offerings
Finance Insurance and Real Estate, Virginia Commonwealth University, Richmond,
VA and
Finance and General Business, Missouri State University, Springeld, MO
We examine how county-level governance affects the cost of raising equity.
Using data on seasoned equity offerings, we nd that the underwriting
spread is determined by the litigation risk of issue certiers, 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
The link between country-level corporate governance (legal systems) and the
development of nancial markets is well established in the law and nance
literatureyet the cost of raising equity capital across nations has received little
Seasoned equity offerings (SEOs), a signicant proportion of the
total equity raised by corporations,
clearly have noteworthy implications for
rmscost of capital, and as a consequence, strongly inuence rmscompe-
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 securitys price from offer price to closing
price on the rst 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 dene 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
© 2018 International Review of Finance Ltd. 2018
International Review of Finance, 19:4, 2019: pp. 821850
DOI: 10.1111/ir.12201
equity issue, and litigation risk as the risk faced by issue certiers (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 rms controlling insiders will extract all
the benets 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
The underwriter, who markets the equity issue, may also be exposed to
potential investment loss if the issue is offered through a rm-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 nal investors, which further reduces the underwriters
exposure to investment risk.
The more signicant risk for underwriters is that of exposure to litigation
from investors. As certiers of issue quality, underwriters can be sued by inves-
tors who suffer a loss. Investorsability to sue an underwriter, however, depends
on whether the countrys legal system recognizes the investorsright 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 riterslitigation risk have mostly been conned
to within-country samples, thereby limiting their generalizability to cross-
country analysis of SEO s. Our study lls this gap in th e literature and pro-
vides empirical evidenc e on cross-country variat ion in SEO spreads and
Evidence from the literatu re suggests that equity i ssue spread increases
with a securitys 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).
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 certication 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

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