Put Your Money Where Your Mouth Is: A Model of Certification with Informed Finance

• Author: Tianxi Wang
• DOI: http://doi.org/10.1111/irfi.12224
• Published date: 01 June 2020
• Date: 01 June 2020

Put Your Money Where Your

Mouth Is: A Model of Certification

with Informed Finance*

TIANXI WANG

Department of Economics, University of Essex, Colchester, UK

ABSTRACT

We consider how funding from informed investors such as banks certifies

the quality of the recipient firms to investors uninformed of it. We show that

informed finance leads to full separation of firms’quality types, with a larger

quantity of it certifying a better quality. Moreover, the increase in the market

value of the recipient firm is a convex, increasing function of the quantity of

informed finance that it obtains. Lastly, firms with attribute X derive a

greater value from the certification service of informed finance than those

without it if the distribution of firms’quality conditional on X is second-

order stochastically dominated by that conditional on its absence. The

informed finance could be commercial bank loans or the purchase of a firm’s

equity preceding its IPO by renowned investment banks.

JEL Codes: G10; G24; D82

Accepted: 9 July 2018

I. INTRODUCTION

Empirical studies suggest that obtaining funding from informed investors, such

as banks, certifies the quality of the recipient firms. It is well documented that

the news of obtaining commercial bank loans induces the equity prices of the

recipient firms to rise significantly, while generally only insignificant price

movements are associated with public debt issuances.

1

In particular, the equity

prices jump higher when the recipient firms are arguably more opaque, for

example, when they receive no debt ratings (according to Ross 2010), or when

they are small (according to Maskara and Mullineaux 2011). Funding by invest-

ment banks can play the certification role as well. For example, Goldman Sachs’

purchase of $375 million of Facebook shares in January 2011 values Facebook

at $50 billion and sends its price-earnings ratio to a strikingly high level of

*I thank the referee for the many constructive comments offered, which led to a great improve-

ment of the paper.

1See Mikkelson and Partch (1986), James (1987), Mikkelson and Partch (1986), Lummer and

McConnell (1989), Best and Zhang (1993), Billett et al. (1995), Maskara and Mullineaux

(2011), and Ross (2010); and for surveys see James and Smith (2000).

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 20:2, 2020: pp. 323–349

DOI: 10.1111/irfi.12224

106.

2

Buying shares at such a price-earnings ratio by members of the general

public would be a squander, but is certainly not when it is by Goldman Sachs.

In 1 year, this deal delivered a net return of more than 100%, when Facebook is

valued at $104 billion at its initial public offering.

3

Moreover, the bank sold

only 43.5% of its stake at the IPO

4

, signaling its trust in the firm’s valuation.

While it sounds straightforward that informed investors certify the recipient

firm’s quality by investing their capital in it, as the idiom “put your money

where your mouth is”suggests, some important issues related to this idea

remain unsolved. (i) Ordinary members of the general public usually lack exper-

tise to evaluate the quality of the finance seeking firms and this information

friction is among factors that determine the efficiency of capital allocation.

Then, to which extent can this information barrier be overcome by the certifi-

cation service of informed finance? (ii) Which kind of firms gain more from this

service? (iii) Besides the well-documented announcement effect of commercial

bank loans, are there other capital-market movements that can be explained

due to the certification role of informed finance? These questions are consid-

ered in this paper.

The model economy is populated by a large number of firms with different

quality types which represent the probability of success of the projects that

they seek to finance. These types are not observed by households, but by banks.

Thus, funding provided by banks is informed finance, while funding of house-

holds is uninformed finance. The former is limited and expensive, while the lat-

ter is abundant in aggregation and cheap. In order to obtain this cheap

funding, high-quality firms need to signal their types to uninformed investors,

namely households. In equilibrium, that is done by the firms obtaining a suffi-

cient quantity of informed finance. Indeed, we show that it leads to full separa-

tion of all the efficient types. To understand this result, consider the trade-off

that a type of firm faces when considering the quantity of informed finance to

obtain. With one more unit of it, the benefit is that the firm is believed by

uninformed investors as having a marginally higher quality and thereby

obtains their funding in marginally better terms, namely at a lower interest rate

if this funding is financed with debt claims or with a smaller number of new

shares if it is with equity claims. On the cost side stands the fact that informed

finance is more expensive and the extra unit of it incurs an extra cost. While

this marginal cost of informed finance is the same for all types of firms, the key

2For the numbers about Facebook, see in order “Facebook move lucrative for Goldman,”

“Facebook,”and “The Facebook rich list,”on Financial Times, the January 4 and 9, 2011 and

May 18, 2012.

3Note that some of the facts mentioned here are also consistent with an explanation basedon

moral hazard in the manner of Holmstrom and Tirole (1997). However, there are empirical

findings that are in favor of the explanation based on certification (or signaling) in relation to

the problem of hidden types. A detailed comparison between these two explanations is to be

found in subsection 5.2.

4Calculated based on the S1 filing of the Facebook with the SEC; see http://www.nasdaq.com/

markets/ipos/filing.ashx?filingid=8622065#D287954DS1A_HTM_TOC287954_15.

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