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

Date01 June 2020
Published date01 June 2020
AuthorTianxi Wang
Put Your Money Where Your
Mouth Is: A Model of Certication
with Informed Finance*
Department of Economics, University of Essex, Colchester, UK
We consider how funding from informed investors such as banks certies
the quality of the recipient rms to investors uninformed of it. We show that
informed nance leads to full separation of rmsquality types, with a larger
quantity of it certifying a better quality. Moreover, the increase in the market
value of the recipient rm is a convex, increasing function of the quantity of
informed nance that it obtains. Lastly, rms with attribute X derive a
greater value from the certication service of informed nance than those
without it if the distribution of rmsquality conditional on X is second-
order stochastically dominated by that conditional on its absence. The
informed nance could be commercial bank loans or the purchase of a rms
equity preceding its IPO by renowned investment banks.
JEL Codes: G10; G24; D82
Accepted: 9 July 2018
Empirical studies suggest that obtaining funding from informed investors, such
as banks, certies the quality of the recipient rms. It is well documented that
the news of obtaining commercial bank loans induces the equity prices of the
recipient rms to rise signicantly, while generally only insignicant price
movements are associated with public debt issuances.
In particular, the equity
prices jump higher when the recipient rms 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 certication 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.
1 See 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. 323349
DOI: 10.1111/ir.12224
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.
Moreover, the bank sold
only 43.5% of its stake at the IPO
, signaling its trust in the rms valuation.
While it sounds straightforward that informed investors certify the recipient
rms quality by investing their capital in it, as the idiom put your money
where your mouth issuggests, 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 nance seeking rms and this information
friction is among factors that determine the efciency of capital allocation.
Then, to which extent can this information barrier be overcome by the certi-
cation service of informed nance? (ii) Which kind of rms 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 certication role of informed nance? These questions are consid-
ered in this paper.
The model economy is populated by a large number of rms with different
quality types which represent the probability of success of the projects that
they seek to nance. These types are not observed by households, but by banks.
Thus, funding provided by banks is informed nance, while funding of house-
holds is uninformed nance. 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 rms need to signal their types to uninformed investors,
namely households. In equilibrium, that is done by the rms obtaining a suf-
cient quantity of informed nance. Indeed, we show that it leads to full separa-
tion of all the efcient types. To understand this result, consider the trade-off
that a type of rm faces when considering the quantity of informed nance to
obtain. With one more unit of it, the benet is that the rm 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 nanced 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
nance is more expensive and the extra unit of it incurs an extra cost. While
this marginal cost of informed nance is the same for all types of rms, the key
2 For 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.
3 Note that some of the facts mentioned here are also consistent with an explanation based on
moral hazard in the manner of Holmstrom and Tirole (1997). However, there are empirical
ndings that are in favor of the explanation based on certication (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.
4 Calculated based on the S1 ling of the Facebook with the SEC; see http://www.nasdaq.com/
© 2018 International Review of Finance Ltd. 2018324
International Review of Finance

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