The operating performance of seasoned equity issuers: Free cash flow and post-issue performance

It is well documented that, on average, when an industrial firm announces a seasoned equity offering (SEO), its stock price falls. Several of the hypotheses that have been advanced to explain this phenomenon predict a decline in operating performance subsequent to the SEO. We examine changes in operating performance for a large sample of firms that conducted SEOs from 1980 to 1991 and find that these firms experienced a sharp, statistically significant decrease in profitability following the SEO. This decrease shows up in both industry-adjusted and unadjusted comparisons. Overall, our results show that the announcement of an SEO conveys negative information about the future operating performance of a firm. Thus, issuing firms should be prepared for a fall in stock price and expectations of future firm operating performance should be reevaluated in the light of an SEO announcement. Managers of issuing firms should make every effort to convey positive information, as for example the planned use of proceeds, to counteract the effect of the announcement. The results of our analysis of the determinants of the performance drop are generally consistent with the models of Myers and Majluf (1984) and Jensen (1986). Jensen argues that there are important divergences of interest between managers and shareholders. Such divergences might induce managers to issue equity and waste funds by taking up negative-net-present-value projects. In the Myers and Majluf model, managers have private information about the firm and, acting on behalf of existing shareholders, prefer to issue equity when their shares are overpriced. They avoid issuing stock when they believe that it is undervalued. Consistent with these models, we find that operating performance is relatively better among SEO firms that have less free cash flow, that have a lower run-up in operating performance prior to the offering, and invest in new fixed assets. Issuing firms exhibit significant gains in performance immediately prior to the SEO and perform above their industry average prior to the SEO. However, the decline in performance during the three-year period following the issue is much larger than the pre-issue increase. It is long-term and appears to be permanent on an industry-adjusted basis. Our results do not support the argument that all firms with large amounts of free cash flow are overpriced and have a greater tendency to issue equity. We also find that leverage, growth opportunities, and firm size are important factors in the decision to issue equity. Firms with higher leverage have a greater tendency to issue equity. This is consistent with the view that firms with high leverage try to avoid increasing the costs of financial distress. Firms with higher growth opportunities have a greater need for funds and issue equity to meet their investment needs. Among high-growth firms, smaller firms have a greater tendency to issue equity. Among low-growth firms, larger firms have a greater tendency to issue equity.