Why do Public Firms
Issue Private and Public Securities?
Gordon Phillips
Robert H. Smith School of Business
University of Maryland
Presentation based on recent research papers
Available on my web site: www.smith.umd.edu/faculty/gphillips
October 2005
Private and Public Security Issues
Questions of Interest
 Where do firms raise money and
why?
 How does the stock market respond?
 How do firms fare after issuing
private equity?
October 2005
Gordon Phillips, University of Maryland
Page 2
Private and Public Security Issues
Case Study 1
GOOGLE Public Seasoned Equity Offering
On Aug 17th, 2005 (after close of stock market) Google announced it would sell 14.1
million shares in the stock market. Price at close of day on Google was $285.10.
This offer would raise over 4 Billion in cash for the company at this stock price.
This compares to the 1.161 Billion (net) it raised at its IPO on Aug. 19, 2004. ( 14.1
million shares sold by company at the time of the IPO, 8 million by other investors.)
Google’s situation today:
 Had 2.9 Billion in cash end of June, 2005. Increased from 1.3 Billion from end of
June, 2004.
 Net income in previous 6 months was 918 million on sales of 2,641 million =
34.8% operating margin. Paid taxes of 239 million.
 In past year Google went up over 300% from its IPO price of $85.
Stock price reaction after the SEO was announced?
-$5.11 or -1.8%
WHY?
October 2005
Gordon Phillips, University of Maryland
Page 3
Private and Public Security Issues
Case Study 2
Interwave Communications (IWAV) Private Placement
On Nov.13th 2003, Interwave Communications announced it would sell 1.350 million
shares in the stock market in a private placement. (PIPE offering).
 Existing shares of stock: 6,872,542 shares. Dilution therefore was 17.7%.
 Stock was offered at $3.93 – a discount of 17.7% versus the previous closing price.
 Gross offer proceeds was $5,299,965
Cash Position:
 Began 2002 with 46.8 million in cash.
 Ended 2002 with 15.68.
 Ended 2003 with 4.4 million in cash.
Firm’s operating cash flow for 2002 was -37 million, in 2003 – 19 million
(sales were 29.9 million in 2003.)
Stock price reaction on the day of the PIPE?
+15.14%
Stock price reaction over a 3-day window( +1, 0, +1 )? +21.0%
WHY?
October 2005
Gordon Phillips, University of Maryland
Page 4
Private and Public Security Issues
Conclusions (In advance)
Where do firms raise money and why?
Firms issue in the private markets when:
 Analysts disagree about their prospects (high asymmetric
information)
 They have negative to low cash flow from current operations
Firms issue in the public market to “time” favorable view of the
company.
October 2005
Gordon Phillips, University of Maryland
Page 5
Private and Public Security Issues
Conclusions (In advance)
How does the external stock market view firms’ decisions?
 Positively for private securities – especially when there is high
disagreement about company prospects
 Investors view investment by more informed private investors
as a good signal (confidence) about the future prospects of the
company.
October 2005
Gordon Phillips, University of Maryland
Page 6
Private and Public Security Issues
The Importance of Private Markets
Table 1
Number and Gross Proceeds of Securities
Public
Public
Public
144-A
Private
Private
Private
Debt Convertibles Equity
Debt Convertibles Debt Convertibles Equity
Year
1995-'03
N
1,820
$MM 636,245
%FV
7%
%FV (med)
3%
201
72,357
14%
9%
1,642
1,017
163,762 320,968
22%
27%
15%
16%
597
159,477
17%
13%
5,609
1,493,159
33%
22%
1,156
30,686
15%
9%
Total
1,377 13,419
25,601 2,902,255
15%
23%
9%
13%
 Private markets are important for public firms.
 62% of convertibles and equity issues are issued
in private markets (57.8% without 144A mkt.)
 For firms in lowest size quartile of issuing firms,
81% of convertibles and equity issues are issued in
private markets
October 2005
Gordon Phillips, University of Maryland
Page 7
Private and Public Security Issues
Private Placements: The Regulations
Securities cannot be issued unless they are
 Registered (i.e. the company files a registration statement
with the SEC that is declared effective)
 Or there is a statutory exemption for the sale - securities
not registered are restricted securities
October 2005
Gordon Phillips, University of Maryland
Page 8
Private and Public Security Issues
Private Placements: The Regulations - 2
Statutory exemptions for restricted securities
 Private placements are generally conducted in accordance
with the “safe harbor” provisions of Regulation D of the
1933 Securities Act
– Basically there can be no more than 35 non-accredited investors
and an unlimited number of accredited investors
 Restricted securities cannot be resold or traded in the public
markets (exchange) before they are registered (Rule 144)
 They may however be traded privately to qualified
institutional buyers (QIB) at any time under Rule 144A.
 Firm can disclose “material, non-public information” to
investors. This exemption remains under Reg. FD.
October 2005
Gordon Phillips, University of Maryland
Page 9
Private and Public Security Issues
Data Used in Our Study

Securities issued from 1/1995 to 12/2003 by publicly traded corporations


Private issues:

Convertible and Common stock PIPE deals from PlacementTracker
database

Private debt from Dealscan Database.
Public issues of equity and convertibles: SDC new issue database
Data linked to analyst data (IBES), stock price and Firm Data.

In CRSP and Compustat (for one year before issue)

Excluding financials (6000-6999) and regulated utilities (4900-4999)
October 2005
Gordon Phillips, University of Maryland
Page 10
Private and Public Security Issues
Some Facts
 First fact, the average PIPE deal is sold at a 11.6%
average discount.
 Second fact, the average public SEO is sold at an
average of 5.6% average discount relative to the current
share price.
– i.e. Price prior to issue of $100, issue new stock at
$94.60 – and also pay 7% to investment bankers
netting the company $87.98. (12% “Cost”)
October 2005
Gordon Phillips, University of Maryland
Page 11
Private and Public Security Issues
Market Reaction
to Security Issuance Decisions?
 Given the discount, does the market react unfavorably,
and more unfavorably to private deals?
– Given that these companies are all publicly traded,
we can measure the stock price reaction to these
issue decisions – on existing stock already trading.
– We examine the reaction net of the overall market
reaction for different windows of time.
October 2005
Gordon Phillips, University of Maryland
Page 12
Private and Public Security Issues
Stock Price Market Reaction to "Typical" Deal
Excess Returns (Days -1 to +1)
Source: CRSP; Sagient Research Systems; Thomson Financial
4.0%
3.0%
Public SEOs (1369 deals)
PIPE Issues (2008 deals)
2.0%
2.75%
1.0%
0.33%
0.0%
-1.0%
-2.90%
-3.09%
-2.0%
-3.0%
-4.0%
October 2005
Average Excess Reaction
Gordon Phillips, University of Maryland
Median Excess Reaction
Page 13
Private and Public Security Issues
Stock Price Market Reaction to "Typical" Deal
Excess Returns (Days -5 to +5)
Source: CRSP; Sagient Research Systems; Thomson Financial
6.0%
4.0%
Public SEOs (1369 deals)
PIPE Issues (2008 deals)
5.14%
2.0%
0.91%
0.0%
-2.0%
-3.88%
-4.26%
-4.0%
-6.0%
October 2005
Average Excess Reaction
Gordon Phillips, University of Maryland
Median Excess Reaction
Page 14
Private and Public Security Issues
Stock Price Market Reaction to "Typical" Deal
Excess Returns (Days -10 to +10)
Source: CRSP; Sagient Research Systems; Thomson Financial
8.0%
6.0%
Public SEOs (1369 deals)
PIPE Issues (2008 deals)
4.0%
6.77%
2.0%
1.05%
0.0%
-2.0%
-4.64%
-4.95%
-4.0%
-6.0%
October 2005
Average Excess Reaction
Gordon Phillips, University of Maryland
Median Excess Reaction
Page 15
Private and Public Security Issues
Excess Return Distribution (Days -10 to +10)
Source: CRSP; Sagient Research Systems
Frequency
350
300
250
200
150
100
50
0
-100
200
-1 - -0.9-80
-0.8 -0.7-60
-0.6 -0.5-40
-0.4 -0.3-20
-0.2 -0.1 00 - 0.1200.2 0.3 40
0.4 0.5600.6 0.7 80
0.8 0.9 100
1 - 1.1 120
1.2 1.3140
1.4 1.5160
1.6 1.7180
1.8 1.9
-0.9 - - - - - - - - - - - - - - - - - 0 0.1 - - 1 1.1 - -2
Excess Return (%)
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1
0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9
Note: Five companies had a (-10,+10) announcement return of less than -100%. Two companies had a (-10,+10) announcement return greater than 200%.
October 2005
Gordon Phillips, University of Maryland
Page 16
Private and Public Security Issues
Characteristics of Private and Public Stock Offerings
Public SEOs
PIPE issues
Average
5.6%
11.6%
Median
5.4%
12.1%
20.0%
70.2%
Offering Discount
Maximum
Issue Size relative to existing floatation (Dilution)
Average
18.7%
21.2%
Median
12.7%
13.1%
600.0%
1260.0%
1331.2M
268.3M
364.0M
73.4 M
Maximum
Firm Size (Market Capitalization)
Average
Median
October 2005
Gordon Phillips, University of Maryland
Page 17
Private and Public Security Issues
Regression Coefficient Estimates
Prediction of 10 Day Announcement
Excess Returns (-10 to +10)
Robust Regression Results
Variable
PIPE Indicator
0.062
a
Dilution
0.029
a
Discount
-0.012
Discount x Dilution
-0.025
log (Market Capitalization)
Constant
Number of Deals
0.008
b
-0.089
a
2728
a, (b): significant at the one (five) percent significance level.
October 2005
Gordon Phillips, University of Maryland
Page 18
Private and Public Security Issues
Extensions to the Basic Model
 Look at all security types.
 Examine impact of:
 “Analyst uncertainty” / asymmetric information
 Taxes
 Profitability
 Financial Distress
October 2005
Gordon Phillips, University of Maryland
Page 19
Private and Public Security Issues
Table 3
Market Reaction to Security Issuance
Table presents regression of 10 trading-day cumulative abnormal returns around security issues on the variables
defined in Table 2A. The earnings surprise variable appears interacted with the public and private market dummy.
We include industry fixed effe
Equity Issues
(1)
(2)
Public Market
-1.62%
b
-2.54
Private Market
2.77%
2.16
Measures of Asymmetric Information
Earnings Surprise*Public Market
Investment Opportunities Measures
R&D / lagged PPE
Tobin's q
October 2005
-1.60%
c
-2.31%
a
-2.53%
Debt Issues
(5)
(6)
a
-0.89%
b
-0.95%
-1.82
-2.65
-2.65
-1.97
-1.83
1.76%
-0.35%
1.83%
-0.07%
-0.02%
1.29
-0.24
1.14
-0.19
-0.06
-3.60%
-1.25
Earnings Surprise*Private Market
Risk Measure
Cash Flow Volatility
b
Convertible Issues
(3)
(4)
0.96%
1.80
-3.68%
-4.15
c
a
-0.22%
-0.20
-0.81%
-1.10
1.10%
1.25
0.06%
0.11
0.26%
0.50
-0.19%
-0.21
-0.68%
-0.69
0.65%
1.31
0.72%
1.32
0.49%
0.94
0.12%
0.20
0.81%
1.09
1.12%
1.25
-1.14%
-1.36
-1.11%
-1.25
-0.18%
-0.30
-0.27%
-0.48
0.57%
0.76
0.06%
0.08
-0.54%
-1.42
-0.48%
-1.22
Gordon Phillips, University of Maryland
c
Page 20
Private and Public Security Issues
Initial Conclusions
 Stock market responds favorably to PRIVATE issues
DESPITE the fact that they are sold at a large discount to the
existing company stock price.
 This reaction to issuing private equity is more positive when:
 analysts disagree more about the company’s future
earnings (there is high asymmetric information about the
company’s future).
 Firms are unprofitable and have indications of financial
distress
 Firms stock price has fallen recently.
October 2005
Gordon Phillips, University of Maryland
Page 21
Private and Public Security Issues
Impact of Strategic Private Investors?
We examine block private purchases of equity by other
related corporations (strategic investors).
Examples include:
 Compaq Computers buying a 20% block in Conner Peripherals
 Eastman Kodak investing $20 million in Immunex Corp.
 DuPont purchasing a stake in Biotech Research Labs.
Stock market response to these types of deals?
Overall + 6.9%
What happens if these deals are combined with specific
product market alliances or joint ventures?
October 2005
Gordon Phillips, University of Maryland
Page 22
Private and Public Security Issues
Stock Price Reaction to Strategic Investors’ Deals
12%
Average Stock Market Excess Returns (days -10 to +10)
10%
Private Placement +
Alliance or JV
8%
Private Placement with
no Alliance or JV
6%
10.10%
4%
5.90%
2%
0%
October 2005
Gordon Phillips, University of Maryland
Page 23
Private and Public Security Issues
How do Firms Fare AFTER their Private Equity Sale?
Source: Allen and Phillps (2000)
October 2005
Year -1 to +1
Year -1 to +2
Gordon Phillips, University of Maryland
Industry
Just Block
Ownership
Industry
Alliances+Ownership
in High Ad./R&D Ind.
Year -1 to +3
Industry
160%
140%
120%
100%
80%
60%
40%
20%
0%
Alliances +
Ownership
Percentage Change
Change in Sales After Equity Sale
Page 24
Private and Public Security Issues
Investment after Private Equity Sale
October 2005
Year -1 to +1
Gordon Phillips, University of Maryland
Industry
Just Block
Ownership
Industry
Alliances+Ownership
in High Ad./R&D Ind.
Year -1 to +2
Year -1 to +3
Industry
140%
120%
100%
80%
60%
40%
20%
0%
Alliances +
Ownership
Percentage Change
Source: Allen and Phillps (2000)
Page 25
Private and Public Security Issues
Operating Cash Flow (Pre-tax Profits)
After Private Equity Sale
October 2005
Year -1 to +1
Year -1 to +2
Gordon Phillips, University of Maryland
Industry
Just Block
Ownership
Industry
Alliances+Ownership
in High Ad./R&D Ind.
Year -1 to +3
Industry
80%
70%
60%
50%
40%
30%
20%
10%
0%
Alliances +
Ownership
Percentage Change
Source: Allen and Phillps (2000)
Page 26
Private and Public Security Issues
How do firms’ choose security type?
 We next examine what drives firms to choose different
markets (public vs. private) and different securities (debt,
convertibles or equity).
 This is related to a firm’s choice of capital structure BUT we
do not limit the firm to choose equity and debt.
October 2005
Gordon Phillips, University of Maryland
Page 27
Private and Public Security Issues
Factors Impacting Choice of Security
and Market Reaction
Profitability and Taxes (Marginal tax rate) vs. Financial
Distress (Trade-off Theory of Capital Structure).
Measures of asymmetric information
 Analyst earnings surprise:
Abs(actual earnings – median(estimate))
 Dispersion (sd) of analyst estimates.
Risk: sd of quarterly cash flow
Market timing: Pre-Issue cumulative abnormal stock price
return.
October 2005
Gordon Phillips, University of Maryland
Page 28
Private and Public Security Issues
Profitability (OCF/laggged assets)
Source: Gomes and Phillps (2005)
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
-10.0%
Public
Debt
Public
Convert.
Public
Equity
Private
Debt
Private
Convert.
Private
Equity
-15.0%
-20.0%
-25.0%
-30.0%
October 2005
Gordon Phillips, University of Maryland
Page 29
Private and Public Security Issues
Marginal Tax Rate
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
Public Public
Debt Convert.
Public
Equity
Private Private Private
Debt Convert. Equity
Security Type
October 2005
Gordon Phillips, University of Maryland
Page 30
Private and Public Security Issues
Asymmetric Information
Average Analyst Earnings Surprise
[Abs(actual earnings-estimate)]
18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Public Debt
Public
Convert.
Public Equity Private Debt
Private
Convert.
Private
Equity
Security Type
October 2005
Gordon Phillips, University of Maryland
Page 31
Private and Public Security Issues
Analyst Earnings Estimate Dispersion
(averages)
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
Public
Debt
Public
Convert.
Public
Equity
Private
Debt
Private
Convert.
Private
Equity
Security Type
October 2005
Gordon Phillips, University of Maryland
Page 32
Private and Public Security Issues
Average Pre-Issue Cumulative Abnormal Stock Return
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
Public Debt
Public
Convert.
Public Equity Private Debt
Private
Convert.
Private Equity
Security Type
October 2005
Gordon Phillips, University of Maryland
Page 33
Private and Public Security Issues
Model of Security Issuance
We estimate several Models of Security Issuance:
Modelling Security and Market Choice.
Our economic model examines the probability of the firm
decisions based on firm characteristics:
October 2005
Gordon Phillips, University of Maryland
Page 34
Private and Public Security Issues
Our Main Findings
The probability of a firm issuing equity (both public
and private) increases when:
 Firm risk increases
 R&D increases
 Firm investment opportunities increase
 More likely to issue public equity when stock
price has risen recently – Market timing i.e.
Google..
October 2005
Gordon Phillips, University of Maryland
Page 35
Private and Public Security Issues
Our Main Findings
Firms are more like to issue PIPEs, when:
 Asymmetric information (uncertainty about the
future) increases.
 Indications of good investment opportunities
and also financial distress increase
Consistent with investment by private investors
certifying firms future prospects.
October 2005
Gordon Phillips, University of Maryland
Page 36
Private and Public Security Issues
Conclusions
 The stock market reacts positively (*except for
convertible “death spirals”) to private equity and
negatively to public equity issues – despite private
equity issues being sold at a much higher discount.
 Firm investment, sales and operating cash flow
increase on average after they issue equity to other
corporations (strategic investors).
October 2005
Gordon Phillips, University of Maryland
Page 37
Private and Public Security Issues
Conclusions - 2
 Firms are more likely to issue private securities and PIPEs
(verses public equity and debt) when:
 Analysts disagree more about the company’s future
earnings (there is high asymmetric information about
the company’s future). (OPPOSITE for public equity
markets.)
 Firms have indications of good investment opportunities
in the future
 Firms have indications of financial distress (Interwave
Communications)
October 2005
Gordon Phillips, University of Maryland
Page 38