Investment Banker Reputation and the Performance of Seasoned Equity Issuers

Financial Management (Financial Management Association), Spring, 2000 by Robyn McLaughlin, Assem Safieddine, Gopala K. Vasudevan

Gopala K. Vasudevan [*]

We study the relation between investment banker reputation and announcement-period returns and between banker reputation and three-year post-issue holding-period returns for firms that conducted seasoned equity offerings (SEOs) between 1980 and 1994. We find a positive relation overall between investment banker reputation and announcement-period returns but no significant relation between investment banker reputation and long-run post-issue stock price performance. We also design an empirical model to predict the prestige of the issuer's underwriter. We find that announcement-period returns are significantly related to banker prestige for issuers with high levels of information asymmetry that go against type to use a high-prestige investment banker.

In this paper, we examine whether the choice of investment banker mitigates the asymmetric information problems faced by outside investors in firms conducting seasoned equity offerings (SEOs). Our paper complements prior empirical work on investment bankers in initial public offerings (IPOs) by examining the association between banker prestige and firm performance in SEOs.

Investment bankers can play many roles in the underwriting of security issues including production and certification of information, provision of interim capital, and/or supplying distribution and marketing skills. The investment bankers' information/certification role can be important, both in practice and in theoretical models of financial intermediation (see, for example, Campbell and Kracaw, 1980; Titman and Trueman, 1986; and Carter and Manaster, 1990). Issuing firms can try to reduce investor uncertainty about the value of the securities that the firm is offering by using prestigious underwriters. High-prestige investment bankers, with valuable reputation capital at risk and superior information regarding the issuing firm's prospects, can credibly certify the value of issues they underwrite (Chemmanur and Fulghieri, 1994).

Prior research on financial intermediation in initial public offerings (IPOs) generally finds that investment banker reputation is significantly related to issuing-firm performance. For example, Carter and Manaster (1990) find that IPOs by high-prestige investment bankers have less underpricing. Michaely and Shaw (1994) find that, for IPO firms, banker reputation is positively associated with both announcement-period and long-run returns. These studies support an important information role for investment bankers in IPOs.

However, the information role for investment bankers might be quite different in SEOs. Since there is no market price prior to an IPO, these issues could be subject to substantial information asymmetries. But, market prices do exist prior to SEOs, providing important information on firm value. Also, SEO firms usually have a longer time series of public, audited financial information available and security analysts following these firms produce additional information. SEO firms are less likely to experience such substantial information asymmetries as IPO firms. Thus, the importance of investment banker certification for SEO firms remains an open empirical question.

Since the importance of the banker's information role for any given issue could depend on the degree of information asymmetry, we conduct our analysis in two stages. In the first stage, we examine the overall association between underwriter reputation and issuing-firm announcement-period and long-run post-issue holding-period returns. In the second stage, we control for endogeneity of the prestige of the investment banker used. Our results provide support for an important information/certification role for investment bankers in SEOs.

The paper is organized as follows. Section I discusses prior theoretical and empirical work on the information role of investment bankers as financial intermediaries, and develops hypotheses. Section II describes the sample selection procedure, the data and the methodology used in the empirical tests. Section III presents the results of our study, and Section IV concludes the paper.

I. Theoretical and Empirical Background

It is an established fact that firms perform poorly around seasoned equity offers, both in below-average stock returns (see, for example, Asquith and Mullins, 1986; Loughran and Ritter, 1995; and Speiss and Affleck-Graves, 1995) and in poor operating performance (Loughran and Ritter, 1997; and McLaughlin, Safieddine, and Vasudevan, 1996 and 1998). Prominent among explanations of this phenomenon are adverse-selection hypotheses based on information asymmetries between firm insiders and outside investors (Myers and Majluf, 1984; Krasker, 1986; and Miller and Rock, 1985).

The Myers and Majluf (1984) model predicts a negative stock price reaction to the announcement of equity issues because of potential adverse selection signaled by the decision to issue equity. Krasker (1986) extends the Myers-Majluf model; his model predicts a negative relation between offer size and announcement-period stock returns. [1] Miller and Rock (1985) predict that the stock price reaction is negative for all security issues, because firms tend to issue securities when there is an unanticipated decrease in future cash flows. These models imply that superior-quality issuing firms with significant information asymmetries can benefit substantially if investment bankers can credibly certify firm value to less-informed investors.