THE OPERATING PERFORMANCE OF SEASONED EQUITY ISSUERS - FREE CASH FLOWAND POST-ISSUE PERFORMANCE

It is well documented that, on average, when an industrial firm announ ces a seasoned equity offering (SEO), its stock price falls. Several o f the hypotheses that have been advanced to explain this phenomenon pr edict a decline in operating performance subsequent to the SEO. We exa mine changes in operating performance for a large sample of firms that conducted SEOs from 1980 to 1991 and find that these firms experience d a sharp, statistically significant decrease in profitability followi ng the SEO. This decrease shows up in both industry-adjusted and unadj usted comparisons. Overall, our results show that the announcement of an SEO conveys negative information about the future operating perform ance of a firm. Thus, issuing firms should be prepared for a fall in s tock price and expectations of future firm operating performance shoul d be reevaluated in the light of an SEO announcement. Managers of issu ing firms should make every effort to convey positive information, as for example the planned use of proceeds, to counteract the effect of t he announcement. The results of our analysis of the determinants of th e performance drop are generally consistent with the models of Myers a nd Majluf (1984) and Jensen (1986). Jensen argues that there are impor tant divergences of interest between managers and shareholders. Such d ivergences might induce managers to issue equity and waste funds by ta king up negative-net-present-value projects. In the Myers and Majluf m odel, managers have private information about the firm and, acting on behalf of existing shareholders, prefer to issue equity when their sha res 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 c ash flow, that have a lower run-up in operating performance prior to t he offering, and invest in new fixed assets. Issuing firms exhibit sig nificant gains in performance immediately prior to the SEO and perform above their industry average prior to the SEO. However, the decline i n 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 t he argument that all firms with large amounts of free cash flow are ov erpriced and have a greater tendency to issue equity. We also find tha t leverage, growth opportunities, and firm size are important factors in the decision to issue equity. Firms with higher leverage have a gre ater tendency to issue equity. This is consistent with the view that f irms 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. A mong low-growth firms, larger firms have a greater tendency to issue e quity.