THE VALUATION EFFECTS OF EQUITY ISSUES AND THE LEVEL OF INSTITUTIONALOWNERSHIP - EVIDENCE FROM ANALYSTS EARNINGS FORECASTS

This paper investigates whether the level of institutional ownership h as any effect on the market reaction to announcements of a firm-level ''event'', namely the issuance of equity. Previous studies that have e xamined the association between some proxy for firm value (either Tobi n's q or a measure of accounting profitability) and ownership structur e have a problem with the direction of causality. For instance, a posi tive association between firm value and institutional ownership can ei ther be interpreted as evidence of monitoring by institutions or that institutions tend to invest systematically in high-value firms. If we find any relation between the announcement effects of equity issues, a nd therefore firm value, and institutional ownership, the direction of causality has to run from institutional ownership to firm values not the other way around. Furthermore, some earlier studies have examined the relation between firm value and ownership structure of the firm by focusing primarily on the stock price reaction to announcements of sp ecific corporate decisions. We also examine revisions to analysts' ear nings forecasts around these announcements. If the announcement of the decision to finance investment projects through the issuance of equit y has an effect on the stock price, it is presumably because the marke t perceives changes in either the expectations of future earnings or i n the variability of these earnings. Therefore, we also study the rela tion between revisions in analysts' earnings forecasts and institution al ownership to corroborate our stock price results. The proceeds from an equity issue give more discretionary cash to managers, which incre ases the likelihood of non-value-maximizing behavior by them. We hypot hesize that under the effective monitoring hypothesis, higher institut ional ownership will give institutional investors greater incentives t o protect their investment in the firm's equity. They achieve this obj ective by carefully monitoring the use of the proceeds of the equity i ssue in order to ensure that the capital is used for productive purpos es. This effective-monitoring hypothesis would then predict a positive relation between announcement-period abnormal stock returns and the l evel of institutional ownership. On the other hand, width higher insti tutional ownership, institutions may develop other profitable business relationships with the firm or may find it mutually advantageous to c ooperate with the managers of the firm, thereby reducing the incentive s to monitor the activities of the managers aggressively in order not to jeopardize these other beneficial relationships. We call this the i neffective-monitoring hypothesis. It predicts a negative relation betw een abnormal stock returns and institutional ownership. We first study the association between the announcement-period abnormal stock price reaction and institutional ownership. We find a significant positive r elation between announcement-period abnormal stock returns and institu tional ownership. This result suggests that higher levels of instituti onal ownership are associated with perceptions of institutions as more effective monitors of the uses of the cash Obtained from the equity i ssue due to their higher ownership stake in the firm. Given that the c ash raised through the equity issue is typically used to finance long- term projects, monitoring by institutions will not impact current-year earnings but will have an effect on long-term earnings. Hence, if the documented stock price relation is the result of effective monitoring of the proceeds of the cash raised through the equity issue, there sh ould be no relation between abnormal forecast revisions in current-yea r earnings with institutional ownership. Consistent with this, we find no relation between analysts' abnormal forecast revisions in current- year earnings and institutional ownership. However, there should be a positive relation between abnormal forecast revisions in five-year ear nings growth and institutional ownership. We also find a significant p ositive relation between analysts' abnormal forecast revisions in five -year earnings growth and institutional ownership. These findings supp ort the view that institutions are effective monitors of the equity is suance decision. Finally, we find that the significant positive relati on between the announcement-period abnormal returns, as well as abnorm al forecast revisions in five-year earnings growth, and institutional ownership is primarily explained by low-q (q < 1) firms. Managers of l ow-q firms are more likely to misuse the proceeds from the equity offe ring; hence, they are the targets of closer scrutiny by institutional investors with relatively high ownership stakes who wish to protect th eir investments in the firm. This result gives further credence to the effective-monitoring hypothesis. By studying the impact of the decisi on by firms' managers to issue equity on both stock prices and analyst s' earnings forecasts, we find evidence of monitoring by institutions. The decision to issue equity to finance investment projects is just o ne among many important decisions that the firms' managers make. It is likely that institutional investors play a similar role regarding a w hole set of decisions managers make. While we document evidence of mon itoring by institutions, we are in no way advocating that firms should unequivocally seek to attract higher levels of institutional ownershi p because of potential monitoring benefits. They should do so if it is an attractive option after taking into account all potential benefits and costs of taking such a course of action. Finally, the ability of institutional investors to impose further capital market discipline on managers is likely to increase as institutional ownership grows and a s the public policy debate comes to recognize the substantial costs of regulations which inhibit the ability of institutions to monitor mana gers.