Equity Issues and the Disappearing Rights Offer Phenomenon

This article presents a theoretical model based on the Myers‐Majluf framework that attempts to explain the choice of public companies among alternative methods for issuing seasoned equity primarily in terms of differences in “information‐asymmetry” and “adverse selection” costs. The key insight is that a “pure” (or uninsured) rights offering is likely to be the lowest‐cost flotation method only in cases where a large fraction of current shareholders are expected to subscribe to the offering (i.e., only when expected shareholder takeup is high). In such cases, direct flotation costs are much lower than those associated with book‐built underwritten offerings to (mainly) new investors. Even more important, because heavily subscribed rights offerings also involve minimal potential for transfer of wealth between existing and new shareholders (since they are mostly the same people), adverse selection costs are not a concern. But as the expected shareholder takeup falls—say, because increases in corporate size cause risk‐averse, wealth‐constrained shareholders to diversify their investments—the potential for costly wealth transfers from issuing mis‐priced equity leads companies to consider underwriter certification of the new issue. This is evidenced in the data by a systematic move from pure rights offerings first towards rights with standby underwriting as shareholder takeup falls and—for sufficiently low shareholder takeup—to fully marketed firm commitment offerings. This adverse selection framework for corporate equity issuance can be used to explain a number of well‐documented phenomena in financial markets: • the disappearance of rights offerings among publicly traded U.S. industrial companies, as well as the notable switch by such companies in all developed economies from pure rights to underwritten offers, as growth leads to less concentrated ownership structure; • the continuing widespread use of rights issues in foreign jurisdictions characterized by smaller and relatively closely held firms; • the more frequent use of rights by public utilities (with less discretion over issue policy and more limited possibilities for wealth transfers) than industrial issuers; • the use of large shareholder subscription precommitments (to signal high shareholder takeup) in pure rights but not in standby rights offers; • the neutral average market response to announcements of pure rights offerings, as compared to the negative response to standby rights offerings, and the still more negative reactions to firm commitment underwritten offerings; • the absence in cases of pure rights offers of the stock price runups that precede firm commitments and, to a lesser extent, standbys; and • the preference of financially distressed companies for rights offers (as a last resort).