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Underwriter warrants, underwriter reputation, and growth signaling

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Abstract

We present an alternative explanation of warrant use for underwriter compensation. We consider underwriter warrants as a signaling device to convey an issuing firm’s future growth potential and test this signaling role of warrant use by taking a direct approach in a seasoned equity offering (SEO) environment. Employing a matched-sample approach, we find that the use of warrants mitigates the negative price effects of SEOs. Specifically, the issuance of SEOs with warrant-based compensation has a significantly less negative impact on abnormal return performance than the issuance of SEOs with cash-based compensation. The results of logit regressions confirm this linkage. We further find that this less negative impact on firm value is attributable to the signaling value representing the issuing firm’s future growth prospects through warrant compensation even in the presence of underwriter reputation variables. These results suggest that firms with greater growth prospects benefit more by issuing SEOs with warrant compensation than with cash compensation. Overall, our results support the growth signaling effect of warrant compensation as an additional role of underwriter warrants in the SEO market.

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Notes

  1. See, for example, Smith (1977), Beatty and Ritter (1986), Booth and Smith (1986), Barry et al. (1991), Dunbar (1995), and Ng and Smith (1996).

  2. Previous literature on underwriter certification suggests that underwriters help reduce information asymmetry through certification in the US (Booth and Smith 1986; Beatty and Ritter 1986; Chemmanur and Fulghieri 1994; Ng and Smith 1996; Puri 1996; Dunbar 2000; McLaughlin et al. 2000), the UK (Slovin et al. 2000), and Japan (Cooney et al. 2003). For instance, Booth and Smith (1986) argue that if the net benefit from revealing the true issuing-firm value of an SEO, after accounting for the cost of hiring a high-quality underwriter, exceeds the benefit of hiding the true issuing-firm value, then the firm will hire high-quality underwriters.

  3. Dunbar (1995) and Ng and Smith (1996) address the selection bias problem using Heckman adjustments in their regression models where the findings are crucially dependent on the assumptions underlying the econometric models.

  4. We do not match firms by industry primarily because our sample SEOs are often clustered in one industry. Loughran and Ritter (1995) note two reasons of industry-wide misvaluations and availability of matching firms for not matching by industry.

  5. We also used the standard deviation of stock returns for 60 days preceding the announcement date as an alternative measure of offering risk. The mean of this variable was 0.292 for CBC offerings and 0.415 for WBC offerings, with the difference being significant at the 0.01 level (t-statistic = 6.70). The regression results using this variable were qualitatively similar to those using SIGMA.

  6. The underpricing of SEOs has recently drawn much attention among financial economists. Several studies (e.g., Altinkiliç and Hansen 2003; Corwin 2003; Mola and Loughran 2004) report that the underpricing of SEOs has become commonplace and that the magnitude of SEO underpricing has increased more dramatically in the 1990s than it did during earlier periods. Corwin (2003) documents that SEO underpricing increased to 2.92% for offers during the 1990–1998 period from 1.15% for offers in the 1980s and that the average reached a high of 3.72% in 1996.

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Acknowledgements

We are grateful to the editor, Cheng-Few Lee and two anonymous referees for valuable suggestions, as well as to Allen N. Berger, Jaisik Gong, Beom-Sik Jang, Yongtae Kim, Chee K. Ng, Eli Ofek, Stephen E. Skomp, and Greg F. Udell for their helpful comments on the earlier version of the article. Bae gratefully acknowledges research support from the CBA Summer Research Grant Program at Bowling Green State University, and Jo appreciates financial support from the Dean Witter Fund and the Breetwor Fellowship.

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Authors and Affiliations

  1. Department of Finance, College of Business Administration, Bowling Green State University, Bowling Green, OH, 43403, USA

    Sung C. Bae

  2. Department of Finance, Leavey School of Business, Santa Clara University, Santa Clara, CA, 95053, USA

    Hoje Jo

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Bae, S.C., Jo, H. Underwriter warrants, underwriter reputation, and growth signaling. Rev Quant Finan Acc 29, 129–154 (2007). https://doi.org/10.1007/s11156-007-0030-2

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