THE CHOICE BETWEEN

This study examines how firms choose between rights offerings and private equity placements, the most commonly used seasoned equity offering (SEO) methods around the world. Developing a nested logit model and employing a new, internationally unique, dataset (the population of SEOs by Swedish public firms, 1986-1999), we find strong evidence supporting three explanations for the choice between rights offerings and private placements: (i) Firms controlled by large family owners choose uninsured rights offerings to avoid control threats. (ii) Private placements and, to a lesser degree, underwritten rights offerings are chosen by potentially undervalued firms to reduce adverse selection costs. (iii) Private placements are also used to reduce contracting costs in newly established product market relationships. * We would like to thank Clas Bergström, Eugene Fama, Jean Helwege, Anil Kashyap, Yrjö Koskinen, Peter MacKay, Dag Michalsen, Tobias Moskowitz, Abraham Ravid, Kristian Rydqvist, Henri Servaes, Per Strömberg, René Stulz, Luigi Zingales, and seminar participants at the Federal Reserve Bank of Philadelphia, Georgia State University, the Norwegian School of Economics and Business, the Norwegian School of Management, Ohio State University, the Stockholm School of Economics, Tulane University, the University of Chicago, the University of Oregon, the 2001 WFA meeting, the 2001 EFA meeting, and the 2001 FMA European meeting, for valuable comments. Financial support from the Center for Research in Security Prices and Torsten och Ragnar Söderbergs Stiftelse (Cronqvist), and from Bankforskningsinstitutet and Jan Wallanders och Tom Hedelius’ Stiftelse för Samhällsvetenskaplig Forskning (Nilsson), is gratefully acknowledged. We thank Affärsdata for providing us with access to their online database. 1 Despite a burgeoning finance literature on seasoned equity offerings (SEOs), there is a surprising lack of studies on how firms choose between different SEO-methods. This is particularly true for stock markets outside the US, where SEOs by public firms are conducted primarily as rights offerings (ROs) or private equity placements (PPs). This study is first to examine how a firm chooses between an RO and a PP, the most common SEO-methods around the world. How do firms choose between different SEO-methods? If firms would only consider direct flotation costs (i.e., fees for legal services, listing fees, merchandising expenses, underwriter compensation, etc.), very few firms would choose an SEO-method other than an uninsured RO, since average costs are only about 1-2% of proceeds (e.g., Smith (1977) and Eckbo and Masulis (1992)). Yet many firms choose more expensive SEO-methods: ROs underwritten by an underwriter who has a standby commitment to purchase any unsubscribed shares (called an underwritten, or insured, RO), or a firm-commitment underwritten public offering (PO), in which an underwriter agrees to purchase all of the new shares for resale to the public. These stylized facts constitute the so-called rights offer paradox (Smith (1977) and Hansen and Pinkerton (1982)). Furthermore, while the importance of PPs among non-listed firms has been recognized (Fenn, Liang, and Prowse (1997)), the question remains why the more expensive private equity market is used by so many public firms so many public firms. This is what we may call the private placement paradox.  Economic explanations other than direct flotation costs should be the focus of any study aiming at solving these paradoxes. We consider three alternative hypotheses related to (i) control considerations, (ii) adverse selection costs, and (iii) monitoring considerations, respectively. To test our different hypotheses on the how firms choose between different SEO-methods, we develop a nested logit model (McFadden (1978, 1981)), in which firms can choose not only between an 1 See Eckbo and Masulis (1995) for an extensive review of the existing evidence on SEOs, and Wu (2002) for recent empirical evidence on the choice of equity-selling mechanism in the US. 2 In an RO, current shareholders are given short-term options, rights, to purchase new shares on a pro rata basis, at a certain exercise price, until a certain expiration date. In a PP, new shares are sold to a small group of  current or new  investors. 3 The direct costs of a PP for public firms are substantial. For example, Hertzel and Smith (1993) find that PPinvestors on average purchases new shares at a 20% discount.