When Do Firms Issue Exchangeable Debt

Introduction Exchangeable debt is bonds issued by one company that are convertible into common shares of a second company (hereafter the underlying firm) in which the issuing firm has a stake. Ghosh et al. (1990) and Barber (1993) propose that exchangeable debt is a way for the issuer to dispose of a block in the underlying firm. Several hypotheses have been put forth to explain what makes exchangeable debt a better alternative to a direct stock sale. Barber (1993) notes that exchangeable debt issuers often mention tax advantages (dividend tax arbitrage (1) and deferral of capital gains realization) as a motivating factor, but argues that tax incentives do not appear to drive the decision to issue this type of instrument. Both Barber (1993) and Gentry and Schizer (2002) examine whether firms issue exchangeable debt in part because it is less costly to do so than to conduct a secondary offering of a large block of stock, and find mixed support for this hypothesis. To shed more light on the growing use of exchangeables, this study investigates the relevance of information-based market timing in the issuance of exchangeable debt offerings. Starting with the seminal study of Myers and Majluf (1984), there has been an ongoing stream of papers that suggest and provide evidence that asymmetric information can be exploited to market-time security issues. Myers and Majluf suggest that managers time security issues to take advantage of the information disparity between themselves and outside investors, and they predict that managers will be inclined to issue equity or convertible debt when common stock is overvalued. In an anonymous survey conducted by Graham and Harvey (2001), executives listed the market price of equity as the most important factor in the decision to issue equity and equity-linked debt. Baker and Wurgler (2002) suggest that corporate capital structure is a cumulative outcome of equity market timing by managers. Recent studies question these findings. Korajczyk and Levy (2003) show that only financially unconstrained firms time security issues when macroeconomic conditions are favorable. Schultz (2003) suggests that apparent evidence on market timing is an artifact of another process and what appears to be market timing is what he calls pseudo market timing and an artifact of issuing equity when stock prices go up. Even if managers do not have any special market timing ability, it appears as if they do simply because more equity is issued when valuations are high. Butler, Grullon, and Weston (2005) argue that the proportion of equity in total new issues is the result of aggregate pseudo market timing. In this paper we ask if managers can use asymmetric information in their decision to issue exchangeable debt. We hypothesize that issuers with unfavorable information about the future value of the underlying firm use exchangeable debt to profit from that information. Large (25.4%) initial stakes in underlying firms coupled with the history of stake formation suggest that the issuers have incentives and opportunities to be well-informed about the future prospects of underlying firms. (2) The study makes three primary contributions. We re-examine price reaction at the announcement of exchangeable debt for a larger sample for both issuing firms and the underlying firms. We conduct a multiple regression analysis in order to examine the ability of managers to time exchangeable debt issues based on information they possess as large shareholders. Finally, we investigate whether a firm signals its intent to conduct an open market sale of the underlying shares by issuing exchangeable debt. We build a dataset that includes 104 issues of exchangeable debt by corporate issuers between 1981 and 2001. In line with the previous literature, we find no abnormal issuer price reaction at the announcement of exchangeable debt. This could imply that the market expected the issuers to be well informed about the prospects of the underlying firms. …