An Adverse-Selection Model of Equity Financing with Private Benefits of Control

Abstract

We develop an adverse-selection model of equity financing that incorporates private benefits of control into managers/controlling shareholders' self-interested objective function. In the model, it is incentive compatible for managers/controlling shareholders to take even bad projects if their private benefits from the new investments overwhelm the adverse effect on their equity holdings. Unlike Myers and Majluf's (1984) and Stulz's (1990) models, our model unveils a wide range of important factors that influence both under- and over-investment. In particular, private benefits, like inside holdings, have opposing effects on under- and over-investment. Surprisingly, a certain level of private benefits can enhance firm value by alleviating underinvestment. The model nests existing important SEO models in predicting announcement effects, which can be both negative and positive. The possibility of positive announcement effects of SEOs has been largely ignored in the literature. Our model predicts that the relationship between announcement effects and investment opportunities may not be monotonically increasing, especially when investment opportunities are so high that the market well anticipates that the firm will not skip the issue/investment - hence little information content of the new issue. Like Ambarish, John and Williams (1987), our model emphasizes that it is not the level of growth per se but the uncertainties about growth that can give rise to positive announcement returns. But differently, our model does not relate positive announcement returns to overinvestment and negative ones to underinvestment. Our model can explain the puzzle found by Fama and French (1999) that small growth firms with less leverage, not following the Myers' (1984) pecking order in financing, issue a lot of new equity without the fear of the severer asymmetric information they face. We argue that such small firms are likely to have more asymmetric information from investment opportunities than from assets-in-place. According to our analysis, the announcement returns in this situation are likely to become positive. However, it does not mean that the new equity issues by small firms would become rampant. The reason is that such a new issue advantage diminishes endogenously when the small issuer gets bigger by the very equity issue.