Hedge Funds as Investors of Last Resort?

Abstract

Hedge funds have become important investors in public companies raising equity privately. Hedge funds tend to finance companies that have poor fundamentals and pronounced information asymmetries. To compensate for these shortcomings, hedge funds protect themselves by requiring substantial discounts, negotiating repricing rights, and entering into short positions of the underlying stocks. We find that companies that obtain financing from hedge funds significantly underperform companies that obtain financing from other investors during the following two years. We argue that hedge funds are investors of last resort and provide funding for companies that are otherwise constrained from raising equity capital. (JEL G14, G23, G32) Hedgefundshaverecentlybecomeanimportantsourceoffundingforpublic companies raising equity privately. Financing young companies with severe information asymmetries is an important investment strategy for some hedge funds. Since 1995, hedge funds have participated in more than 50% of the private placements of equity securities and have contributed about one-quarter of the capital raised in such equity issuances, a total investment that has exceeded the contributions of other investor classes. Thispapershedslightontheroleofhedgefundsinsuchprivateplacements. In perfect financial markets it should be irrelevant whether a firm obtains funding from hedge funds or from other investors. To investigate whether the identity of the investors matters, we use a unique dataset that