THE JOURNAL OF FINANCE • VOL. LVII, NO.

6 • DECEMBER 2002

Long-Run Performance following Private

Placements of Equity

MICHAEL HERTZEL, MICHAEL LEMMON,

JAMES S. LINCK, and LYNN REES*

ABSTRACT
Public firms that place equity privately experience positive announcements effects,
with negative post-announcement stock-price performance. This finding is incon-
sistent with the underreaction hypothesis. Instead, it suggests that investors are
overoptimistic about the prospects of firms issuing equity, regardless of the method
of issuance. Further, in contrast to public offerings, private issues follow periods of
relatively poor operating performance. Thus, investor overoptimism at the time of
private issues is not due to the behavioral tendency to overweight recent experi-
ence at the expense of long-term averages.

IT IS WELL ESTABLISHED that the stock market reacts negatively to announce-

ments of seasoned equity issues.^ Recently, Spiess and Affleck-Graves (1995)
and Loughran and Ritter (1997) document that, in addition to the negative
announcement period returns, issuing firms experience abnormally low stock
returns over the five years following the issue announcement. One explana-
tion of these findings is that managers time equity issues to take advantage
of "windows of opportunity" to issue overvalued equity. This explanation
requires not only that investors are overly optimistic about the issuing firms'
prospects at the time of the issue announcement, but also that investors
underreact to information conveyed by the announcement. While Fama (1998)
argues that the results reflect normal random variations that occur in effi-
cient markets, the long-run post-announcement abnormal stock-price per-
formance is widely viewed as presenting an important challenge to the
traditional paradigm of market efficiency.

* Hertzel is at Arizona State University, Lemmon is at the University of Utah, Linck is at the
University of Georgia, and Rees is at Texas A&M University. We thank Kent Daniel, Steve
Foerster, Ludger Hentschel, Sherry Jarrell, Srini Kamma, Ed Kane, Ajay Khorana, S. P. Kothari,
Wayne Mikkelson, Jim Nelson, Cliff Smith, two anonymous referees, Rick Green and Ren6
Stulz (the editors), and seminar participants at the American Graduate School of International
Management, the University of Arizona, Arizona State University, Georgia Tech, the University
of Miami, the University of Rochester, Texas A&M University, the University of Western On-
tario, the 1997 Financial Management Association Meetings, and the 1998 Southern Finance
Association meetings for helpful comments. Greg Durham, Lalitha Naveen, and Jerry Chen
provided valuable research assistance. Hertzel acknowledges financial support from the Dean's
Council of 100 Faculty Summer Grant Program and the Jack B. Furst Private Equity Research
Program. Any errors or omissions are the responsibility of the authors.
' See, for example, Asquith and MuUins (1986), Masulis and Korwar (1986), and Mikkelson
and Partch (1986).

2595
2596 The Journal of Finance

Providing an additional challenge to the traditional framework are behav-

ioral theories that have been advanced to explain: (1) investor overoptimism
at the time of the issue announcement, and (2) investor underreaction to
information conveyed by the announcement. For example, Loughran and Rit-
ter (1997) argue that investor overoptimism at the time of the issue may
reflect the behavioral tendency, as observed in psychology studies, for hu-
mans to overweight recent experience at the expense of long-term averages.^
They show that operating performance peaks at the time of the equity issue,
and suggest that the post-announcement stock-price decline reflects overex-
trapolation by investors of the pre-issue trend in operating performance.
Daniel, Hirshleifer, and Subrahmanyam (1998) formalize the underreaction
hypothesis in a model where investors are overconfident' and have biased
self-attribution. Given these behavioral attributes, they show that the val-
uation effects of public news events will not be fully incorporated at the
announcement, and that subsequent ahnormal performance will continue in
the same direction as the announcement period returns.^
In this study, we provide further evidence on investor behavior and expec-
tations around equity issues by investigating the stock-price and operating
performance of a sample of publicly traded firms conducting private equity
issues. In contrast to public equity issues, which are underwritten, regis-
tered with the Securities and Exchange Commission, and sold to a large
number of investors, private equity issues are typically negotiated directly
with a single or small group of investors without SEC oversight. Our study
is motivated, in part, by evidence that announcements of public and private
equity issues are associated with opposite stock-price effects: While public
issues, on average, are associated with negative stock-price effects, private
issues are associated with positive stock-price effects. The positive stock-
price response to the announcement of private equity issues sets the stage
for an interesting experiment, since the underreaction hypothesis predicts
continued positive stock-price performance following the announcement,
whereas investor overoptimism associated with the "windows of opportu-
nity" framework predicts long-run post-announcement underperformance.
For a sample of 619 publicly traded firms announcing private placements
of equity during the 1980 to 1996 period, we find that positive announce-
ment period returns are followed by abnormally low post-announcement stock-
price performance. In our sample, the mean raw buy-and-hold return for the
three-year period following private equity issue announcements is only 0.2 per-
cent. Relative to a size-and-book-to-market matched sample of control firms,
the mean three-year buy-and-hold abnormal return is -23.8 percent. This

^ See, for example, Kahneman and Tversky (1982).

^ Appendix A in Daniel et al. (1998) lists a variety of settings in which evidence of under-
reaction has been documented. They state that the underreaction anomaly is "pervasive" with
a pattern that "ohtains for the great majority of event studies." In contrast, Kang, Kim, and
Stulz (1999) do not find evidence consistent with the underreaction hypothesis for Japanese
equity issues.
 Long-Run Performance following Private Placements of Equity 2597

level of underperformance is similar to tbat found for initial public offerings

(e.g., Ritter (1991) and Lougbran and Ritter (1995)) and seasoned equity
offerings (e.g., Lougbran and Ritter (1995, 1997) and Spiess and Affleck-
Graves (1995)), and suggests that investors are overoptimistic about the pros-
pects of firms tbat issue equity, regardless of tbe method of issuance. We do
not find evidence consistent with the underreaction hypothesis. Instead, our
evidence suggests that the direction of the average announcement effect is
incorrect. We discuss the implications of this for earlier studies by Wruck
(1989) and Hertzel and Smith (1993) that offer explanations for the positive
stock-price reaction to private placement announcements.
Given the evidence of investor overoptimism, we next investigate whether
the behavioral explanation of investor overoptimism around public equity is-
sues holds in the case of private equity issues. In sharp contrast to evidence
that public equity issues tend to follow periods of above average operating per-
formance, we find tbat private equity issues tend to follow periods of rela-
tively poor operating performance. Tbus, tbe bebavioral tendency for humans
to overweight recent experience cannot explain investor overoptimism around
the time of private issue announcements. In fact, our results suggest that, if
anything, investors put insufficient weight on recent performance, that is,
investors appear to be overly optimistic that the poor current operating per-
formance will improve in the future. Consistent with this, we find high market-
to-book ratios and significant stock-price run-ups prior to private equity issues.
To further investigate the nature of investor overoptimism at the time of pri-
vate issue announcements, we examine the pattern of capital and R&D ex-
penditures in the periods surrounding the private issues in our sample. Loughran
and Ritter (1997) find that firms tbat issue publicly tend to bave above aver-
age capital expenditures both before and after the issue and view this as evi-
dence that investors and managers may be too optimistic about tbe prospects
of tbese new investments. We document a similar pattern for firms that issue
equity privately, and suggest that investors may similarly be overoptimistic
about tbe future growth opportunities of firms that issue equity privately.
In addition to the positive announcement period stock-price reaction, an-
other interesting feature of private equity issues is that they are typically
sold to investors at substantial discounts from current market value (16 per-
cent, on average, for our sample). Prior literature suggests the discounts
reflect compensation to private placement investors for expected monitoring
services and expert advice (Wruck (1989)), illiquidity (Silber (1991)), and
information production (Hertzel and Smith (1993)). Our findings suggest
another potential explanation, that is, the negative post-issue stock-price
performance suggests that private placement discounts may reflect private
investors' assessments of true (lower) firm value.*

'' This finding has potentially important implications for the widely used practice in the
appraisal industry of relying on discounts from private placement studies as an estimate of the
illiquidity discount used when valuing minority interests in private firms. See Koeplin, Sarin,
and Shapiro (2000) and Bajaj et al. (2001) for recent discussions of this practice.
2598 The Journal of Finance

The remainder of our paper is organized as follows. In Section I, we de-

scribe our data and research methods. In Section II, we provide evidence on
post-announcement stock-price performance and tests of the underreaction
hypothesis. Section III examines the operating performance and capital ex-
penditures of our sample firms and explores sources of overoptimism at the
time of the issue. Section IV discusses the implications of our findings for
prior studies that have been advanced to explain positive announcement
effects and the sizable discounts at which shares are issued to private place-
ment investors. Section V concludes.

I. Data and Research Methodology

A. Sample Description
Through Dow Jones News Retrieval Service searches, we identify 952 an-
nouncements of equity private placements from the 1980 to 1996 period by
firms that existed on the Center for Research in Security Prices (CRSP)
NYSE/AMEX/Nasdaq monthly stock files at the year-end prior to the pri-
vate placement announcement.^ To avoid potential problems with low-price
stocks (Ball, Kothari, and Shanken (1995)), we exclude 209 firms with a
price less than two dollars at the time of the private placement announce-
ment. We also eliminate 124 firms that had completed a private placement
within the preceding three years (the firm's first private placement is in-
cluded in the sample), leaving us a final sample of 619 equity private
placements.
The private placements in our sample are most heavily concentrated in
the periods 1985 to 1987 and 1991 to 1993. Firms traded on Nasdaq com-
prise 79 percent of the sample. By comparison, 50 percent of the public
offerings in the Spiess and Affleck-Graves (1995) sample are Nasdaq firms.
Aggregate proceeds raised from the private placements in our sample is
$9.1 billion (in 1996 dollars), $5.6 billion of which is raised by Nasdaq
firms.
Panel A of Table I shows that the sample spans a large number of in-
dustries. However, some clustering is evident, with just under 55 percent
of the sample belonging to six industry groups (chemicals and allied prod-
ucts, electric and electronic equipment, holding and other investment of-
fices, instruments and related products, industrial machinery and equipment,
and business services). To address this issue, we control for industry ef-
fects in our empirical analysis. Panel B indicates that the average proceeds
raised from the private placements in our sample is $12.7 million, and
that the mean number of new shares issued as a percentage of total shares
outstanding after the issue is 21.2 percent. In contrast, Krishnamurthy
et al. (1999) report, over a similar time period, average proceeds of $48.8

^ Our sample period ends in 1996 because we need at least three years of post-announcement
data for most of our analyses.
 Long-Run Performance following Private Placements of Equity 2599

Table I
Sample Characteristics of Equity Private Placements
from 1980 to 1996
Through Dow Jones News Retrieval Service searches, we identified 952 announcements of eq-
uity private placements over the 1980 to 1996 period for firms covered on the CRSP monthly
stock files (NYSE/AMEX/Nasdaq) at the year-end prior to the private placement announce-
ment. We eliminated observations with a price less than two dollars at the time of the an-
nouncement, and those where the firm had a previous private placement in the last three years,
leaving a sample of 619 private placement announcements from 1980 to 1996. Panel A reports
the distribution of sample firms across two-digit SIC codes, and Panel B reports various sample
characteristics of the private placement and the private placement firms. Significance of the
announcement period return is based on the market model standardized residual method with
Scholes-Williams (1977) betas.

Panel A: Distribution of Sample Firms across Two-Digit SIC Codes

% of
SIC Code N Sample
Chemicals and allied products 28 88 14.2
Electric and electronic equipment 36 60 9.7
Holding and other investment offices 67 59 9.5
Instruments and related products 38 49 7.9
Industrial machinery and equipment 35 47 7.6
Business services 73 37 6.0
Health services 80 30 4.8
Oil and gas extraction 13 21 3.4
Communication 48 20 3.2
Banking 60 20 3.2
Engineering and management services 87 14 2.3
Motion pictures 78 13 2.1
Wholesale trade-durable goods 50 12 1.9
Other 149 24.2
Total 619 100.0

Panel B: Sample Characteristics of Equity Private Placements

N^ Mean Median
Dollar proceeds (millions) 581 $12.7 $4.5
Fraction placed (% of shares after private placement) 493 21.2% 13.9%
Market value of equity (millions) 619 $188.6 $31.9
Book-to-market 591 0.43 0.26
Discount (% of market price at month-end prior to event) 404 16.5% 13.4%
Announcement period abnormal return: Days - 3 to 0° 619 2.4% 0.7%
Discount adjusted annc. period abnormal return: Days - 3 to 0° 398 15.2% 3.7%

" Announcement period return significantly different from zero at the one percent level. Sig-
nificance based on the market model standardized residual method with Scholes-Williams (1977)
betas.
'' Number of observations varies across statistics due to differing disclosures in the private
placement announcements. Number of "discount adjusted annc. period abnormal return" ob-
servations is lower than the number of discount observations because insufficient data was
available to calculate the fraction placed.
2600 The Journal of Finance

million for public issues, representing 17.4 percent of total shares outstand-
ing after the issue. Thus, although private placements are of significantly
smaller dollar value, the fraction of shares sold is slightly larger than that
in a typical seasoned public issue. The mean (median) market value of
equity of our sample firms is $188.6 ($31.9) million. The mean (median)
book-to-market ratio is 0.43 (0.26).^ Thus, the sample is skewed towards
small, low book-to-market firms. We control for size and book-to-market
effects in our empirical analysis.
The private placements in our sample are sold at a mean (median) dis-
count of 16.5 percent (13.4 percent), measured relative to the share price
at the end of the month prior to the announcement date.'' The table also
reports that the mean four-day {-3,0} announcement period return is 2.4 per-
cent, significant at the one percent level.^ This translates to a four-day
discount-adjusted abnormal return of 15.2 percent, significant at the one
percent level.'' These findings are consistent with previous studies of pri-
vate placements, which also find that private placements are associated
with positive announcement period returns and are issued at substantial
discounts.

B. Measurement of Long-Run Abnormal Stock-Price Performance

We adopt two basic approaches to measure long-run abnormal stock-price
performance following private placements of equity. First, we follow the ap-
proach of Barber and Lyon (1997) and benchmark performance by using an
appropriately selected single control firm for each sample firm (buy-and-
hold abnormal return method). However, as pointed out by Fama (1998) and
Mitchell and Stafford (2000), this methodology may be problematic because
it does not adequately account for potential cross-sectional dependence in
returns. To address this possibility, we also estimate abnormal returns using
the calendar-time portfolio approach used by Mitchell and Stafford. The
calendar-time portfolio approach was first used by Jaffe (1974) and Man-
delker (1974). We describe our methodology in more detail helow.

® We define the book-to-market ratio as the firm's book value of equity divided by its market
value of equity, measured at the fiscal year end prior to the equity issue announcement. We
hand-collected the book equity from Moody's Manuals for 66 of our sample firms that did not
have sufficient information on COMPUSTAT.
'' When the discount is measured as of the month-end after the private placement announce-
ment, the mean (median) discount is 16.9 percent (15.9 percent).
^ Abnormal returns are measured using residuals from the market model with Scholes-
Williams (1977) betas estimated over the period beginning 200 days and ending 51 days prior
to the announcement.
^ As recognized by Wruck (1989), the observed announcement effect is a measure of the
information effect net of placement costs. We follow Wruck's procedure, as developed from Bra-
dley and Wakeman (1983) and calculate the information effect (the discount-adjusted abnormal
return) as AiJ'^'"'' = [1/(1 - a)][AR] + [a/(l - aMP^ - Po)/Pb], where AR is the abnormal stock
return, a is the ratio of shares placed to shares outstanding after the placement, P^ is the
market price at the end of the day prior to the event window, and PQ is the placement price.
 Long-Run Performance following Private Placements of Equity 2601

B.I. Buy-and-Hold Abnormal Returns

The buy-and-hold abnormal return (BHAR) for stock i over the period from
time a to time b is defined as

BHAR^^,,, = BHR.^^.j, - BHR,,^^^^,,,, (1)

where BHR^^.i, is the buy-and-hold return of the sample firm and

BHR^a^paj, is the buy-and-hold return of the control firm over the same
time period. We compute buy-and-hold abnormal returns for our sample firms
beginning the month after the private placement announcement through
the end of the three-year period following the announcement or until either
the sample or control firm delists, whichever is sooner.i" The average buy-
and-hold abnormal return is

= ( - ) i BHAR,^,,,, (2)

where n is the number of firms in the sample.

In calculating the buy-and-hold abnormal returns, we consider three bench-
marks of post-announcement performance: (1) a size-matched sample, (2) an
industry- and size-matched sample, and (3) a book-to-market- and size-
matched sample. To assess the statistical significance of the abnormal re-
turns calculated with this method, we utilize a bootstrapping procedure as
suggested in Kothari and Warner (1997). Additional details of our method
for selecting control firms and of the bootstrapping procedure are provided
in the Appendix.

B.2. Calendar-Time Abnormal Returns

For each calendar month in our sample period, we form a portfolio of all
sample firms that have announced a private placement in the previous three
years. We then regress the portfolio excess return on the three Fama and
French (1993) factors as follows:

Rp, -Rf, = a + p^(/?„,, -Rft) + /3,SMBt + p^HML, + e,, (3)

where iJ^^ is the portfolio return for month t, Rf^ is the risk-free interest
rate, (R^^ - Rf^) is the excess return on the market, SMBt is the difference
in returns between a portfolio of "small" and "big" stocks, and HMLt is the
difference in returns between a portfolio of "high" and "low" book-to-market

'" Studies of puhlic issues hegin measuring returns after the issue date. In the case of pri-
vate placements, we measure performance heginning at the announcement date hecause the
completion date is often not reported. In many cases, the private placements have already been
completed at the time of the announcement.
2602 The Journal of Finance

stocks. If tbe model adequately describes returns, then the expected value of
tbe intercept, a, which measures tbe montbly abnormal return, is zero un-
der the null hypothesis of no abnormal performance. As sbown by Fama and
French, however, the three-factor model is unable to completely describe tbe
cross section of expected returns, particularly for small, low book-to-market
stocks (which comprise a large part of our sample). Thus, we follow Mitchell
and Stafford (2000) and also estimate the intercept relative to the expected
intercept. The expected intercept is computed as the average intercept ob-
tained from 1,000 calendar-time portfolio regressions for random portfolios
with the same size and book-to-market composition as the sample firm port-
folios.^^ The test statistic is then estimated as follows:

d-E{d)
t = , (4)
se

where d is the intercept for the sample firm calendar-time portfolios, E{d) is
the average intercept from 1,000 calendar-time portfolio regressions for the
random portfolios, and se is the estimated standard error of the intercept
from the regression in equation (3). We estimate the calendar-time portfolio
intercept and adjusted intercept for both equal- and value-weighted portfolios.

II. Post-Announcement Stock Returns

A. Buy-and-Hold Abnormal Returns
Table II reports the cumulative raw returns of our sample firms, and buy-
and-hold and calendar-time abnormal returns over the three-year period fol-
lowing the private placement announcements. The results show negative
long-run abnormal performance following private equity announcements, re-
gardless of the benchmark. As shown in Panel A, the mean three-year buy-
and-hold abnormal returns for the size-matched, size- and industry-matched,
and size- and book-to-market-matched control portfolios are -45.15 percent,
-38.18 percent, and -23.78 percent, respectively. Both the cross-sectional
^-statistics and tbe bootstrap p-values indicate tbat all of tbese abnormal
returns are statistically significant at tbe one percent level. Additionally, the
mean three-year buy-and-bold raw return is 0.21 percent. Tbese returns are
lower than those reported following public issues. For example, Spiess and
Affleck-Graves (1995) report mean three-year buy-and-bold raw returns of
34.11 percent and abnormal returns relative to a size- and industry-matcbed
benchmark of -22.84 percent following public equity issues. Both the me-
dian abnormal returns and the corresponding five-year abnormal returns

^^ The specific criterion for mimicking the size and book-to-market characteristics of the
sample portfolio is to choose nonevent firms in the same size and hook-to-market quintiles as
the sample firms, based on NYSE breakpoints.
 Long-Run Performance following Private Placements of Equity 2603

Table II
Long-Run Returns Following Private Placements to Investors
Not Participating in the Private Placement
Through Dow Jones News Retrieval Service searches, we identified 952 announcements of eq-
uity private placements over the 1980 to 1996 period for firms covered on the CRSP monthly
stock files (NYSE/AMEX/Nasdaq) at the year-end prior to the private placement announce-
ment. We eliminated observations with a price less than two dollars at the time of the an-
nouncement, and those where the firm had a previous private placement in the last three years,
leaving a sample of 619 private placement announcements from 1980 to 1996. Panel A reports
huy-and-hold returns for the sample firms, and buy-and-hold adjusted returns for the sample
firms relative to control firms, for the three-year period following the private placement an-
nouncement. The buy-and-hold return (BHR) is the BHR for the firm (sample or control) beginning
the month after the private placement announcement through the end of the three-year period
following the announcement, or until either the sample or match firm delists, whichever is
sooner. The buy-and-hold adjusted return (BHAR) is the difference between the BHR on the
sample firm and that of the control firm (and relative to investing in, and rolling over. Treasury
bills). Cross-sectional i-statistics are reported in brackets. The p-values (reported in parentheses)
are based on bootstrap procedures and represent the percentile ranks of the mean return for the
issuing firms relative to the 1,000 mean returns from randomly selected matched portfolios. Panel B
reports results from calendar-time portfolio regressions where the dependent variables are event
portfolio returns, Rp, in excess of the Treasury bill rate, R/-. Each month, we form portfolios of all
sample firms that have announced a private placement in the previous three years. The three fac-
tors, from Fama and French (1993), are the excess return on the market {R,,, - Rf), the return
difference between a portfolio of "small" and "big" stocks {SMB), and the return difference be-
tween a portfolio of "high" and "low" book-to-market stocks (HML). The intercept (a) measures
the monthly abnormal return, given the model. The adjusted intercept {Adj a) measures the
difference between the event portfolio intercept and the average intercept from 1,000 random
samples of nonevent firms in the same size and book-to-market quintiles as the sample firms, based
on NYSE breakpoints. Calendar months with less than 10 observations in the event portfolio are
excluded. The ^-statistics are reported in brackets, and the number of monthly observations is
reported in parentheses. The Implied 3-year AR [(1 + Intercept)^'' - 1] is the estimated average
buy-and-hold return from earning the intercept return every month for 36 months.

Panel A: Three-Year Buy-and-Hold Returns (%)

BHAR (in Percent)

Raw Return
Private Size Size/Ind Size/BM T-bill
Placement Matched Matched Matched Adjusted

N 619 619 619 591 619

Mean 0.21 -45.15 -38.18 -23.78 -14.73
Median -27.27 -41.13 -30.44 -19.99 -44.05
^-statistic [0.05] [-5.83]° [-6.94]" [-4.68]" [-3.41]"
Bootstrapped p-value (<0.01) (<0.01) (<0.01)

Panel B: Calendar-Time Portfolios : Rp, - Rf, - a + P,,,{R,,,, -Rr>) + P.SMB, -H l3i,HML, + e.

Equal-Weighted Value-Weighted
a Adj a Adj. R^ a Adj a Adj. R'^
[i-stat.] [<-stat.] {N Obs.) [t-stat.] [t-stat] (N Obs,)
Full sample (N = 619) -1.18" -1.03" 0.773 -1.23" -1,18" 0.592
-[5.11] -[4.44] (223) -[4,11] -[3,97] (223)
Implied 3-year AR (%) -34.82 -31.04 -35.85 -34,83
" The ^-statistic is significantly different from zero at the one percent level.
2604 The Journal of Finance

(not reported) yield similar inferences. Finally, the table also shows that the
sample firms returned less than a contemporaneous investment in Treasury
bills.

B. Calendar-Time Abnormal Returns

Panel B of Table II reports equal- and value-weighted calendar-time port-
folio abnormal returns. The calendar-time portfolios include all sample firms
issuing equity privately in the previous three years. For the equal-weighted
portfolio, the regression intercept (a) indicates that the private placement
firms exhibit average abnormal returns of -1.18 percent per month over tbe
36-month period following the private placement announcement, which is
statistically significant at tbe one percent level (^-statistic = -5.11). The
average abnormal performance based on tbe adjusted intercept (Adj a) is
slightly smaller in absolute value, averaging -1.03 percent per montb (^-
statistic = -4.44). Tbis translates to a tbree-year return of approximately
-31.04 percent [(1 - 0.0103)^^ - 1], wbicb is similar to tbe underperfor-
mance reported based on tbe control-firm approacb. Results for tbe value-
weighted portfolio are similar to tbose of tbe equal-weighted portfolio. The
unadjusted intercept for tbe value-weighted portfolio indicates an average
abnormal return of -1.23 percent per month (^-statistic = -4.11) for the
tbree-year period following tbe private placement announcement; tbe ad-
justed intercept indicates an average monthly abnormal return of -1.18 per-
cent (^-statistic = -3.97). In botb cases, tbe abnormal performance is
statistically significant at tbe one percent level.

C. Cross-sectional Patterns of Post-Announcement

Stock-Price Performance
We partition our sample in several ways to examine wbether the long-run
underperformance is correlated with observable characteristics and to as-
sess tbe robustness of our results. We find no statistically significant differ-
ences in the level of underperformance across subsamples segmented on firm
size, book-to-market, tbe listing date of tbe firm, industry classification, and
various characteristics of tbe private placements. For brevity, tbe results are
not reported in a table, but are described below.

C.I. Firm Size

In each quartile of firm size, tbe sample firms significantly underperform
tbeir benchmarks. Tbe mean tbree-year buy-and-bold abnormal returns rel-
ative to tbe size- and book-to-market-matcbed control firms in eacb size
quartile (smallest to largest) are -34.63 percent, -20.71 percent, -20.42
percent, and —19.46 percent; all significantly different from zero at tbe five
percent level. An i^-test cannot reject tbe bypotbesis tbat tbe abnormal re-
turns are equal across tbe size quartiles.
 Long-Run Performance following Private Placements of Equity 2605

C.2. Book-to-Market
There is some evidence that the magnitude of underperformance is lower
for firms in the highest quartile of book-to-market. The mean three-year
buy-and-hold abnormal returns relative to the size- and book-to-market-
matched control firms in each book-to-market quartile (lowest to highest)
are -36.36 percent, -21.80 percent, -22.18 percent, and -14.86 percent,
significantly different from zero at the five percent level in all but the high-
est book-to-market quartile. However, an F-test cannot reject the hypothesis
that the abnormal returns are equal across the book-to-market quartiles.
Our finding that high book-to-market issuers appear to have slightly less
underperformance is consistent with similar results documented for public
issuers by Spiess and Affleck-Graves (1995).

C.3. Newly Listed Firms

We also examine the possibility that the poor long-run stock-price perfor-
mance is driven hy the underperformance of newly listed firms (e.g., Ritter
(1991)). We define newly listed firms as those listed on CRSP for less than
three years as of the event date (we also use a five-year cutoff and obtain
similar results). Using this definition, approximately 38 percent of our sam-
ple firms are newly listed. In both subsamples (newly listed and estab-
lished), private equity issuers significantly underperform their benchmarks.
For example, relative to the size- and book-to-market-matched control firms,
the mean three-year buy-and-hold abnormal returns for the newly listed and
established firms are -32.29 percent and -18.58 percent, respectively, both
significantly different from zero at the one percent level. An /^-test cannot
reject the hypothesis that the abnormal returns are equal across the two
subsamples.
To provide additional evidence on the performance of the newly listed firms
in our sample, we also estimate abnormal returns (using the calendar-time
portfolio approach) from the CRSP listing date through the date of the pri-
vate placement. In this model, the adjusted intercept in the equal-weighted
calendar-time portfolio method is 0.11 percent, not significantly different
from zero, indicating that the newly listed firms do not underperform over
the period between the listing date and the date of the private equity issue.
Taken together, these findings indicate that the poor long-run stock-price
performance following private equity issues is not simply a manifestation of
Ritter's (1991) IPO results.

C.4. Industry and Private Placement Characteristics

The mean three-year buy-and-hold abnormal returns relative to the size-
and book-to-market-matched control firms are negative in 12 of the 14 in-
dustry groups defined in Table I; an F-test cannot reject the hypothesis that
the long-run abnormal performance is equal across industries. We also can-
not reject the hypothesis that the level of long-run abnormal performance is
2606 The Journal of Finance

Table III
Association between Announcement Period Return
and Long-Run Returns following Private Placements
of Equity from 1980 to 1996
The table reports the Spearman rank correlations between the announcement period returns
and the three-year buy-and-hold raw returns and abnormal returns. The buy-and-hold adjusted
return {BHAR) is the difference between the buy-and-hold return on the sample firm and that
of the control firm based on size- and industry-matched control firms. The discount-adjusted
announcement period return = [1/(1 - a)][AR] + [a/(l - a)\[{P^ - Po)IPb\, where AT? is the
announcement period abnormal stock return (day - 3 to day 0) based on market model resid-
uals, a is the ratio of shares placed to shares outstanding after the placement, P^ is the market
price at the end of the month prior to the event, and PQ is the placement price. The p-values are
reported in parentheses.

Discount-Adjusted
Announcement Announcement Period
Period Return Return
Buy-and-hold raw return -0.08 -0.19
(0.04) (0.00)
Buy-and-hold adjusted return
Size and industry benchmark 0.01 -0.03
(0.82) (0.58)
Size benchmark 0.00 -0.08
(0.91) (0.12)
Size and book-to-market benchmark -0.01 -0.02
(0.75) (0.72)

equal across quartiles of the fraction of shares placed or by whether the

private placement was issued at a discount or a premium from the current
market price.
D. The Underreaction Hypothesis
Given the positive mean stock-price reaction at the announcement, our
evidence of negative post-announcement abnormal stock-price performance
is inconsistent with the underreaction hypothesis. To investigate further, we
more directly test the underreaction hypothesis using the approach of Kang
et al. (1999). In particular, we test whether the announcement period return
is a constant fraction of the long-run return. If this is the case, then a firm's
announcement period abnormal return should be positively correlated with
its long-run abnormal return. The results, presented in Table III, show that
all of the correlations between the announcement period returns and the
long-run post-announcement returns are small in absolute magnitude, and
six of the eight correlation coefficients are negative. The only positive cor-
relations are small in magnitude and statistically insignificant. These find-
ings are similar to those reported in Kang et al. for Japanese equity issues
and are not consistent with the predictions of the specific version of the
underreaction hypothesis tested.
 Long-Run Performance following Private Placements of Equity 2607

While our results are inconsistent with the underreaction hypothesis, we

know of no alternative behavioral theory that can explain why investors
would systematically react in the wrong direction to an announcement as we
have documented here. In Section IV, we discuss our findings in the context
of earlier studies that attempt to explain positive private placement an-
nouncement effects. Although we offer possible explanations of where inves-
tors may have gone wrong, these are only meant as a possible starting point
for further investigation. We do not resolve the issue in this study.
The puzzling announcement effect notwithstanding, the negative post-
announcement stock-price performance we document is consistent with the
view that, at the time of the private issue announcement, investors are over-
optimistic about the prospects of the issuing firms. Given similar findings
for initial public offerings and seasoned equity offerings, our results suggest
that long-run underperformance is a phenomenon associated with the issu-
ance of equity independent of the placement method. In the next section, we
examine the operating performance of our sample firms in the years sur-
rounding the private equity issue in an attempt to better understand the
potential sources of investor overoptimism.

III. Investor Overoptimism, Operating Performance,

and Capital Expenditures
In their investigation of investor overoptimism following public equity is-
sues, Loughran and Ritter (1997) report that the operating performance of
issuing firms is better than that of a control group just prior to the issue,
but deteriorates afterwards. They view this evidence as consistent with the
hypothesis that the poor post-offer stock-price performance reflects investor
disappointment that the favorable trend in earnings prior to the issue does
not continue after the issue. This explanation is based on the behavioral
observation that humans tend to overweight (overreact to) recent experience
at the expense of long-term averages (see Kahneman and Tversky (1982)).
We consider whether a similar behavioral explanation can account for in-
vestor overoptimism at the time of private equity issues.
To gauge the operating performance of our sample firms, we compute the
ratio of operating income to total assets (OIBD/assets) and the ratio of net
income to total assets (ROA) for the years surrounding the private equity
issues.^2 We define operating income as operating income before deprecia-
tion, amortization, and taxes, plus interest income. We follow Loughran and

'^ The ratio of operating income to total assets is computed as (COMPUSTAT item #13 +
COMPUSTAT item #62)/(COMPUSTAT item #6). The ratio of net income to total assets is
computed as (COMPUSTAT item #172)/(COMPUSTAT item #6). Table IV also reports the market-
to-book equity ratio, computed as (COMPUSTAT item #25 * COMPUSTAT item #199)/
(COMPUSTAT item #60), and the ratio of capital and R&D expenditures to total assets, computed
as (COMPUSTAT item #128 + COMPUSTAT item #46)/(COMPUSTAT item #6). Only 511 of our
619 sample and control firms have complete data on COMPUSTAT for sales, assets, and oper-
ating income in the year prior to the private placement announcement.
2608 The Journal of Finance
Table IV
Operating Performance around Private Placements
from 1980 to 1996
Panel A reports median operating performance for the sample firms and Panel B reports the
samples' median industry-adjusted operating performance (defined as the sample median less
the median for the sample firms' industries). Year represents the firm's fiscal year relative to
the year of the private placement (year 0 is the year of the private placement), N is the number
of ohservations with available COMPUSTAT data, OIBD/assets is operating income before de-
preciation (COMPUSTAT item #13) plus interest income (COMPUSTAT item #62) deflated by
fiscal year-end total assets (COMPUSTAT item #6). ROA is net income (COMPUSTAT item
#172) divided by fiscal year-end total assets. CE + RD/assets is capital expenditures (COM-
PUSTAT item #128) + research and development expenditures (COMPUSTAT item #46) divided
by total assets. If CE or RD is missing from COMPUSTAT, their values are set equal to 0. M/B,
market-to-book, is the number of shares outstanding (COMPUSTAT item #25) multiplied by
fiscal year-end price (COMPUSTAT item #199) divided by book value of equity (COMPUSTAT
item #60), Sample firms are those that privately placed equity from 1980 to 1996,

OIBD/Assets ROA CE+RD/Assets

Year N (%) (%) (%) M/B

Panel A: Sample Firm Medians

-3 343 2.25 0.44 13.26 2.30

-2 430 1.73 -3,25 13.47 2.54
-1 511 -1,53 -9,34 15,92 3,33
0 477 -1.86 -10,97 15,72 3,11
1 375 -1.01 -9,01 13,92 2,64
2 292 1.18 -8,81 12.77 2,67
3 234 1.80 -7.38 12,49 2.38

Panel B: Industry-Adjusted Performance (Sample Median - Industry Median)

-3 343 -8.88" -2,98" 3,55° 0,74"
-2 430 -8.62" -6,03" 3.54" 0.82°
-1 511 -11.92" -11.93" 5,41" 1.49°
0 477 -11.93" -13,41" 5,16" 1,07
1 375 -10.72" -11.06" 3,24" 0,49
2 292 -8.58" -10.48" 1.76" 0,59
3 234 -7.60" -9.06" 1.97" 0,17

"•'' Significantly different from zero at the one percent and five percent levels, respectively,
based on Wilcoxon rank sums test (two-sided).

Ritter (1997), and include interest income because many issuers temporarily
invest some of the proceeds in interest-earning instruments prior to invest-
ing in operating assets.
In sharp contrast to public issues, Table IV shows that private equity
issues tend to follow periods of relatively poor operating performance. Panel A
shows that operating performance of firms issuing equity privately declines
over the four-year period leading up to and including the year of issue. Also
noteworthy is evidence that the median sample firm has a negative ROA in
 Long-Run Performance following Private Placements of Equity 2609

tbe two years prior to tbe issue and tbe year of tbe issue. Panel B presents
industry-adjusted performance relative to the median firm in the same two-
digit SIC industry and shows that botb OIBD/Assets and ROA for the me-
dian issuer are substantially lower than the industry median in each of the
three years prior to the issue and in tbe year of tbe issue. Taken togetber,
tbese results rule out tbe bebavioral explanation that the poor post-
announcement stock-price performance reflects the tendency for investors to
overweight recent operating performance in forming expectations of future
performance. Rather tban overweighting tbe recent poor performance, our
evidence suggests that investors may be too optimistic about the potential
tbat operating performance will improve in tbe future.
Tbe post-issue operating performance is consistent witb tbis view. Table IV
sbows tbat operating performance remains weak after tbe private equity
issue. Botb OIBD/assets and ROA for tbe median issuer are substantially
lower tban tbe industry median in eacb of tbe tbree years after tbe issue. To
provide additional evidence on tbe post-issue operating performance, we fol-
low Barber and Lyon (1996) and matcb eacb sample firm to a control firm on
the basis of industry (two-digit SIC), total assets, and operating perfor-
mance (OIBD/assets) at the end of the year preceding the private place-
ment. ^^ The results (not presented in a table) further support the view that
the poor post-issue stock-price performance reflects investor disappointment
about tbe failure to reverse tbe poor operating performance prior to the
issue. Specifically, OIBD/assets for tbe median issuer is lower tban that of
the median control firm in tbe year of and the years following the private
placement announcement. The differences are statistically significant in years
0, 1, and 2 relative to tbe year of tbe private equity issue. Tbe results are
similar for tbe return on assets (ROA) measure, i"*
Lougbran and Ritter (1997) report tbat public equity issues are preceded
by a positive and significant stock-price run-up, and tbat issuing firms bave
bigber tban average market-to-book ratios at the time of issuance. This evi-
dence suggests tbat tbe ex post operating performance deterioration is not
impounded into market prices at the time of issuance. To shed light on the

•'' Specifically, for each sample firm, we find the set of COMPUSTAT firms with the same
two-digit SIC as the sample firm, that have stock prices greater than two dollars, and have
total assets between 25 percent and 200 percent of the sample firm. If no firms meet the above
criteria, control firms are selected from the set of firms with total assets between 90 percent
and 110 percent of the sample firm without regard to industry. From the resulting set of firms,
we select the firm that has the closest operating performance to that of the sample firm in the
year prior to the private placement announcement. We also matched on one-digit SIC code with
similar results.
'•* We also checked whether the poor operating performance was driven by newly listed firms
that have yet to report positive earnings as discussed in Section II.C. Although we find that
newly listed firms do have lower operating performance relative to their industries than do the
established firms, both subsamples (newly listed and established) show similar patterns in
operating performance: Both groups perform significantly worse than their industries and their
Barber and Lyon (1996) matched counterparts before and after the private placement
announcement.
2610 The Journal of Finance

nature of investor expectations at the time of private equity issues, we in-

vestigate whether pre-issue market-to-book ratios and stock-price perfor-
mance provide similar indications of investor overoptimism.
Similar to the results for public equity issues, we find high market-to-book
ratios and significant stock-price run-ups prior to private equity issues.
Table IV shows that the issuing firms have higher market-to-book ratios
(M/B) than the control firms in the years prior to the issue. The differences
are significant in the three prior years. Table V shows that over the one-year
period ending one month prior to the month preceding the private place-
ment, issuing firms have a mean raw buy-and-hold return of 52.8 percent,
significantly higher than the mean contemporaneous buy-and-hold returns
for the size, size and industry, and size and book-to-market control firm
benchmarks. The calendar-time portfolio methodology confirms these findings.
Given the relatively poor pre-issue operating performance of our sample
firms, the stock-price run-ups and high market-to-book ratios we document
are consistent with the view that, prior to the issue, investors are anticipat-
ing an improvement in future operating performance. One possibility is that
investors are anticipating a turnaround in the performance of the firms'
existing assets in place. Another possibility is that investors are overopti-
mistic about the future payoffs from the firms' current investments and growth
opportunities. We find some evidence of this latter possibility in the data.
Table IV shows that the ratio of capital and R&D expenditures to total as-
sets (CE + RD/assets) for the issuing firms is significantly higher than that
of the industry median firm in the years surrounding the private place-
ment, i^ We also examine the extent to which pre-issue operating perfor-
mance and pre-issue capital expenditures explain the stock-price run-up (not
reported in a table). Although we find some evidence that larger capital
expenditures are associated with higher pre-announcement performance, the
results are statistically weak. Loughran and Ritter (1997) also find high
levels of capital expenditures prior to public issues and similarly conclude
that investors (and managers) may be too optimistic about the firms' growth
prospects. ^^
In summary, firms that issue equity privately have higher than average
market-to-book ratios, positive stock-price run-ups, and post-announcement
stock-price underperformance that is similar to that found in firms making
public equity offerings. In sharp contrast to public issues, however, firms
making private placements of equity have poor operating performance in

'^ The capital expenditure results are also consistent with the idea that managers invest in
negative NPV projects to increase the size of the organization under their control (Jensen and
Meckling (1976)). This argument, however, cannot explain the stock-price run-up prior to the
issue unless the market incorrectly views these as profitahle investments.
'^ We also examine whether corporate control activity in these firms can explain the pre-
issue stock-price run-up. Only 12 of our 619 sample firms experience any corporate control
activity over the year preceding the private equity issue. We find that the pre-issue run-up
remains even after removing these firms from the sample, indicating that control activity can-
not explain the pre-issue run-up of these firms.
 Long-Run Performance following Private Placements of Equity 2611

Table V
Pre-Announcement Period Returns to Investors
Not Participating in the Private Placement
Panel A reports the buy-and-hold return for the sample firms, and the buy-and-hold adjusted
returns for the sample firms relative to control firms, for the one-year period ending the month
prior to the month preceding the private placement (e.g., month - 1 3 through month -2). Panel
B reports the same for the two-year period ending the month prior to the month preceding the
private placement (e.g., month - 2 5 through month -2). The buy-and-hold adjusted return
{BHAR) is the difference between the BHR on the sample firm and that of the control firm.
Cross-sectional i-statistics are reported in brackets. Wilcoxon p-values are reported in paren-
theses. Panel C reports results from calendar-time portfolio regressions where the dependent
variables are event portfolio returns, Rp, in excess of the Treasury bill rate, iJ^. Each month, we
form portfolios of all sample firms that announce a private placement within the following year
(excluding the current and next month). The three factors, from Fama and French (1993), are
the excess return on the market (i^,„ - Rf), the return difference between a portfolio of "small"
and "big" stocks {SMB), and the return difference between a portfolio of "high" and "low"
book-to-market stocks {HML). The intercept {a) measures the monthly abnormal return, given
the model. The adjusted intercept {Adj a) measures the difference between the event portfolio
intercept and the average intercept from 1,000 random samples of nonevent firms in the same
size and book-to-market quintiles as the sample firms, based on NYSE breakpoints. Calendar
months with less than 10 observations in the event portfolio are excluded. The t-statistics are
reported in brackets, and the number of monthly observations is reported in parentheses. The
implied 1-year AR [(1 -t- Intercept)'^ - 1] is the total buy-and-hold return from earning the
intercept return every month for 12 months.

BHAR (in Percent)

Raw Return
Private Size Size/Ind Size/BM
Placement Matched Matched Matched

Panel A: Returns Prior to Private Placement Announcement

(Month -13 through Month - 2 , in %)
N 619 619 619 591
Mean 52.78° 33.82° 28.61° 17.26'
^-statistic [7.70] [4.98] [3.93] [2.43]
Median 17.67 9.89 8.31 5.16
Wilcoxon p-value (<0.01) (<0.01) (0.03) (0.09)

Panel B: Returns Prior to Private Placement Announcement

(Month -25 through Month - 2 , in %)
N 619 619 619 591
Mean 61.06° 18.28'' 13.15 -19.14''
^-statistic [9.48] [2.08] [1.54] -[1.98]
Median 22.22 4.55 8.57 -7.46
Wilcoxon p-value (<0.01) (0.52) (0.01) (0.08)

Panel C: Calendar-Time Portfolios (Months - 1 3 through -2):

- Rfi = a + Pn,(Rm, - Rft) + P^SMB, + 13^ HML, +
Equal-Weighted Value-Weighted
a Adj a Adj. R^ a Adj a Adj. R^
[<-stat.] [<-stat.] {N Obs.) [(-stat.] [t-stat.] (N Obs.)
Full sample {N = 619) 1.79° 1.58° 0.633 1.79" 1.19° 0.563
[5.03] [4.44] (196) [4.87] [3.25] (196)
Implied 1-year AR (%) 23.70 20.65 23.73 15.31

°''' Significantly different from zero at the one percent and five percent levels, respectively.
2612 The Journal of Finance

the period prior to the issue and improved, albeit weak, performance fol-
lowing the issue. These results are consistent with the idea that investors
are disappointed when performance does not improve significantly follow-
ing the equity issue. Our results suggest that the source of investor over-
optimism may be related to expectations about tbe payoffs from tbe firms'
current and future investments. Consistent with this, we find that issuing
firms bave high levels of capital expenditures in the years preceding tbe
equity issue.

rV. Positive Announcement Effects, Private Placement Discounts,

and the "Windows of Opportunity" Hypothesis
Evidence of long-run abnormal stock-price performance following corpo-
rate announcements raises concerns as to how to interpret event-study re-
sults based on announcement period returns. To the extent that investors
underreact to corporate announcements, announcement period returns under-
estimate, but correctly sbow the direction of, valuation effects. Our findings
are more troubling since tbey suggest that the direction of the initial valu-
ation effect is incorrect. This section begins witb a discussion of the impli-
cations of our findings for earlier studies that attempt to explain the positive
stock-price reaction to private placement announcements. Although we offer
alternative explanations for positive announcement effects, we acknowledge
at the outset that these are necessarily ad hoc and we cannot discriminate
among them based on long-run stock-price performance. We conclude witb a
discussion of private placement discounts and the "windows of opportunity"
hypothesis.
Wruck (1989) attributes the positive announcement effect to an improve-
ment in the ownership structure of the firm, that is, firm value increases
because tbe resulting increase in ownersbip concentration is expected to align
incentives and/or tbe new blockholder is expected to provide value-enhancing
monitoring and/or expert advice. One interpretation of the reversal of the
announcement period value gains is that the market was overoptimistic about
the monitoring/incentive alignment effects of the private placements. How-
ever, the continued long-run negative stock-price performance, after the re-
versal of tbe announcement period value gains, suggests tbat tbe ultimate
valuation effects of private placements are negative. This suggests, in Wruck's
framework, that altbough investors appear to have expected improvements
in ownership structure, the private placements ultimately served to en-
trench management. Given that public equity issues do not result in similar
ownership structure changes, this "entrenchment explanation" suggests that
there are very different factors hehind the negative stock-price performance
following public and private issues.^'^

^' See Barclay, Hoiderness, and Sheehan (2001) for an investigation of the entrenchment
hypothesis.
 Long-Run Performance following Private Placements of Equity 2613

Hertzel and Smith (1993) provide an information-signaling explanation of

the value gains associated with private placement announcements. In their
model, managers of a firm with undervalued assets, who in a Myers and
Majluf (1984) world would decline to issue publicly, may choose to negotiate
a private placement with a single or small group of investors rather than
forgo a profitable investment opportunity. In their analysis, the willingness
of private placement investors to commit funds to the firm, together with
management's decision to forgo public issue, conveys to the market manage-
ment's belief that the firm is undervalued. Clearly, our evidence suggests
that on average firms are overvalued at the time of the private placements.
A possible explanation for a positive announcement effect in this framework
is that managers may be overly optimistic about the firm's prospects and
that investors (including the private placement investors), who look to man-
agers and managerial decisions for signals of inside information, do not rec-
ognize that managers are overoptimistic^^ We note that managerial
overoptimism, and the failure of the market to recognize such, has been
similarly suggested as an explanation for the stock-price behavior around
public equity issues (see Loughran and Ritter (1997)).
Our findings also raise related questions about the nature of private place-
ment discounts. Earlier studies have characterized discounts as a way of
providing compensation to private placement investors for expected moni-
toring services and expert advice (Wruck (1989)), lack of liquidity (Silber
(1991)), and/or the costs of due diligence (Hertzel and Smith (1993)). In the
Wruck and Hertzel and Smith frameworks, positive announcement effects
reflect the market's expectation that the gains associated with the private
placement outweigh the costs of compensating the private placement inves-
tors via the discount. However, our evidence of post-announcement under-
performance raises an alternative possibility that private placement discounts
reflect informed investors' assessments of true (lower) firm value. This pos-
sibility is particularly troubling for the efficient markets view since, in our
sample, the discounts are known at the time of the issue announcement.
Thus, the obvious challenge for the information view of the discount is to
explain why public investors would systematically ignore the negative in-
formation in the discount. ^^

'^ In the two-state Myers and Majluf (1984) framework employed by Hertzel and Smith
(1993), managerial overoptimism might be thought of as managers incorrectly determining that
they are in the good state.
'" For completeness, we note that, when measured relative to the discounted price at which
they purchase shares, private placement investors earn normal returns in the three-year
post-announcement period. Unfortunately, this finding is not conclusive. On the one hand, it
can be interpreted as evidence that discounts reflect true value. Alternatively, it may be the
case that private placement investors do require compensation (and build such into the dis-
count) but they too, as may be the case for outside investors and managers, are overoptimistic
about the future prospects of the firm. In this scenario, evidence that private placement
investors only earn normal post-announcement returns suggests that they have overpriced
the issue.
2614 The Journal of Finance

Finally, tbe uncertainties about the nature of private placement discounts

and announcement effects make it more difficult to understand private place-
ments in tbe "windows of opportunity" framework. Tbe negative post-issue
stock-price performance we document suggests that private placements of
equity, like public equity issues, take place when investors appear willing to
overpay for the firms' equity. However, the positive stock-price response to
private placement announcements suggests tbat investors do not recognize
the timing motivation for tbe case of private placements. Furtbermore, tbe
fact that private placements are sold at substantial discounts raises the ques-
tion of wbetber managers take advantage, or are able to take advantage, of
tbe apparent "windows of opportunity" to issue overvalued equity. We sug-
gest tbat a more definitive investigation of tbis issue will require a measure
of the private placement investors' holding periods and well-specified mod-
els of private placement discounts and the choice between public and private
issue.2°

V. Conclusion
We examine post-announcement stock-price performance for a sample of
firms that sell equity tbrougb private placements. We find that, despite hav-
ing a positive stock-price reaction at tbe announcement, firms tbat issue
equity privately significantly underperform relative to several benchmarks
over tbe tbree-year period following tbe offering. Tbis finding is inconsistent
witb tbe underreaction bypotbesis. Furtbermore, we know of no bebavioral
tbeory tbat can explain wby investors would systematically react in tbe wrong
direction to an announcement as we bave documented bere.
The negative post-announcement performance we document for private
placements is similar to tbe long-run underperformance documented for ini-
tial public offerings and seasoned equity offerings (Ritter (1991), Lougbran
and Ritter (1995), and Spiess and Affleck-Graves (1995)). Taken togetber,
tbe evidence suggests tbat investors are too optimistic about tbe prospects of
firms tbat issue equity, regardless of tbe form of issuance (IPO, seasoned, or
private placement).
Private equity issues tend to follow periods of poor operating performance.
Thus, our evidence is not consistent with the behavioral explanation that
tbe poor long-run performance results from tbe tendency of investors to over-
weigbt recent experience wben forming expectations. Firms tbat issue eq-
uity privately tend to invest more tban a control group, botb before and
after tbe issue. Tbis evidence suggests tbat managers and investors may be
too optimistic about tbe investment opportunities of firms tbat issue equity
privately.

^^ See Sheehan and Swisher (1998) for an investigation of the returns earned by different
types of private placement investors and Krishnamurthy et al. (1999) for some evidence of
factors that influence the choice between a public and a private equity issue.
 Long-Run Performance following Private Placements of Equity 2615

Finally, our results are inconsistent with theories that have been ad-
vanced previously to explain the positive stock-price reaction to private place-
ment announcements. Our results also provide a challenge for earlier
explanations of private placement discounts. We leave the puzzling announce-
ment effect and uncertain nature of private placement discounts for future
study.

Appendix: Measurement of Long-Run Stock-Price Performance

A. Selection of Control Firms
The procedure for identifying control firms is similar to that used by Spiess
and Affleck-Graves (1995), and is summarized as follows. At each year-end,
we segment, by exchange (NYSE/AMEX/Nasdaq), all CRSP-listed firms, ex-
cluding all firms that previously issued private equity. From this population,
we select a single control firm within the same exchange group for each
sample firm as of the year-end prior to the private placement for each of our
benchmarks. For the size-matched benchmark, we select the firm with the
market value closest to, but larger than, the sample firm. If the sample firm
is the largest firm, we choose the second largest firm as the control firm. For
the industry- and size-matched sample, we also require that each control
firm have the same two-digit SIC code as the sample firm. For the book-to-
market- and size-matched benchmark, we select the control firm that min-
imizes the sum of the absolute percentage difference between the sizes and
the book-to-market ratios of each offering and control firm.

B. Bootstrapping Procedure
To measure the statistical significance of the buy-and-hold abnormal re-
turns, we follow Barber and Lyon (1997) and report ^-statistics from a cross-
sectional t-test. However, because the post-announcement periods overlap
across firms and the distribution of buy-and-hold returns is skewed, infer-
ences made from cross-sectional ^statistics may be inappropriate. To ad-
dress this concern, we combine our control firm approach with a bootstrapping
procedure similar to that used by Ikenberry, Lakonishok, and Vermaelen
(1995), except that we couple our bootstrapping procedures with the matched
control firm approach consistent with our abnormal return calculations. Spe-
cifically, for each sample firm, we compute the three- and five-year buy-and-
hold return beginning the month after the private placement announcement.
We then randomly select with replacement a control firm that is in the same
size decile at the year-end prior to the private placement announcement.
After forming our first matched portfolio, we estimate the three- and five-
year buy-and-hold returns for each firm, and use the cross-sectional mean
(median) of these returns as our first return observation. We repeat this
procedure 1,000 times to obtain 1,000 matched-portfolio return observa-
tions. This procedure yields empirical distributions of returns (one for three-
year and one for five-year holding periods) under the null hypothesis of no
2616 The Journal of Finance

abnormal performance. The null hypothesis is rejected at the a percent level

if the mean return for our sample firms is less than the (1 - a) percentile
return of the matched-portfolio empirical distribution. We repeat this pro-
cess for our size- and industry-matched and size- and book-to-market-
matched controls, respectively, by (1) randomly selecting control firms that
are in the same size decile and have the same two-digit SIC code, and (2)
randomly selecting control firms that have the same quintile ranking on
both size and book-to-market.

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