Studying long-term performance following private placements of equity, Hertzel, Lemmon, Linck and Rees (2002) find negative long term returns. They consider the finding of negative long-term returns “troubling” since the announcement effects of private placements are documented to be positive. Wruck (1989) attributes the positive announcement effect to the discipline imposed by an active investor who can alleviate any agency problems.
Hertzel and Smith (1993) attribute the positive announcement effect to the signal that a well-informed private investor has uncovered value in the issuing company. Neither of these explanations would predict long-term underperformance following private placements of equity.
The long-term underperformance is also inconsistent with the underreaction hypothesis. This hypothesis predicts that the market reaction to an announcement is incomplete but that announcement effects are revealed over a longer time period. The underreaction hypothesis has been applied to explain the combination of a negative market reaction followed by long-term underperformance after the offering for public equity offerings. Daniel, Hirshleifer and Subrahmanyan (1998) present the underreaction hypothesis in a model where investors are overconfident.
Due to biased beliefs by investors, new information will not be fully incorporated into prices at the time of the announcement, but, as prices gradually reflect that information, abnormal performance will continue in the same direction as the original market reaction. Frazzini (2006) presents a model explaining the underreaction effect as a behavioral consequence of unrealized capital gains and losses.