Ebook Stock Market Liquidity and the Cost of Issuing Equity
Should a firm have any interest in the market liquidity of its securities? Previous studies have tried to answer this question by relating liquidity to the firm’s cost of capital. However, the empirical evidence to date on this issue is somewhat mixed. This paper takes a different approach to test whether liquidity matters to the firm by examining an event that links liquidity to the direct cost of raising external capital. We hypothesize that when firms access the external equity capital markets the liquidity of their stock affects the transaction costs—specifically, the investment banking fees—associated with floating new equity. Using a sample of 2,387 seasoned equity offerings (SEOs) during 1993-2000, we test this hypothesis and find that, ceteris paribus, investment banks’ fees are substantially lower for firms with more liquid stock.
The rationale for why liquidity might affect the flotation costs associated with a seasoned equity offering is that the costs faced by the investment banking group are similar in spirit to those of other market makers such as dealers, specialists, or block traders who line up buyers and sellers to acilitate the intermediation process. For example, the underwriting syndicate may face inventory risk from receiving the shares as well as adverse selection risk if they maintain a net position in the stock. Further, the investment banking group may also incur sunk costs in seeking out investors and processing the transactions. As a result, the more liquid the market for the underlying stock, the easier it is for the investment bank to place the new issue and reduce these intermediation costs. Since it should be easier to place an equity issue in a liquid market than to place it in an illiquid market, the stock market liquidity of the issuing firm should be an important determinant of the investment banking fees.
To test this hypothesis, we examine a sample of seasoned equity offerings (SEOs). We use this corporate transaction because it is intuitively appealing along many dimensions. First, the costs of raising external capital are large, and investment banking fees often represent the lion’s share of the total flotation costs of a new issue. For example, Lee, Lochhead, Ritter, and Zhao (1996) find that the average firm pays around seven percent of the total proceeds to raise capital through a seasoned equity offering (SEO). Investment banking fees are by far the largest portion of the flotation costs, representing over 76 percent of the total costs of raising external capital for SEOs. These fees also vary considerably—from less than one percent for some issues to up to 10 percent for others. Second, this transaction is pragmatic from a researcher’s perspective because an active secondary market for the underlying securities already exists for the SEO shares. Thus, we are also able to measure the liquidity of the underlying shares. Unlike initial public offerings, in which investment banking fees tend to cluster and there is no pre-issue liquidity, SEOs have easily observable pre-issue liquidity, economically large fees, and considerable variation in both fees and liquidity.
Our results indicate that stock market liquidity is a major determinant of total investment banking fees (i.e., the gross spread or gross fees) in SEOs. We show that there is a surprisingly large and robust inverse relationship between the total fees paid to investment banks and the stock market liquidity of the issuing firm. Our finding is robust to each of the seven measures of liquidity we use in our analysis. Further, we show that these results are not only statistically significant, but are also economically meaningful. For instance, the average SEO fees for firms with high liquidity are more than 100 basis points lower than for those with low liquidity, ceteris paribus. These results are important because they highlight the economic significance of the effect of stock market liquidity on the cost of raising capital.
Moreover, we find that the effect of market liquidity on investment banking fees is stronger for large equity issues than for small issues. For large (top issue size quintile of our sample) equity issues, the average difference in gross fees for liquid versus illiquid stocks, controlling for other factors, is 164 basis points per share issued. This difference represents 34 percent of the average gross fee for all the SEOs in our sample and 43.6 percent of the average gross fee for large SEOs. For small equity issues, the average difference in gross fees for liquid versus illiquid stocks, controlling for other factors, is 86 basis points. As a large issue is more difficult to place in an illiquid market than a small issue, this result suggests that the effects of liquidity on investment banking fees are stronger in those situations in which liquidity should matter the most. This can be interpreted as evidence that the marginal cost of illiquidity is higher for large issues.
These results complement Corwin (2003) who finds that liquidity may also reduce the magnitude of underpricing in seasoned equity offerings. Corwin shows that underpricing in seasoned equity offerings is, on average, 2 percent of the issue size and that a portion of this underpricing is negatively related to some measures of market liquidity. In our sample, the investment banking fees are on average 4.8 percent of the issue size and we also document that the effect of liquidity on these fees can be substantial. This underscores the importance of market liquidity on the total cost of raising capital beyond that found by Corwin (2003).
Our findings also complement previous studies that examine the link between liquidity and firms’ cost of equity. Our paper establishes a link between stock market liquidity and the cost of raising capital; this link is significant because we document that liquidity matters to the firm without relying upon any equilibrium asset pricing model. This is important because any test that attempts to demonstrate empirically an effect that liquidity may have on required returns is, of course, a joint test that liquidity is priced and that the asset pricing model the researcher uses is correct. Further, our results do not rely upon the assumption that expected returns, risk factors, and factor loadings are properly measured.
Overall, our paper shows that liquidity may affect firm value through its effect on the direct costs of raising capital. Rather than demonstrating an association between liquidity and discount rates, we document a connection between market liquidity and the flotation costs of raising external capital. This is an important contribution to the debate on whether a firm has any interest in the market liquidity of its securities because it suggests that the effects of liquidity on the value of the firm go beyond those predicted by existing theoretical models.
The remainder of the paper is structured as follows. In Section II we discuss the potential determinants of investment banking fees. In Section III we discuss our data and sample construction. Section IV presents our empirical findings. Section V provides robustness tests for our results, and Section VI concludes.
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