Why Do Investors Frequently Pay More than the Prevailing Market Price?
Professors Leonce Bargeron and Ioannis Floros2 recently conducted a study (the “Study”) documenting the fact that private investments in public equity (PIPEs) frequently raise funds at a premium, where the offer price is higher than the issuer’s previous trading day closing price. This is adverse to what has been extensively documented in the academic literature so far. Their finding is prevalent across time, liquidity levels, issuer size and industry and investor type.
The Study cited a white paper authored by Bauguess, Gullapalli and Ivanov (2018), which revealed the economic dominance of PIPE transactions. The white paper presented evidence that the amounts raised through unregistered securities (the majority of the PIPE transactions that are exempted from registration according to the exemption provided by Rule 506 of Regulation D) have outpaced the amounts raised via registered securities offerings during the years from 2009 to 2017, exceeding $ 1.8 Trillion in 2017 as total gross proceeds raised. The exemption offered by Rule 506 of Regulation D is largely used by PIPE issuers.
Professors Bargeron and Floros noted that premium PIPEs will flip the cost of a discount in an equity issuance into a benefit while simultaneously increasing the value of the issuer shares through the positive signal sent by the premium PIPE. In the case of premium PIPEs, undervalued firms issue shares. Premium PIPEs’ prevalence contributes to the authors’ understanding of the equity issuer types. While the general theory is that undervalued firms repurchase stock and overvalued firms issue stock to take advantage of information asymmetry between inside and outside investors about the issuer’s future prospects, the authors note that premium PIPEs reverse this pattern.
The Study’s evidence suggests that premium PIPEs resolve information asymmetry about issuer value or an evolving relationship with an investor that is expected to enhance issuer value. The resolution of asymmetric information results in positive average announcement period, abnormal returns and positive average signaling returns. The presented results suggest firms that have value increasing private information or value increasing strategic opportunities can substantially reduce or even reverse the issuance costs of equity by issuing premium PIPEs.
Several hypotheses are tested in the Study: The Misevaluation Hypothesis, the Value Enhancement Hypothesis, the Courtship Hypothesis, the Value Extraction Hypothesis and the Illiquidity Hypothesis.
Information asymmetry between the issuer and the market leads to the Misvaluation Hypothesis. The market is aware that the PIPE investor acquires private information about the issuer during the PIPE negotiation and due diligence process. The informed investor’s willingness to pay a premium for the shares certifies that the shares are undervalued.
The Value Enhancement Hypothesis also relies on information asymmetry between the issuer and the market, but the subject of the information differs. It posits that a premium PIPE is jointly negotiated with a value increasing relationship between the issuer and investor, such as a strategic partnership or a monitoring and advising role.
In a third hypothesis, information asymmetry between the issuer and the investor leads to the Courtship Hypothesis. It posits that the PIPE investor is considering creating binding ties with the issuer but wants greater clarity about a potential union before committing to it. Because the investor expects to learn about the issuer through interactions after the PIPE investment, the investor is willing to pay an information premium for the PIPE shares.
Alternatively, frictions such as financial constraints or agency conflicts could motivate the issuer to accept value reducing contractual features and investor influence. Due to the resulting expected net value destruction for the issuer, the Value Extraction Hypothesis predicts negative announcement returns for premium PIPEs. This hypothesis also predicts that premium PIPEs will be more common in PIPEs with additional contractual features, which is not supported by the evidence.
Illiquidity in the Market
Illiquidity in the market for the issuer’s shares prior to the PIPE creates another potential explanation for premium PIPEs. If the issuer’s stock is illiquid, the price impact from accruing a substantial number of shares in the open market can require an investor acquiring a large block of shares to pay an average price significantly higher than the current trading price. Consequently, paying a premium in a PIPE can be a cheaper way to acquire a large block of shares. The Illiquidity Hypothesis predicts that low liquidity drives premium PIPEs, but is not supported by the evidence. The Study provides strong support only for the Misvaluation and the Value Enhancement Hypotheses.
Overall, the Study shows that average abnormal announcement returns are 9.4% greater for premium PIPEs than discount PIPEs. Long-term abnormal returns are also significantly higher for premium PIPEs. The authors find investors’ willingness to pay a premium credibly signals issuer undervaluation resulting from either private information or evolving strategic/monitoring relationships. These results are important given the last decade’s strategic PIPE investments’ popularity and they reverse the long-standing consensus that PIPE investments are costly financing venues.
Ioannis (Yianni) V. Floros, Ph.D.
Associate Professor of Finance
Dean’s Research Fellow
University of Wisconsin-Milwaukee
Sheldon B. Lubar College of Business
Director of Research, Dream Exchange
Leonce Bargeron, Ph.D.
PNC Associate Professor of Finance
Gatton College of Business & Economics
University of Kentucky