Whether issuing shares through private placement will reduce the perils associated with

information asymmetry ?

Whether the issue of equity through placement have a favorable effect on the earnings of the
firm/stock price ?

Whether an Initial Public Offering made after the issue of equity through private placement
will be underpriced ?

What are the characteristics of the firms issuing private equity as compared to firm offering
public equity ?

Information asymmetry between the firms and investors is one of the factor in Initial Public
Offerings (IPO) underpricing of firms that have a history of external financing activities. It
has been found by Cai and Ramchand that firms offering public debt before their IPOs have
less underpricing compared to other IPO issuers.1 This happens because pre-IPO offerings of
public debt decreases the extent of information asymmetry with respect to the quality of
firms, which results in lesser IPO underpricing. In addition to this, bank loans also have a
good impact on the valuation of the firm obtaining loan because banks by providing loan,
impliedly divulge a portion of their proprietary information about the borrowers and validate
the borrowing firm’s financial conditions.2 The extent of information imbalance is improved
by the validating power of the banks, thus, the firms with banking relations before IPO does
not face much IPO underpricing.

Similarly, private placement (form of external funding) of equity may also lessen the IPO
underpricing of firms. Firstly, issue of private placements provides private firms the
opportunity to present themselves to the community of investors priors to their IPOs. The
details of a completed private placement is made accessible to general investors through
media coverage.3 These accessibility of these details creates awareness among the public
about the issuing firm prior to IPOs and thus the extent of information disproportionality

1
Nianyu Cai, Latha Ramchand and Arthur Warga, “ The Pricing of Equity IPOs that Follow Public Debt
Offerings”, FINANCIAL MANAGEMENT ASSOCIATION, Vol. 33 No. 4, 2004, p. 5.
2
Christopher M. James, “ Some Evidence on the Uniqueness of Bank Loans”, JOURNAL OF FINANCIAL
ECONOMICS, Vol. 19 no. 2, 1987, p.225.
3
Carola Schenone, “The Effect of Banking Relationships on the Firm’s IPO Underpricing”, THE JOURNAL
OF FINANCE, Vol. 59 No. 6, 2004, p. 2914.
relating to the quality and value of the firm, get reduced. Issuing businesses that have pre-IPO
private placements would face reduced underpricing at the time of their IPOs, to the extent
that a larger degree of information asymmetry leads to a higher amount of IPO underpricing.

Second, the pre-IPO private placement investors play a validating role in indicating the worth
of the firm. Likewise the banking relations, private placements gives an efficient medium to
the issuing firms to provide profitable details regarding the quality of the firm to target
institutional investors, high-net worth and well-informed individual investors. The
involvement of well-learned and informed private placement financiers could be regarded as
validation for firm’s quality and results in less underpricing of firm’s IPO.4

Third, the participation of active institutional investors in pre-IPO private placements as

monitors might increase the effective use of company resources because clustered ownership,
which is achieved when a big percentage of shares are offered to a limited number of
investors, as in a private placement, strengthens shareholder monitoring incentives. This
might further lessen the underpricing of IPOs of issuing firms that have profitable private
placement prior to going public.

Empirical Reasoning:

Professional Analyst’s coverage is taken as a delegate for information imbalance regarding

the worth of the issuing firm. Various previous studies have used analyst coverage to
compute the degree of details available to the market and financiers. Chang, Hilary and
Dasgupta, has contended an inverse relation between the degree of analyst coverage and
extent of information asymmetry. Such a negative relation may be an outcome of analysts’
capability to decrease information imbalance, or analysts are drawn to companies with
reduced information asymmetry, which decreases the cost of information collection. 5 As,
there exists no coverage by analyst before IPO, it is predicted that post-issue analyst coverage
is directly related to the availability of information during IPO. It has, further, being
suggested that IPO firms may buy analyst coverage along with underpricing. It was found
that analyst coverage is directly related to underpricing of IPO.

Firms issuing Private Placement prior to Initial Public Offerings (hereinafter, PP IPO firms)
venerate substantially (at 10% extent) greater analyst coverage two months (expiration date
4
Mitchell Petersen and Raghuram Rajan, “The Effect of Credit Market Competition on Lending Relationships”,
QUARTERLY JOURNAL OF ECONOMICS, Vol. 110 No. 2, 1995, p. 410-412.
5
Chang X., S. Dasgupta and G. Hillary, “ Analyst Coverage and Financing Decisions”, JOURNAL OF
FINANCE, Vol. 61 No. 6, 2006, p. 3012-3015.
of the quiet period) subsequent to IPOs. Further, the percentage of PP IPOs that get analyst
coverage six months after their IPOs is much greater (at the 5% level) than the matched
sample. These consequences are in line with the belief that firms issuing private placement
prior to IPO may face reduced extent of information asymmetry regarding the firm’s quality
as compared to their counterparts at the point of IPOs.6

Firms with more publicly available and transparent information are predicted to have lower
underpricing at the time of their IPOs. Older firms have larger probability of being linked
with more information accessibility because they are more settled and familiar to investors,
and thus prone to less information asymmetry. Following this, it has been found that
approximately 34% of PP IPO firms, in comparison to 30% for the matched sample, have
details on Compustat (database for firms) a year prior to IPOs. Though, the variance is
substantial at 11% level.7

These findings, thus, are in consonance with the notion that profitable pre-IPO private
placements assist in mitigating information asymmetry.

Certification Explanation:

Private placement financiers are classified into seven non-exclusive clusters: (i) Managers
(Officers and directors), (ii) Strategic alliance partners ( Suppliers and Customers), (iii)
Existing large shareholders (shareholders with at least 5% ownership), (iv) Venture Capital
firms, (v) Financial Institutions (Pension funds, Insurance companies, Mutual funds etc.), (vi)
Corporate Investors with no business ties with issuing firm, (vii) Individual Investors with
ties with issuing firm.8

It has been reported that almost 50% of the pre-IPO private issue of equity of the 130 PP IPO
issuers are issued to financial institution, thenceforth venture capitalist (29%) and strategic
alliance partners – 21.5% and approximately 30% of private placements are issued to various
financiers.9
6
Kelly Nianyun Cai, Hel Wal Lee and Vivek Sharma, “ Underpricing of IPOs That Follow Private Placement”,
THE JOURNAL OF FINANCIAL RESEARCH, Vol. 34 No.3, 2011, p. 454.
7
Ibid.
8
Yilin Wu, “The Choice of Equity-Selling Mechanisms”, JOURNAL OF FINANCIAL ECONOMICS, Vol. 74
No.1, 2004, p. 100.
9
Alon Brav and Paul Gompers, “ Myth or Reality ?The Long-Run Underperformance of Initial Public
Offerings: Evidence from Venture and Nonventure Capital-Backed Companies”, THE JOURNAL OF
FINANCE, Vol.52 No.5, 1997, 1802.
These private placement financiers are categorized on the grounds of information available to
them. It has been defined that first three clusters of financiers of private placements i.e.,
managers, strategic alliance partners and large shareholder, to be well-informed investors,
and other financiers as incognizant financiers. The readiness of experienced financiers, who
have exclusive details regarding the firm, to engage in the pre-IPO private placements
provides validation for the worth of the firm. The findings indicate that the undervaluing of
PP IPOs is substantially less as compared to matched sample, with no regard to the categories
of private placements. However, PP IPOs with learned private placements enjoy lesser
undervaluing as compared to under-informed private investors (24.71% vs. 34.44%), the
variance is not empirically substantial. Thus, there is limited support for certification
explanation.10

Private Placement financiers are also categorized on the grounds of how actively they
monitor the firm. Pension funds and Venture Capitalist are considered the most active
monitor for the issuers. Managers of pension funds diligently counsel their portfolio firm via
involvement in proxy proposals , private negotiation or both, and venture capitalist function
with management, and hence toil them extensively.11 As stated above, the diligently tracking
financiers have substantially less underpricing as compared to their peers, however, the
variation between the IPO undervaluation of passive financiers and their peer firms is not
empirically significant.

The cluster of 51 PP IPOs with diligent financiers of private placement enjoy reduced
underpricing (28.31%) as compared to 79 PP IPOs along with passive financiers. Although,
the measure of variance in the undervaluation of PP IPOs with diligent financiers and their
IPO peers (34.79%) is greater than twice the measure of distinction in undervaluation for the
PP IPOs with passive financiers sample (16.70%). Thus, it can be concluded that there exist
possible but bounded functioning of monitoring activities in ameliorating the worth of PP
IPOs.12

10
Supra Note No.7.
11
William L Megginson and Kathlenn Weiss Hanley, “Venture Capitalist Certification in Initial Public
Offerings”, THE JOURNAL OF FINANCE, Vol. 57 No.3, 1991, p. 1178.
12
Jay Ritter, “ A Review of IPO Activity, Pricing and Allocatin”, THE JOURNAL OF FINANCE, Vol.57 No.4,
2002, 1798-1801.
The general opinion is that private and public equity markets are capable of alleviating
concerns about information asymmetry in various ways. Response to price of stock indicates
that market has new data regarding the value of the firm as a result of the occurrence. Sale of
private equity experience favorable reaction from the market and public issue bear
unfavorable response. It has been reported by Hertzel and Smith that private placements
appreciate a 1.7 % hike, however, Wruck discovered anomalous returns of 4.4% for a sample
bigger enterprises. Contrary to this, firms announcing public offerings suffer unfavorable
aberrant returns of 3%.13

The public equity offerings results in unfavorable stock reactions in a semi-strong effective
marketplace has been elaborated by Myers and Majulf. Investors are concerned about adverse
selection in the context of information asymmetry and evaluate all enterprises on an average
basis. Because above-average companies will be unable to raise cash at a price that reflects
their worth, they will avoid going public and underinvest in growth possibilities. Contrary to
this, issue of public equity will be prioritized by low-quality companies, as they are
overestimated by the marketplace.14 Therefore, public offers convey management’ judgement
that the market price is high relative to genuine worth, there is a unfavorable stock price
reaction.

A private sale can alleviate worries about opportunistic conduct by discussing concerns about
managers’ own talents, motivations, and firm possibilities by allowing them to negotiate
straight with the buyer. An informed, non-management financier purchasing a chunk of
private equity conveys favorable details to the market inducing a positive shift in the
market’s evaluation of firm’s value, since private equity’s sale can solve the issue of adverse
selection and moral hazards.15 It is suggested that a higher level of ownership concentration
boosts company value by allowing investors to utilize their votes to ensure that corporate
resources are handled more effectively or by raising the likelihood of a value-boosting
acquisition.

In consonance with the belief that moral hazard issue is resolved by private placement. It has
been found that variation in value of the firm on the declaration of private equity issue is
favorably associated with change in concentration of ownership when the extent of ownership

13
Michael Hertzel and Richard L. Smith, “ Market Discounts and Shareholder Gains for Placing Equity
Privately”, THE JOURNAL OF FINANCE, Vol. 48 No.2, 1993, p. 467.
14
Stewart C. Myers and Nicholas S. Majulf, “Corporate Financing and Investment Decisions When Firms Have
Information that Investors do not Have”, JOURNAL OF FINANCIAL ECONOMICS, Vol. 13 No. 2, 1984, 192.
15
Supra Note No. 13.
is soaring. The inclination of private investors to commit capital, along with management’s
choice to avoid a public offering, indicates to the market that the company is undervalued.
After maintaining constant ownership levels, it has been discovered that anomalous returns
associated with private placements are linked to features that expose the business to greater
risk for undervaluation, such as larger market-to-book ratios and more speculative product
offers. Therefore, it can be said that private issue of equity alleviates the concerns of adverse
selection and moral hazards.16

The moral hazard issue encouraged by the hidden actions can be alleviated by the efficient
tracking of the firm, which is provided through private placements. Contracts entered into by
private investors consists of clauses, where financiers can more closely oversee
management’s actions and productivity by inspecting facilities, books, and records, as well as
receiving timely financial reports and operational statements. Private investors regularly sit
on the boards of directors of target companies. 17 Though, the voting control might not be
available to financiers, there exists tenacious disadvantages for managers to evade as private
financiers generally handle/ control chances for prospective funding, providing them
substantial access to and hold on tactical concerns. Thus, low-quality companies are unlikely
to seek private investors due to such strict monitoring measures.

According to prior studies of changes in earning and risks around the issue of public equity
are encouraged by information asymmetric model that suggest unfavorable stock price
response to declaration of public issue. It has been demonstrated by Myers and Majulf that
the decision to issue stock reflects management’s judgement that the business is overpriced
when managers operate in the best interests of current shareholders. In their framework, when
the proportion of assets-in-place transferred to new shareholders exceeds the current
shareholders’ assertion on the new project, management of an under-evaluated business with
a lucrative new project will opt not to issue and so let go the new project. As a result,

16
Karen Hopper Wruck, “ Equity Ownership Concentration and Firm Value: Evidence form Private Equity
Financings”, JOURNAL OF FINANCIAL ECONOMICS, Vol. 23 No.1, 1989, p. 25.
17
Timothy B. Folta and Jay J. Janney, “ Strategic Benefits to Firms Issuing Private Equity Placements”,
STRATEGIC MANAGEMENT JOURNAL, Vol. 25, 2004, p. 225-228.
financiers see equity issue as negative news, because managers with overvalued have greater
propensity to issue new equity.18

It has been indicated by Hertzel and Smith that a managers with an undervalued business,
who in the Myers and Majulf’s world would deny public issue, would seek to arrange a
private placement with a small set of investors, instead of sacrificing a profitable new project.
The reasoning is that direct talks with a small number of investors allow management to
communicate their positive information about the firm’s worth more efficiently. The
readiness of the private placement financiers gives signal to the market that firm is
underpriced.19

Evidence on subsequent profits and risk changes shows that announcements of public and
private equity transactions convey divergent signals to the market about businesses’
prospects, which is consistent with the stock price impacts and theoretical interpretations.
Healy and Palepu through a sample public issue report that after the offer there exists a surge
in equity and asset betas, however, no proof exists of decrease in earnings post offer. They
come to the conclusion that public equity offerings provide investors with adverse
information about changes in riskiness rather than changes in the level of cash flow
prospects.20 In addition to this, Brous discovered evidences that unfavorable information
concerning future profits is disseminated via issue of public equity. These studies look at how
analysts’ earnings projections change when a company announces intentions to sell stock to
the public. They find that when a company announces plans to sell stock to the public,
analysts’ earnings forecasts drop.21

However, private equity issue face favorable earning changes post the offer and have a
favorable relation with stock price effect. However, the increase in equity betas subsequent to
the offer is because of increase in financial leverage rather than a surge in riskiness of assets
of businesses. These findings suggest that private equity offerings provide financiers with
fresh and positive information regarding changes in the amount of future earnings. We find
little evidence that private placements transmit information about a firm’s assets’ underlying

18
Merton H. Miller and Kevin Rock, “ Dividend Policy under Asymmetric Information”, THE JOURNAL OF
FINANCE, Vol. 40 No.4, 1985, p. 1043-1045.
19
Michael Hertzel and P.C. Jain, “Earnings and Risk changes Around Stock Repurchase Tender Offers”,
JOURNAL OF ACCOUNTING AND ECONOMICS, Vol.14, 1991, p. 253-274.
20
Paul M. Healy and Krishna G. Palepu, “Earnings and Risk Changes Surrounding Primary Stock Offers”,
JOURNAL OF ACCOUNTING RESEARCH, Vol. 28 No.1, 1990, p. 30-32.
21
Peter Alan Brous, “Common Stock Offerings and Earnings Expectations: A Test of the Release of
Unfavourable Information”, THE JOURNAL OF FINANCE, Vol. 47 No.4, 1992, p. 1520-1530.
riskiness. The rise in financial leverage as a result of private equity offerings underscores a
fundamental difference in the type of information given by public and private offerings. That
is, private equity investments do not appear to be recapitalization efforts motivated by
expected increases in company risk.

The data acquired from various equity placement firms advocates that a surge in equity betas
subsequent to sales of private equity are because of increases in financial leverage and not
due to variations in the underlying riskiness of the assets of the firm as evaluated by assets
betas. The drop in financial leverage associated with public equity problems, according to
Healy and Palepu, is a managerial response to private knowledge they have regarding an
increase in the riskiness of the businesses’ assets. Apparently, this is not the situation when it
comes to private equity difficulties. 22 Our findings suggest that private offer announcements
do not provide investors with information about the offer companies’ business risk.

According to Healy and Palepu, debt reduction was envisaged as the major use of the offer
proceeds by 56 % of the businesses in their sample of public equity offers. They find no
indication of a shift in capital expenditures during the equity offer year, which is consistent
with this. Contrary to this, Wall Street Journal provided that just 16% of the corporations in
our sample plan utilized the offer proceeds to decrease debt, while 56% plan to use the
proceeds for expansion or working capital requirements. In addition to this, proof of
substantial hike in capital expenditures in the year of private placements, has been found.
According to the statistics on capital expenditures, the mean and median changes in capital
expenditures in the offer year are favorable and substantial at 1% level. 23 These findings
contribute to our conclusion that private equity offerings are not a managerial response to a
perceived rise in company risk, and they support our conclusion that private equity issue
announcements do not carry risk information.

Further, the findings for median earnings changes demonstrate a positive and substantial
change in raw earnings in the year 0 i.e., offer year. Changes in earnings in the following
years are favorable but not substantial. Similarly for industry-adjusted earning changes, in
year 0, the median earnings change for private placement companies was much higher than
that of their sector. Although not statistically significant, median industry-adjusted earnings
22
Supra Note No. 20.
23
Michael Hertzel and Lynn Rees, “Earnings and Risk Changes Around Private Placement of Equity”,
JOURNAL OF ACCOUNTING, AUDITING AND FINANCE, Vol. 13 No.1, 1998, 25-30.
changes in years + 1 and +2 are greater than median earnings changes in the years preceding
the private placement, indicating that wages have not returned to pre-placement levels. Test
conducted using annual earnings also report that Year 0 is defined as the quarter of the
announcement and the next three quarters, while year 1 is defined as the total of four
consecutive quarterly earnings compared to the private placement. 24 We find greater and
more substantial earnings changes in year 0 for both raw and industry-adjusted results, and
qualitatively similar results for the other years in both raw and industry-adjusted results.
Thus, the results are in consonance with the notion that announcements of private placement
provides favorable data about prospective earnings.

In recent times, it has been observed that private equity shares are issued and sold to
financiers at significant discounts from the market price of the publicly traded firms, though
some them are issuing at premium as well. Several theories have been proposed in the finance
literature to explain the large discounts on private equity placements i.e., Monitoring
Hypothesis, Information effect Hypothesis and Liquidity Discount Hypothesis.25

The Monitoring Hypothesis states that the issuing firm enjoy advantages from institutional
investors’ diligent involvement in the management of the companies whose private equity
they buy, and discounts in private issue of equity compensate these “blockholders” for the
monitoring work they do representing all shareholders and the promise of improved firm
governance.26

Further, the discounts given on private issue of shares can be considered as remittance to
private financiers for the cost incurred to decrease the information imbalance regarding the
worth of the firm. They also claim that companies in financial difficulties at the time of
issuance have a particularly high level of uncertainty about their future success. As a result,
private investors might expect to get considerable discounts on the shares of such companies
to recompense them for the risk they have taken.27

24
Prem C. Jain, “ Equity Issues and Changes in Expectations of Earnings by Financial Analysts”, THE
REVIEW OF FINANCIAL STUDIES, Vol. 5 No.4, 1992, p.672-675.
25
George W. Fenn, Stephen Prowse and Nellie Liang, “ The Economics of the Private Equity Market”, BOARD
OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, 1995.
26
Ernst Maug, “Large Shareholders as Monitors: Is There a Trade-Off Between Liquidity and Control ?, THE
JOURNAL OF FINANCE, Vol. 53 No.1, 1998, p. 70-75.
27
Anjali Tuli and Abha Shukla, “ Informational Effect of Selected Private Placements of Equity”, THE
JOURNAL FOR DECISION MAKERS, Vol. 40 No.2, 2015, p. 166-169.
The price discounts on private equity issuance reward private investors for renouncing
liquidity, according to the liquidity discount explanation. Liquidity is an important attribute
for the large financiers of financially distressed firms, whose worth rely on the prospects of
investment opportunities. Private investors can sell their shares in liquid marketplaces before
“bad news” hits the market, causing the share price to drop. As a result, liquidity provides a
useful “bail out” alternative.28

Following this, it has been contended that the primary motive for public companies to issue
private equity is that they want more capital but are unable to obtain it through regular public
markets at prices and terms that are acceptable to them due to their poor financial state.
Because of their current financial situation, the managers of these companies fear their shares
will be severely undervalued on the public capital markets. Thus, it is suggested that
significant discount given on issue of private equity is remittance to private financiers for
their readiness to provide required money to such businesses.

The costs of addressing information asymmetry are projected to be higher for financially
distressed firms than for financially robust ones. Individual private financiers generally invest
in huge blocks of privately-issued equities, therefore smart investing in their equity needs
substantial due diligence into their financial state and future opportunities as a prerequisite of
making the transaction. As a result, we argue that sophisticated private investors’ readiness to
lend capital on conditions that are acceptable to both parties (supply and receiver) occurs
after a due diligence inquiry accommodate management and investor perspectives on the
firm’s long-term economic prospects.29 Further, this readiness may also be result of the
confidence that these private financiers hold in their capability of providing quality
management monitoring of the firm, which they finance over an investment horizon.
Researchers attribute the generally observed favorable stock price reactions following the
news of a private equity issuance to the fact that sophisticated private investors are ready to
invest large sums of money in these companies, and this certification has been credited by
researchers for the generally observed positive stock price reactions after the news of a
private equity issuance is published.

Evaluation of ratios signifies about the condition of Private Equity Firms (PE). The Private
equity businesses’ operational performance is lower than the Equity Offering firms’ in the
28
William L. Silber, “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices”, FINANCIAL
ANALYST JOURNAL, Vol. 47 No. 4, 1991, p. 60-64.
29
Tim Loughran and Jay R. Ritter, “ The New Issue Puzzle”, THE JOURNAL OF FINANCE, Vol. 50 No. 1,
1995, p. 25-28.
matched sample, according to the median values of the four operating performance ratios.
Apart from Gross profit margin ratio, the median value of all other operating ratios are
negative in the year of issue and at least 2 years prior to the issue year. The measure of these
ratios indicate that the private equity businesses were suffering from poor financial
conditions, before the date of issue, along with the inference that alternative sources of
financing may have become unavailable to the companies offering private equity. 30 The
operating performance of equity offerings businesses, which ameliorated before and peaking
in the year of issue, and is in contrast with the performance of private equity firms.

Private Equity offering businesses have larger market-to-book ratios than Equity Offering
businesses, implying that the former’s valuation is dependent more largely on predicted
growth potential than the latter’s, and that their expected value is thus more uncertain. The
uncertainty associated with private equity businesses, would favor a higher risk premium and
a greater price discount.31 However, the debt ratio of the both private and public equity issue
is almost same, suggesting that leverage is not a necessary differentiating feature.

According to the aforementioned operating performance comparisons, the high average price
discount on Private equity offering issuance at least partially compensates investors willing to
make hazardous equity investments in firms in poor financial shape.

The average price discount on privately placed shares, while substantial, may be too little to
compensate investors on a risk adjusted basis in the absence of measures, such as some kind
of credit enhancement, that reduce the risk to investors purchasing large blocks of shares of
private equity.

The firms offering equity privately can be classified into two categories, First, the firms
suffering serious financial issues. Considering their bad financial situation, private placement
may be the only viable way for these companies to raise required capital, assuming
management can persuade sophisticated investors that the companies have positive net
present value investment opportunities that will significantly improve their financial situation
in the future. Second, the firms that are not suffering from financial distress but expresses
certain indications of financial fragility. Managers of such companies pick the private
placement route as the least expensive form of obtaining money, thinking the company has

30
Shing- Herng Michelle Chu, George H. Lentz and Espen Robak, “ Comparing the Characteristics and
Performances of Private Equity Offering Firms with Seasoned Equity Offering Firms”, JOURNAL OF
ECONOMICS AND MANAGEMENT, Vol.1 No.1, 2005, p. 69-71.
31
Ibid.
good Net Present Value projects but are afraid of undervaluation of their shares by the public
stock market.32

It’s possible that companies that issue private equity at a deep discount fit into the first
category, while those that issue at a premium fall into the second.

According to the data concerning businesses offering equity through private placements at
discounts and at premiums in the issuing year. Premium companies are larger on average, as
measured by market capitalization and total assets, and have higher revenues (sales) and net
income than discount offering companies. Price discount businesses have a greater ratio of
intangible assets, which might indicate that their predicted value is more uncertain.33

Comparing the financial performance indicates that the premium businesses’ median market-
to-book and debt-to-asset ratios are consistently lower than the discount offering businesses.
The four operating performance ratios i.e., net and gross profit margins, return on assets, and
operating cash flow to total assets, are all greater than the comparable ratios of the firms
offering discounts. Likewise, Premium enterprises consistently outperform price discounters
in terms of earnings per share. The average price discount business has four years of negative
earnings per share, including the issuing year, whereas the typical premium firm has positive
profitability in the years leading up to and including the year of issue, however their earnings
decline from year –3 to the year of issuance. 34 If investor expectations are created by previous
experience, then premium businesses’ operational performance expectations should
outperform discount firms’ operating performance expectations, resulting in a pricing
differential between the two groups’ shares at the time of the offering.

Introduction:

Equity financing is one of the source of raising capital through sale of shares. Equity
offerings can be made either through public issue or private placement. Public Issue is the
technique of releasing convertible securities or shares in the primary market by promoters to

32
Tim Loughran and Jay Ritter, “ The Operating Performance of Firms Conducting Seasoned Equity Offerings”,
JOURNAL OF FINANCE, Vol. 52 No.5, 1997, p. 1830-1832.
33
Armando Gomes and Gordon Philips, “Why do Public Firms Issue Private and Public Securities”, JOURNAL
OF FINANCIAL INTERMEDIATION, Vol. 21, 2012, 630-632.
34
Hei Wai Lee and Claudia Kocher, “Firm Characteristics and Seasoned Equity Issuance Method: Private
Placement Versus Public Offering”, JOURNAL OF APPLIED BUSINESS RESEARCH, Vol. 17 No.3, 2011, p.
25-30.
attract new investors. Companies produce a prospectus to call the general public and offer
shares in exchange for funding in a public offering. As a result, investors who wish to
subscribe for shares submit an application to the relevant firm, which subsequently grants
them shares. An Issuer is a corporation that issues its own stock or securities.

Public Issue can be further categorized as Initial Public Offer and Seasoned Public offer. An
initial public offering (IPO) is the process of a company’s shares or securities being listed on
a stock market. It serves as a conduit for any unlisted firms or fledgling start-ups to list their
shares on a recognized stock exchange and raise financing from the general public. Seasoned
Public Offer refers to The issue of shares of a corporation that is already listed on a stock
market.

Private placement refers to sell of equity shares to a small set of financiers. This is referred to
as a non-public offering in other words. Insurance firms, huge banks, pension funds, and
mutual funds are some of the most common investors in private placements. There are no
strict criteria for Private Placement, and corporations and firms are not required to register
with the Securities and Exchange Commission, which regulates the industry.

Both Public and Private issue of equity are efficient methods of raising but they both have
their advantages and disadvantages attached to it. Thus, in this paper there will be a
comparative analysis of pros and cons of public issue and private placements to both
financiers and firms. This analysis will be based on the operative performance of the firms
around the years of issue of private placement. Further, the effect of choice of method on the
earnings, risks and stock price will also be evaluated and the link between the private
placement and IPO will also be examined i.e., whether the pre-IPO placement will
complement or detract the price of IPO during the offer of initial public issue.

CONCLUSION:

The issue of shares will help resolve the problem of information asymmetry, associated with
public offer due to no direct communication between issuers and investors, and moral
hazards due to the monitoring of the firms by institutional investors and certify the value of
the firm in the market. Further, there exists substantial increase in earnings of the firms post
private placement, however, the private placement does not signify the riskiness associated
with businesses and future prospect of the firm.

The Private Placement can be issued both at discounts and at premium, from aforementioned
analysis, it could be suggested that firms providing private placements at premium are larger
with respect to asset size and revenue and are in better financial position as compared to firms
issuing placements at discounts. This is because greater discounts are offered to investors to
recompense the for the risk they are taking by putting their money in firms which are not in
good condition.

In addition to this, the firms issuing private placement before Initial Public offer will have a
positive impact on the stock price and will lesser underprice the firm as compared to their
matched sample. Though, private placement is not suitable large firms, they should resort to
private issue for a short period of time as it create favorable surroundings for the public issue
in the market.

From the above conclusions, it can be summarized that though private placements resolve
various issue associated with public issue, but still its scope is limited regarding the amount
of finance, thus at some point shares has to be issued publicly, however, they can be preceded
by private placements in case firms are new to the market.