Private equity deal activity ebbed and flowed, often unexpectedly, in 2013. Despite some slow periods, strong debt and equity markets helped support first nine-months numbers that are well ahead of 2012, although Q4 2013 is unlikely to match Q4 2012, where activity was stimulated by anticipated changes in the tax laws. Successful sponsors again demonstrated their ability to perceive and exploit changing market conditions. Moreover, the private equity industry posted its best fundraising numbers in years. It was a year that showed that Semper Paratus may indeed be the industry’s new motto.
Posts Tagged ‘Equity capital’
As market professionals, you obviously live the U.S. equity markets first hand, day in and day out. As an association, you have used your voice to focus attention on the value of our equity markets—an all-important engine for capital formation, job creation, and economic growth.
Like you, I believe that we must constantly strive to ensure that the U.S. equity markets continue to serve the interests of all investors. That mutual challenge must come fully of age and address today’s, not yesterday’s, markets. And today, I will speak about the path forward.
In our paper, Executive Pay Disparity and the Cost of Equity Capital, forthcoming in the Journal of Financial and Quantitative Analysis, we investigate the association between executive pay disparity and the cost of equity capital. Understanding the association is important because the cost of capital is one of the key considerations for managers in their capital budgeting and corporate financing decisions. In fact, the cost of capital is a more direct yardstick of corporate investment and financing decisions than firm valuation. A higher cost of capital means fewer positive net present value (NPV) projects, leading to fewer growth opportunities. In addition, the cost of capital summarizes an investor’s risk-return tradeoff in his resource allocation decision (Pástor, Sinha, and Swaminathan (2008)).
In general, there are two perspectives on executive pay disparity. The tournament perspective views the large pay gap between the CEO and other executives as the prize for a tournament in which players compete for the CEO position (Lazear and Rosen (1981); Kale, Reis, and Venkateswaran (2009)). A large pay disparity motivates non-CEO senior executives to work hard and to invest in firm-specific human capital. This, in turn, helps build a large pool of skilled internal candidates for the CEO position. The availability of skilled internal candidates not only reduces the entrenchment of the incumbent CEO by increasing the bargaining power of the board, but also reduces CEO succession risk. Therefore, this perspective predicts a negative association between executive pay disparity and the cost of capital.
The Basel Committee on Banking Supervision (the “BCBS”)  recently issued a revised framework (the “Revised G-SIB Framework”) for assessing a common equity surcharge on certain designated global systemically important banks (“G-SIBs”)  that updates and replaces the framework for assessing the G-SIB capital surcharge issued by the BCBS in November 2011 (the “Prior G-SIB Framework”).  The Revised G-SIB Framework largely maintains the Prior G-SIB Framework’s indicator-based approach for determining when a capital surcharge will be applied and does not change the calibration of the surcharge. However, the Revised G-SIB Framework makes several noteworthy changes to, and clarifies important aspects of, the Prior G-SIB Framework, including:
In our paper, Financing Through Asset Sales, which was recently made publicly available on SSRN, we analyze a source of financing that is first-order in reality but relatively unexplored in the literature — selling non-core assets such as a division or a plant. Asset sales are substantial in practice: in 2010, there were $133bn of asset sales in the U.S., versus $130bn in seasoned equity issuance. In contrast, most existing research on a firm’s financing decisions studies the choice between debt and equity and ignores asset sales. We build a model that allows asset sales to be undertaken not only to raise capital, but also for operational reasons (dissynergies). We study the conditions under which asset sales are preferable to equity issuance and vice-versa, how financing and operational motives interact, and how firm boundaries are affected by financial constraints.
The firm comprises a core asset and a non-core asset. The firm must raise financing to meet a liquidity need, and can sell either equity or part of the non-core asset. Following Myers and Majluf (1984) (MM), we model information asymmetry as the principal driver of this choice. The firm’s type is privately known to its manager and comprises two dimensions. The first is quality, which determines the assets’ standalone (common) values. The value of the core asset is higher for high-quality firms. The value of the non-core asset depends on how we specify the correlation between the core and non-core assets. With a positive (negative) correlation, the value of the non-core asset is higher (lower) for high-quality firms. The second dimension is synergy — the additional value that the non-core asset is worth to its current owner.
Amid the current debate over tax policy in Washington, there is a bipartisan consensus on one issue: the corporate tax rate, which is currently 35 percent, should be reduced to roughly 25 percent. At the same time, budgetary pressures preclude any significant increase in the deficit to accomplish corporate tax reform.
In light of these competing demands, most corporate tax reformers advocate broadening the corporate tax base to pay for any rate reduction. Unfortunately, few politicians have put forth base-broadening measures that would generate revenue sufficient to significantly lower the corporate tax rate on a revenue-neutral basis.
In fact, revenue-neutral corporate income tax reform is likely to be very difficult, because corporate tax expenditures represent a relatively small portion of total corporate tax revenues. A preliminary analysis by the Joint Committee on Taxation suggested that the elimination of all corporate tax expenditures—except for the deferral of tax on foreign source profits, a provision whose repeal would be politically and economically infeasible—would allow for the corporate tax rate to be reduced to only 28 percent.
Therefore, if policymakers want to reduce the corporate tax rate on a revenue-neutral basis, they will likely have to adopt other types of reforms to broaden the corporate tax base. Ideally, those reforms should offer the potential for significant revenue gains and reduce economic distortions.
The Committee on Capital Markets Regulation (CCMR), an independent and nonpartisan research organization dedicated to improving regulation and enhancing the competitiveness of U.S. public equity capital markets, today released data from the third quarter of 2012. According to the new study, U.S. capital markets reversed the second quarter downgrade and showed slightly improved competitiveness, though most measures of competitiveness still fall short of historical averages. Hal S. Scott, Director of the Committee said, “While foreign companies continue to prefer non-U.S. financial markets for raising capital outside their home markets, and regulatory reform is still needed, this quarter’s data offers a promising sign that competitiveness can be restored to U.S. markets.”
Of the global initial equity offerings conducted outside a company’s home market, 18.3% of these IPOs, by value, were listed on a U.S. exchange. While this measure is at its highest level over the past five years, the U.S. share of this volume remains well below its historical average of 28.7% (1996-2006). These percentages include all IPOs by foreign companies listed on either U.S. public markets or issued through private Rule 144A offerings. Excluding global IPOs that use the Rule 144A markets, the percentage of global IPOs listed on a U.S. exchange rises to 55.9%. However, the total value of these IPOs has decreased from $79.8 billion in 2010 and $39.3 billion in 2011 to only $9 billion thus far in 2012.
Following the outline released by France’s and Germany’s Ministers of Finance on September 9, 2011, and the publication of a draft directive by the EU Commission on September 28, 2011, draft legislation to introduce a financial transaction tax (the “FTT”) in France was presented by the French government on February 8, 2012. This proposal will now be discussed by the French Parliament.
The scope of the FTT would not be as broad as that of the EU proposal. First, the FTT would be applicable on acquisitions of equity instruments only. Second, the FTT would be due if the equity instrument is issued by a French-listed company with a market capitalization of at least €1bn. The FTT would amount to 0.1% of the value of the equity instrument. The French government estimates that the revenues from the FTT would amount to €1.1bn per year.
Two other specific taxes would also be introduced by the same finance bill: a 0.01% tax would apply to high frequency trading operations located in France (the tax basis would be equal to the value of cancelled orders), and another 0.01% tax would apply to the notional amount of credit default swaps on EU sovereign bonds that are acquired by entities established or individuals domiciled in France.
In addition, the finance bill would repeal the recent reform of French transfer tax rules applicable to transfers of shares.
In my forthcoming Accounting Review paper Does Mandatory Adoption of International Financial Reporting Standards in the European Union Reduce the Cost of Equity Capital? I test whether mandatory IFRS adoption affects the cost of equity capital using a sample of 6,456 observations representing 1,084 distinct firms in 18 EU countries during the period of 1995 to 2006. I define firms that do not adopt IFRS until it becomes mandatory in 2005 as mandatory adopters, firms that adopt IFRS before 2005 as voluntary adopters, and I divide the sample period into pre- and post-mandatory adoption periods.
My primary analysis consists of regressing the cost of equity (using average estimates from four implied cost of capital models) on a dummy variable indicating the type of adopter (mandatory versus voluntary), a dummy variable indicating the time period (pre- versus post-mandatory adoption period), the interaction between these two dummies, and a set of control variables that include whether a firm is cross-listed in the U.S., country-specific inflation rate, firm size, return variability, financial leverage, as well as industry and country fixed effects. This difference-in-differences design, which includes the population of both mandatory and voluntary adopters over the period of 1995 through 2006, compares the change in the cost of equity for mandatory adopters before and after the mandatory switch, relative to the corresponding change in the cost of equity for voluntary adopters.
In our forthcoming Journal of Accounting Research paper entitled The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity, we explore the relation between internal control quality and idiosyncratic and systematic risk, and the potential benefits of effective internal control in terms of cost of equity. Specifically, we investigate whether firms that disclose internal control deficiencies (ICDs) exhibit higher systematic risk, higher idiosyncratic risk, and higher cost of equity relative to firms with effective internal controls. Further, we investigate whether managements’ initial disclosures of ICDs and remediation of previously reported ICDs are related to changes in firms’ cost of equity.
We conduct both (1) cross-sectional tests to assess whether firms with ICDs present higher information risk to investors relative to firms having effective internal controls; and (2) inter-temporal tests to assess whether changes in the effectiveness of internal control yield changes in cost of equity consistent with changes in information risk. The results of our cross-sectional tests indicate that firms reporting ICDs exhibit significantly higher idiosyncratic risk, betas, and cost of equity relative to firms not reporting ICDs. These differences persist after controlling for other factors shown by prior research to be related to these risk measures. Our finding that differences in these risk measures pre-date the first disclosures of ICDs suggests that market participants’ assessment of non-diversifiable market risk (beta), idiosyncratic risk, and cost of equity incorporated expectations about internal control risks based on observable firm characteristics prior to firms’ initial revelation of control problems.
In an attempt to assess whether a causal relation may exist between internal control quality and firms’ cost of equity, we construct four sets of inter-temporal change analysis tests. The first inter-temporal test finds that ICD firms experience a statistically significant increase in market-adjusted cost of equity, averaging about 93 basis points, around the first disclosure of an ICD. In our second change analysis, we find that ICD firms that subsequently receive an unqualified SOX 404 opinion exhibit an average decrease in market-adjusted cost of equity of 151 basis points around the disclosure of the opinion. In contrast, for our third change test we find that ICD firms that subsequently receive adverse SOX 404 audit opinions, which indicate that internal control problems persist, exhibit a modest but insignificant increase in cost of equity around the SOX 404 opinion release. In our final inter-temporal change analysis, we find no significant cost of equity change for firms least likely to report an ICD, but a significant decrease in the average market-adjusted cost of equity of 116 basis points around the release of an unqualified SOX 404 opinion for firms most likely to report ICDs.
Collectively our cross-sectional and inter-temporal tests present consistent evidence that information risk as proxied by ineffective internal control is an important determinant of both idiosyncratic risk and systematic market risk that affects the market’s assessment of firms’ cost of equity. We document that firms with effective internal control or firms that remediate previously reported ICDs are rewarded with a significantly lower cost of equity.
The full paper is available for download here.