Rights Issues, Information Asymmetry and Equity Overvaluation: UK Evidence

Abstract

This study extends UK research on rights issues by examining the link between the post-issue long-term underperformance, pre-SEO security overvaluation and post-SEO investors’ under-reaction hypotheses. In contrast to prior UK studies that concentrated on different time-periods, and with results based on limited samples, this paper uses a new and unique dataset covering the entire population of rights issues for the period 1988 – 1998. We report evidence that the post-issue negative performance can be considered as the reaction of investors to prior excessive stock valuations, that might have been caused by the recognition of the information advantage that management possesses and which is signalled by the equity issue announcement. On average terms, equity issuers report an average abnormal profit of 20.7% within a 36-month window prior to the event. This performance soon reverses with an average drop of 54.22% in returns during the issue announcement month and an additional major collapse of 72.3% three-months after the event. The reported evidence suggests that the cause of this economically and statistically significant fall in returns is caused by investors’ negative reaction to the announcement of the rights issue and the subsequent revision of their forecasts regarding the future performance of such companies.

Overall, these results are supportive of the Behavioural Finance advocates’ view that investors fail to adjust promptly their views regarding equity issuers’ future potential and that the re-evaluation process appears to be gradual over the entire k-month period following the event. However, decisive conclusions can not be made, as this gradual decrease in prices may perhaps be the product of a gradual deterioration of certain key fundamentals of the companies in question such as their operating performance and profitability. This question should be answered in future research.

Keywords: Rights issues, seasoned equity offerings, stock market under-reaction, behavioural finance

JEL Classification: G14, G32