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The impact of stock transfer restrictions on the private placement discount.

The literature contains four explanations for the private placement discount. I find that all four contribute to the discount: loss of option value due to transfer restrictions, equity ownership concentration, information gathering, and overvaluation and expected underperformance post-issue. An average-strike put option model calculates marketability discounts that are consistent with empirical private placement discounts when observed discounts are adjusted for equity ownership concentration, information, and overvaluation effects. In contrast to the positive signaling effect of traditional private placement announcements, there is a negative signaling effect for private investments in public equity when the firm commits to register the shares promptly.

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The factors responsible for the common stock private placement discount continue to be of both theoretical and practical interest. Numerous studies have documented significant discounts in private placements of letter stock, which is not freely transferable due to resale restrictions imposed by Rule 144 under the Securities Act of 1933, averaging from 13% to 34% (Securities and Exchange Commission (SEC), 1971; Wruck, 1989; Silber, 1991 ; Hertzel and Smith, 1993; and Hertzel, Lemmon, Linck, and Rees, 2002). (1) The conventional wisdom in the business appraisal field is that the appropriate marketability discount is between 25% and 35% for a two-year restriction period and between 15% and 25% for a one-year restriction period (Longstaff, 1995). (2) Longstaff (1995) obtains an upper bound on the marketability discount consistent with this range by modeling the value of marketability as the price of a lookback put option. (3)

The marketability hypothesis predicts that the entire discount on restricted shares at the time of issue is due to the Rule 144 transfer restrictions. Accordingly, the private placement discount is often referred to as a "marketability discount." However, Hertzel and Smith (1993) point out that discounts of the magnitude observed in private placements of letter stock (averaging 20% in their study and as much as 42% in earlier studies) would provide powerful incentives at the time of the private placement for firms to commit to register the shares promptly following the private sale if they were due solely to the Rule 144 restrictions. There are many large financial institutions with long-dated liabilities, such as life insurance companies and pension funds, that may be less concerned about liquidity than other investors. As such, should investors require such large discounts just for agreeing not to resell their shares in the public securities market for two years? (4) A private resale market exists and the options market provides hedging opportunities. When they allow for the information and equity ownership concentration effects that accompany a private placement, Hertzel and Smith (1993) find that the discount attributable to lack of registration is only 13.5%. Hence, transfer restrictions only partly account for the discount.

The finance literature has put forth three alternative explanations. First, a private placement to a small set of sophisticated investors can increase ownership concentration and enhance value if it results in more intensive monitoring, and the discount compensates the new private investors for their future monitoring services and expert advice (Wruck, 1989). Additionally, it also reimburses private investors for the cost of information gathering during the private offering's due diligence process (Hertzel and Smith, 1993). Moreover, if knowledgeable private investors can identify stocks that overoptimistic public investors have overvalued, they will purchase shares privately only at a discount to compensate them for the stock's expected underperformance post-issue (Hertzel et al., 2002). New evidence presented in this paper concerning PIPE (Private Investment in Public Equity) placements supports this explanation. Privately placed shares are not freely transferable until they are registered with the SEC. A PIPE typically requires the firm's commitment to register the shares as quickly as possible as a condition of closing. The discount is smaller than in placements without the registration commitment. As with a traditional public offering, a PIPE enables a firm to exploit a window of opportunity to issue overvalued stock (Hertzel et al., 2002).

In addition, some private equity placements involve a premium, which is not consistent with the marketability hypothesis. Allen and Phillips (2000) find that privately selling a block of stock to a nonfinancial firm leads to significant excess returns when the investment is coupled with a strategic product market relationship. They report that 59% of the strategic private placements take place at a premium, strategic private buyers, on average, pay a 6% premium, and the private placement premium is comparable to the average premium paid in open market and other corporate equity block purchases. I control for private placements to strategic and related investors.

The ownership concentration hypothesis, the information hypothesis, and the overvaluation hypothesis imply that the private placement discount overstates the marketability discount. However, Longstaff (2001) solves the investor's intertemporal portfolio choice problem for an investor who is restricted to trading strategies of bounded variation and obtains values for the shadow cost of illiquidity that are consistent with the apparently large 25%-35% discounts for lack of free transferability that have been measured empirically. His model demonstrates that such large discounts are sustainable in a rational model of investor behavior. Thus, a "private placement discount" may reflect a "marketability discount," as well as equity ownership concentration, information gathering, and overvaluation effects, although the relative importance of the transfer restrictions and the other factors is an unresolved issue. This paper reconciles the four explanations for the private placement discount and tests the relative importance of transfer restrictions and the other factors in explaining private placement discounts.

The paper is organized as follows. Section I demonstrates that a firm should choose a private placement over a public offering when the private placement elicits the more favorable information effect or the old shareholders will retain a greater percentage of the firm. Section II explains the restrictions on hedging that make the Rule 144 transfer restrictions costly. Section III describes the sample of private placements. Section IV reports that the initial private placement announcement and the completion announcement both convey useful information and that in contrast to the findings in earlier studies, these announcements are negative signals when the stock's recent trading momentum is positive and also when the firm precommits to register the shares promptly. Section V indicates that the loss of timing flexibility inherent in the Rule 144 transfer restrictions, as well as the ownership concentration, information, and overvaluation effects, are all significant drivers of the private placement discount. Section VI furnishes evidence that the marketability discounts predicted by the average-strike put option model are more consistent with empirical private placement discounts than those predicted by the lookback put option model after adjusting for ownership concentration, information, and overvaluation effects. Section VII provides my conclusions.

I. Why Firms Place Shares Privately

Wruck (1989) and Hertzel and Smith (1993) provide two situations in which a private share placement can be superior to a general cash offer. Due to asymmetric information, firms should issue common stock privately, rather than through a registered general cash offer, to finance an investment when: (1) the net present value of the new information (about the firm and the investment) released to the market through the private placement exceeds what it costs the old shareholders to inform new shareholders about the firm's true value or (2) the fraction of ownership the existing shareholders retain after a private placement (with full information disclosure) is greater than the fraction they would retain after a public offering. Privately placing stock can improve economic efficiency by eliminating the underinvestment problem (Myers and Majluf, 1984) when information asymmetries prevent investors from recognizing that a firm is undervalued (Hertzel and Smith, 1993). If a private placement signals undervaluation (Wruck, 1989) and a public offering signals overvaluation (Smith, 1986), old shareholders may be better off with a private placement even if the discounted price at which firms usually sell shares privately results in the old shareholders retaining a smaller percentage of the firm if the private placement's information signal increases firm value sufficiently.

Thus, the relative advantage of a private share placement under asymmetric information depends upon the offering's announcement effect and the fraction of the firm the old shareholders surrender. The change in the value of the old shareholders' claim ([DELTA] [V.sub.OLD]) when new information with value [DELTA][NPV.sub.private] is released through the announcement of a private equity placement is: (5)

[DELTA] [V.sub.Old] = ([P.sub.After] - [P.sub.Before])[S.sub.Before] = [DELTA][NPV.sub.private] - ([P.sub.After] - [P.sub.Offer])[S.sub.Offer] T, (1)

where the price of the firm's shares is [P.sub.Before] before and [P.sub.After] after the private financing, the firm has [S.sub.Before] shares before the financing, new shareholders pay [P.sub.Offer] per share to buy [S.sub.Offer] shares, and the firm pays T in placement expense (Wruck, 1989). A private share placement increases the old shareholders' claim when the net present value of the new information exceeds what it costs to inform new shareholders about the firm's true value.

An equation similar to Equation (1) explains the change in the old shareholders' claim due to a public offering. I use a carat over V, P, S, and T to distinguish a public offering. To make the public and private alternatives comparable, both must raise the same net proceeds:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (2)

The old shareholders' fractions of the firm's equity following a private placement (a) or a public offering ([??]) are, respectively:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (3)

Take the difference between the changes in the value of the old shareholders' claim with a private placement and with a public offering and use Equation (2) to simplify. A private placement increases the value of the old shareholders' claim relative to a public offering when:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. (4)

[V.sup.*] is the post-offering value of the firm apart from any information effects. A shareholder wealth maximizing firm should choose a private placement over a public offering to finance a positive net present value (NPV) investment only if the private placement leads to a greater increase in the wealth of the old shareholders. This can occur when the private placement: (1) elicits the more favorable information effect ([DELTA] [NPV.sub.Private] > [DELTA] [NPV.sub.Public])(Wruck, 1989) or (2) results in the old shareholders retaining a greater percentage of the firm ([alpha] > [??]) (Hertzel and Smith, 1993).

The old shareholders may be better off with a private placement of shares at a discount if the positive information effect of the private placement announcement is large enough. This positive information effect occurs only if the private placement announcement is a credible signal concerning the firm's undervaluation. However, an overvalued firm might benefit by privately placing its shares, and the purchasers would not suffer a loss if they could resell the shares before the firm's true value is revealed. Placing unregistered shares that cannot be resold to public investors without an effective registration statement and forcing purchasers to wait a significant length of time before the shares can be registered makes the signal credible. However, they also make the signal costly as private investors might require a discount before they agree to purchase the shares to compensate for the loss of resale flexibility and also for the cost of gathering private information about the firm's true value and how it might change during the Rule 144 holding period.

In the 1990s, investment bankers developed the PIPE offering method as an alternative to traditional private placements (Dresner and Kim, 2006). In a PIPE offering, a firm with publicly traded shares sells newly issued, but unregistered securities, typically stock or debt convertible into stock, directly to accredited investors, usually hedge funds, in a private transaction. (6) It typically requires the firm to file a shelf registration statement on Form S-3 as quickly as possible, but no later than about 45 days after closing and to use its best efforts to have it declared effective within 30 days after filing. Registration allows the investors to resell the shares in the public market well before the Rule 144 period expires.

An overvalued firm can capitalize on its overvaluation by issuing a PIPE, which can be completed within about two to three weeks, as compared to months when a firm registers the shares earlier using Form S-1 (Dresner and Kim, 2006). The registration commitment potentially undercuts the credibility of the private placement signal since registering overvalued shares might enable the purchasers to resell them before the firm's true value is revealed, thus signaling overvaluation and expected underperformance post-issue (Hertzel et al., 2002). Consequently, a PIPE announcement is likely to have a negative signaling effect, just like a public offering announcement, if investors perceive that the firm is using the PIPE method to capitalize on overvaluation. I test this hypothesis later in the paper.

II. Legal Restrictions on Hedging Privately Placed Common Stock

A traditional common stock private placement involves the direct sale of a fixed number of shares of common stock at a fixed price to accredited investors in compliance with Section 4(2) of the Securities Act of 1933 and Regulation D thereunder. The price may be fixed when a purchaser "circles" the number of shares it wants to buy at an agreed price, or it may be based on an agreed upon discount to the closing price, or an average of recent closing prices just prior to the closing. In the first case, the price may be adjusted downward right up to the closing date to attract enough investors to sell the entire offering. The shares are not freely transferable because they have not been registered with the SEC for public resale. Purchasers may receive limited rights to demand SEC registration of their shares (demand registration rights), request that their shares be included in a public stock offering (piggyback registration rights), or, in the case of a PIPE, the firm's commitment to register the shares as quickly as possible (mandatory registration rights).

The persistently large average private placement discounts found in empirical studies over more than 30 years raise an intriguing question. Why don't arbitrageurs purchase restricted shares, hedge their price risk exposure, and capture the discount net of hedging costs as their profit? A stockholder can hedge its price risk exposure in any one of at least three ways: (1) at the time it buys the restricted shares, it could purchase an average-strike put option on an equal number of shares with an exercise price equal to the arithmetic average of the forward prices of the unrestricted shares and a time to expiration that matches the restriction period; (2) each day during the resale-restriction period, it could sell short against the box an equal fraction of the block of restricted shares it purchased; or (3) each day it could sell equity swaps covering an equal fraction of the block of restricted shares. The arbitrageur could exercise the put option or cover the short sales after the resale-restriction period expires using the previously restricted shares.

There are potential legal and financial impediments to all three hedging strategies for capturing the private placement discount. Under Rule 144, a purchaser of restricted shares is permitted to hedge the price risk exposure, but only after paying in full for the shares (SEC, 2007). Prehedging is not permitted, so the feasibility and cost of hedging are uncertain at the time the unregistered shares are purchased. After buying unregistered shares, the purchaser could sell short against the box to hedge, if it can borrow unrestricted shares. However, it must comply with Rule 144's price and volume restrictions on the short sales and bear the cost of maintaining the hedge.(7)

Alternatively, the purchaser could buy put options or sell call options, if there are traded options on the stock or it could arrange an equity swap if it can locate a dealer who is willing to take the other side of the swap. (8) During the sample period, the equity swap market was generally limited to large capitalization stocks. Public firms that issue unregistered shares through private placements tend to be smaller, relatively unprofitable NASDAQ or OTC companies. Equity swaps are unlikely to be available for such stocks.

Other hedging strategies are available that would appear to involve less legal risk. For example, the purchaser of restricted shares could purchase stock index put options or sell stock index futures short. Both hedging strategies expose the shareholder to basis risk. Nevertheless, to the extent such strategies reduce the price risk exposure inherent in purchasing unregistered shares, they could reduce the size of the discount that investors require when purchasing letter stock. Consequently, marketability discounts are likely smaller since the advent of the equity derivatives markets, which postdate the seminal SEC (1971) study. However, at least some residual unhedged transfer restriction risk remains because while price risk is hedgeable, liquidity risk is not. The available hedging strategies cannot eliminate the marketability discount, but they can reduce it to the cost of hedging the price risk plus a return on the arbitrageur's capital plus a risk premium for the cost of liquidity risk.

III. Data and Methodology

I collected a sample of 275 private placements of letter stock that took place from April 1, 1991 to March 8, 2007. Table I contains a summary description of the sample of letter stock private placements.

A. Description of the Issuers

I searched on 10kwizard.com using "private placement of common stock" and similar key words Wruck (1989) and Allen and Phillips (2000) employed. I identified an initial sample of 403 private placements by public US firms that sold unregistered shares of common stock to US investors for cash. I excluded private placements that were accompanied either by a non-US offering (under Regulation S) or by the simultaneous sale of another class of securities (publicly or privately). I also excluded placements by regulated utilities and depository institutions. I searched the Dow Jones Interactive-Publications Library, the Bloomberg database of company announcements, and the Wall Street Journal Index to confirm the private placement information and identify the earliest announcement date for each offering. I checked each firm's Form 10-K report for the year of the financing to obtain any reported details concerning the offering and the identity of the purchasers, if they were disclosed.

Fifty of the firms in the sample conducted two or more private placements. In two cases, two private placements were less than three months apart. The second private placement was dropped from the sample. In all of the other cases, the private placements were at least five months apart. Investors will react to a contemporaneous significant corporate announcement. I dropped the 14 issues from the sample with a significant corporate announcement that occurred within five trading days prior to and ten trading days following the pricing announcement in order to isolate the information effect of the private placement announcement. I restricted the sample to public firms with at least three months of continuous historical stock prices in the Center for Research in Security Prices (CRSP) monthly stock files immediately prior to the announcement date. One hundred twelve issues had to be dropped from the sample due to insufficient historical trading prices or missing financial data. (9) This left a final sample of 275 private placements.

Table I describes the sample. Panel A reports that the public shares of the firms making 189 of the 275 placements, or roughly two-thirds of the sample, were listed on the NYSE, AMEX, or NASDAQ National Market. The remaining third were quoted in the NASDAQ Small Cap, OTC Bulletin Board, or Pink Sheet markets. As indicated in Panel B, 52 of the private placements occurred before and the other 223 occurred after the SEC reduced the Rule 144 resale-restriction period to one year from two years on February 20, 1997 (SEC, 1997a). Also, 155 of the private placements, or roughly half of the sample, occurred during the five-year period from 2000 to 2004. This period marks the development of the PIPE market. 39 of the 275 private placements were priced at a premium to the closing price of the public shares the day immediately preceding the announced issue date. The listing breakdown and the chronological breakdown for the discounted placements are very similar to the respective breakdowns for the full sample.

Panel C describes the issuers. The average market value of firm equity is $203.33 million (median market value $93.31 million). The average and median net income for the latest fiscal year immediately preceding the offering are both negative, and the average and median cash flow from operations are both very small. Of the 275 issuers, 204 had negative net income and 129 had negative cash flow from operations for the latest fiscal year. 17 of the 71 with positive net income earned less than $1 million. These sample characteristics are consistent with Hertzel et al.'s (2002) findings that private equity issuers are generally small, young, and unprofitable, and tend to issue equity privately following periods of relatively poor operating performance.

B. Description of the Private Placements

Table II describes the private placements. The mean gross proceeds were $14.16 million for the pre-February 1997 offerings and $20.40 million for the post-February 1997 offerings. I report gross proceeds because the private placement agent's fee was disclosed publicly for only 23 of the offerings. These average proceeds compare to the average proceeds of between $4.3 million and $31.5 million in previous stock private placements studies (Wruck, 1989; Silber, 1991; Hertzel and Smith, 1993; and Hertzel et al., 2002). The new shareholders purchased an average of 16% of the equity in the pre-February 1997 offerings and an average of 12% in the post-February 1997 offerings. These relative issue sizes compare to issue sizes from 13.6%-21.2% in previous studies (Wruck, 1989; Silber, 1991; Hertzel and Smith, 1993; and Hertzel et al., 2002). None of the differences between the pre-February 1997 and post-February 1997 means or medians is significant at conventional levels.

C. Private Placement Discount

Panel B reports the mean and median percentage private placement discount calculated with respect to the closing price on the last trading day immediately prior to the date the pricing terms of the private placement are announced. The discount (off the prior day's closing price) is calculated:

Discount = [[P.sub.-1] - [P.sub.0]]/[P.sub.-1], (5)

where [P.sub.-1] is the closing price on the trading day immediately preceding the pricing announcement date and [P.sub.0] is the private placement offering price. Discount in Equation (5) corresponds to one minus the offer price/market price ratio in Wruck (1989).

Hertzel and Smith (1993) measure the discount relative to the share price ten days after the private placement announcement date. I measure the discount relative to the closing share price immediately prior to the pricing announcement date, which seems appropriate for calculating the private placement discount for two reasons. First, the issuer and investors can renegotiate the offering price, size of the issue, and other terms right up to the private placement closing date and, under the securities laws, the terms of the offering must be promptly disclosed publicly once they have been finalized. Additionally, market participants express the discount relative to the freely traded share price and a contemporaneous market price is most appropriate for such a comparison.

The private placement price is usually determined on the closing date (Dresner and Kim, 2006; Morrison and Foerster, 2006). Of the 275 private placements, 236 took place at a discount relative to the closing price the preceding trading day. Allen and Phillips (2000) find that 59% of the private placements to strategic buyers occur at a premium. (10) Table II summarizes the private placement discounts. The mean (median) Discount is 20.82% (19.78%) for the pre-February 1997 offerings and 14.62% (11.89%) for the post-February 1997 offerings. For the discounted offerings, the mean (median) Discount is 24.78% (20.19%) for the pre-February 1997 offerings and 20.41% (13.75%) for the post-February 1997 offerings. The discount should be lower after February 1997 as the SEC halved the resale-restriction period. The difference between the median discounts is significant at the 5% level.

The discounts in Table II compare to average discounts of 13.5% for unregistered placements reported by Wruck (1989), 33.75% in Silber (1991), 20.14% in Hertzel and Smith (1993), and 16.5% in Hertzel et al. (2002). As all four studies have observed, private placement discounts vary widely. In my sample, 64 of the private placements were made at discounts that exceeded 25% and 161 were at discounts that exceeded 10%.

IV. Market Reaction to the Announcements and the Commitment to Register the Stock

Wruck (1989), Hertzel and Smith (1993), and Hertzel et al. (2002) find that a private stock placement has a positive announcement effect in contrast to the negative announcement effect of a public stock offering. None of these studies considers the separate effects of the two announcements that may occur in connection with a private placement: (1) an offering announcement of the firm's intention to place shares of common stock privately and (2) the firm's completion announcement that it has completed the offering furnishing the terms on which it sold the shares, which may also identify the investors. I refer to the earlier of the two as the "initial announcement."

The securities laws do not require public disclosure until the firm has obtained definitive purchase commitments (Dresner and Kim, 2006, Chapter 5), and firms usually do not announce a private placement until they have received definitive purchase commitments from investors (Morrison and Foerster, 2006). And 68 issues in my sample were initially announced prior to the completion announcement. In the other three-quarters of the private issues, the firm waited until the offering had been completed before making any public announcement, and the offering announcement and the completion announcement coincide.

A. Reaction to the Offering and Completion Announcements

A private placement is a best efforts undertaking, in contrast to a general cash offer, which is usually underwritten. There is no assurance in advance that this effort will be successful. Investors will not know that the offering has succeeded until the firm announces its completion and provides the terms on which the shares were sold to investors. In none of the 68 cases did the offering announcement indicate the offering price; it was first disclosed in the completion announcement. The completion announcement also disclosed the number of shares sold. It identified institutional investors in 136 cases, strategic investors in 18 cases, and related investors (directors and 5% shareholders) in 30 cases. It also provided the private placement agent's fee in 23 cases. Thus, both the offering announcement (when one occurs) and the completion announcement may contain useful information. If a private placement announcement signals management's belief that the firm's stock is undervalued, investors should react more strongly to the offering announcement even though there is no assurance the private placement will be successful. Alternatively, they will react more strongly to the completion announcement if the certification effect of successfully completing the stock placement is greater than the effect of the undervaluation signal.

I find that the 275 private placements in my sample had a statistically significant positive mean and median announcement effect during the 11-day window (-5, +5) around the initial announcement and also in the same 11-day window around the completion announcement confirming results previously reported in the literature. However, the median cumulative abnormal return (CAR) is negative for the three-day window (-1, + 1) for both announcement dates. More than half of the CARs are negative suggesting that the market's reaction to a private placement announcement may be more complex than previously realized.

The private placement is supposed to remain confidential until the firm announces it. However, information is released privately as soon as the placement agent approaches prospective investors to offer shares. I found evidence that information does leak into the marketplace affecting the firm's stock price. The pre-announcement mean CARs are positive for periods up to ten days prior to the offering for 207 placements where the firm made only a single announcement upon completion. The median CAR is positive, although not significant, and 52% of the CARs are positive for the 11-day window (- 10, 0). This may reflect the effect of pre-announcement marketing of the private placement by firms (or their investment bankers) that refrain from making an announcement until the shares have been successfully placed. Prospective purchasers, as well as other market participants, can be expected to react to the firm's attempt to sell common stock as soon as this information enters the market. If so, then the market's reaction to the offering may already have been incorporated into the firm's common stock price before the initial announcement when the offering and completion announcements coincide.

I find that the offering announcement and the completion announcement both convey useful information to investors. The impact of the coincidental announcement of the offering and its completion is stronger than the separate impact of the initial announcement and the offering announcement. The mean and median CARs are greatest and the percentage of positive CARs is highest for every event window considered when there is no pre-announcement and the two effects are combined in a single announcement. The greater effect of the combined announcement than either announcement alone is consistent with both the offering announcement and the completion announcement conveying useful information. However, the evidence as to which effect is stronger is inconclusive.

B. Momentum Effect

Hertzel et al. (2002) find that firms that privately place stock have generally experienced significant stock price appreciation just prior to the offering despite poor historical operating performance. One of the advantages of a PIPE, as compared to a registered public offering, is timing. The firm does not have to wait for the SEC to declare its registration statement effective. However, if the firm initiates a PIPE because it believes its stock is overpriced and investors detect the overvaluation, they will expect underperformance post-issue (Hertzel et al., 2002), and the market will react negatively to the private issue announcement. Announcing a PIPE is more likely to signal overvaluation if the firm's stock price has recently increased in price. In that case, the market reaction to the announcement will be the opposite of the positive reaction that prior studies have documented.

I partitioned the sample into those placements for which the comparison period (-120, -21) CAR was positive (positive momentum stocks) and those for which it was negative (negative momentum stocks) and tested the announcement effects for the 68 placements where there was a separate offering announcement. The event windows up to 11 days around the offering announcement have positive (negative) mean CARs for negative momentum (positive momentum) stocks, although only the negative mean CAR for the (-5, +5) window is significant at the 5% level. The positive stock market impact typifies negative momentum stocks, but the opposite effect occurs for positive momentum stocks.

The offering announcement of a private equity issue may signal the firm management's confidence in the firm's prospects and its willingness to open the firm's books to the scrutiny of outside investors. The completion announcement can convey positive information if it signals that private investors have implicitly certified the firm by agreeing to invest after completing their due diligence, notwithstanding a previous drop in share price. However, there is a cost to announcing a common stock private placement when the firm's stock has recently increased in price as the announcement signals possible overvaluation, as with the announcement of a public offering.

C. PIPEs with Quick Registration of the Shares

An overvalued firm can issue a PIPE, quickly register the shares for public resale by filing the abbreviated Form S-3 with the SEC (which can become effective within two days), and thereby enable the purchasers to resell the PIPE shares before the true value of the firm is revealed. I expect that a commitment to register the shares will lead to a smaller discount since investors will expect that they will be able to sell their shares prior to the end of the Rule 144 restriction period. However, investors will also recognize the agency cost inherent in the firm's granting registration rights, resulting in a negative signal. First, I test for the impact of the commitment to register the shares on the size of the discount, which will be reflected in the registration occurring soon after the private placement.

Hypothesis 1: A commitment to register the common shares will reduce the size of the private placement discount.

Then, I test the difference in the signaling effect between private stock placements that are registered contemporaneously and those that are not. I expect that the market impact of the announcement is negative, just like a public offering announcement, when the shares are registered contemporaneously.

Hypothesis 2: When the privately placed shares are registered (not registered) contemporaneously with the offering, there is a negative (positive) announcement effect.

Since it has been demonstrated that private placement announcements have a positive market impact, at least for negative momentum stocks, it is sufficient in testing Hypothesis 2 to test for a negative market reaction when the stock is registered contemporaneously with the offering.

Hertzel and Smith (1993) find that the lack of registration accounts for about two-thirds (13.5%) of the 20.14% average discount in their sample. The PIPEs market has developed since their study. PIPE investors usually require the firm to use its best efforts to register the private placement shares as quickly as possible (Morrison and Foerster, 2006). This commitment shortens the expected holding period so long as it is credible, which should reduce the discount. The firm can enhance the credibility of this signal by filing a registration statement with the SEC by the private placement closing date (Morrison and Foerster, 2006). Such an arrangement is typical with Rule 144A private placements.

I checked the private placement announcements and the firms' subsequent Form 10-K reports to search for mention of a commitment to register the private placement shares. Of the 236 discounted private placements, 50 of the firms announced that they had granted the purchasers registration rights, and 149 of the firms registered the shares before the end of the Rule 144 holding period. The firm only commits to use its best efforts to register the shares and, even then, there is no assurance that the SEC will declare the registration statement effective. I also investigated how long it took firms to register the shares.

Table III quantifies the impact on the discount of the firm's contemporaneous registration of the shares. And 79 of the private placements were registered within 30 days of the completion announcement, 19 were registered within the next 30 days (12 within the first 15 days), 12 more within the following 30 days, and 39 thereafter, but before the end of the Rule 144 holding period. Thus, about two-thirds of the discounted placements are registered within the Rule 144 restriction period. The discount is smaller for the 30-day registration period than for the more than 90-day registration period for each class of investors. The average discount is more than one-third less (15.32% vs. 25.14%) and the difference is significant at the 1% level when the shares are registered within 30 days as compared to when they are registered more than 90 days later or not at all supporting Hypothesis 1. The differences are greater when the shares are purchased by strategic investors or related investors (such as insiders) than by institutional investors, but the small sample sizes prevent definitive conclusions for these groups. While the difference is smaller for purchases by institutional investors, it is significant at the 5% level.

Hertzel et al. (2002) find that the positive average private placement announcement effect is incorrect due to post-issue underperformance, which they attribute to investor overoptimism. I investigated the stock market's reaction to the announcement of a stock private placement when the firm registers the shares promptly. Prompt registration is consistent with the hypothesis that managers time equity issues to take advantage of "windows of opportunity" to issue overvalued stock (Hertzel et al., 2002).

I compared the announcement effect when the firm registers the stock within 30 days to the reaction when it is not registered within 90 days. The results are reported in Table IV. The mean CARs are all negative and seven of the eight median CARs are negative when the stock is registered within 30 days, but the mean CARs are all positive and five of the eight median CARs are positive when it is not registered within 90 days. All eight mean CARs and seven of the eight median CARs are greater when the shares are not registered within 90 days, and the mean differences for the (-3, 0) and (-1, +1) windows are significant at the 5% level. These results are consistent with Hypothesis 2. The stock market reacts negatively when the firm registers the shares promptly following the private placement. Investors recognize that a PIPE has the same agency cost implications as a public offering as the firm uses the PIPE structure to conduct a two-step public offering.

V. Transfer Restrictions and Ownership Concentration, Information, and Overvaluation Effects

Private placement transfer restrictions entail a loss of timing flexibility, which imposes a cost that can be modeled as foregone put option value (Longstaff, 1995, 2001; Kahl, Liu, and Longstaff, 2003). Wruck (1989), Hetzel and Smith (1993), Allen and Phillips (2000), and Hertzel et al. (2002) furnish empirical evidence that ownership concentration, information, and overvaluation effects also contribute to the private placement discount.

Transfer restrictions can explain a marketability discount, but not a premium. As such, in the balance of the paper, I focus on private placements at a discount. This section performs a cross-sectional regression analysis to test the relative importance of transfer restrictions and ownership concentration, information, and overvaluation effects when explaining the size of the discount in the 236 discounted private placements.

A. Proxies for the Impact of Transfer Restrictions

Discount, the dependent variable, measures the percentage discount relative to the closing market price of the issuer's registered stock on the trading day immediately preceding the completion announcement date as in Equation (5), which is the market price that is usually used as the basis for pricing privately placed shares (Dresner and Kim, 2006). (11)

Kahl et al. (2003) find that the stock's volatility and the length of the restriction period are the key drivers of the discount in their restricted stock model. Longstaff (1995) models the marketability discount as a lookback put option whose value depends upon stock volatility and the time to expiration of the transfer restrictions. Volatility is the annualized standard deviation of the total return on the issuer's common stock for the period ending on the last trading day immediately preceding the initial announcement date. Options are valued based on implied volatilities (Hull and Suo, 2002). Since only 48 of the stocks had traded stock options (none were LEAPS), I estimated each stock's implied future volatility using the generalized autoregressive conditional heteroskedasticity (GARCH) model (Bollerslev, 1986). I restricted the private placement sample to firms with at least three months of historical stock prices, but I used up to one year's historical stock prices if those data were available. In 119 cases, the estimated implied volatility exceeded 90%. I rescaled estimated volatilities that exceed 90% to lie between 90% and 120% as option market participants discount very high volatilities estimated from historical share prices when choosing Volatility. (12) I interact Volatility with the length of the Rule 144 restriction period (T) to capture the interdependence between T and Volatility. Volatility x [square root of T] is used with T = 2 up to February 1997 and T = 1 thereafter.

I used a second proxy to capture another dimension of the timing effect of the transfer restrictions (Time). Rule 144 imposed a minimum two-year (one-year) restriction period prior to (after) February 1997. For one year following the initial restriction period, the number of shares that could be sold during any three-month period is limited to the lesser of: (1) the average weekly trading volume during the four calendar weeks immediately preceding the filing with the SEC of Form 144 indicating the holder's intention to sell and (2) 1% of the number of outstanding shares. Time captures the effect of this second restriction. Even when the firm commits to register the shares promptly, the stock's trading volume will limit the investors' ability to dispose of the registered shares. I use the ratio of the number of shares offered to the common stock's trading volume during the three-month period ending on the last trading day immediately preceding the initial announcement date as a proxy for Time.

I also control for the riskless rate and the stock's dividend yield, which affect value in traditional option pricing models. Due to Rule 144's minimum restriction period, I use the two-year Treasury yield prior to February 1997 and the one-year Treasury yield thereafter as of the initial announcement date as the riskless interest rate (Rate). The stock's dividend yield (Yield) is the annualized dividend yield based on the most recently declared cash dividend as of the completion announcement date and the closing price of the registered shares on the last trading day immediately preceding that date. Discount should be smaller for dividend paying stocks because the greater flow of cash to investors during the restriction period reduces the degree of illiquidity. (13) However, only 16 of the 236 firms had declared a cash dividend within the prior 12 months. I test the following marketability hypothesis:

Hypothesis 3: Discount varies directly with Volatility x [square root of T] and Time.

I expect positive coefficients for the variables Volatility x [square root of T] and Time in the regression models after controlling for ownership concentration, information, and overvaluation effects.

B. Proxies for Equity Ownership Concentration, Information, and Overvaluation Effects

I use several proxies to capture ownership concentration, information, and overvaluation effects. The discount investors require will depend upon the intensity of monitoring by outside shareholders and the firm's board of directors. I use one minus the fraction of directors that are also managers (Direct), according to the issuer's most recent proxy statement as of the competition announcement date, to proxy for the intensity of monitoring by outside board members. Fama and Jensen (1983) argue that outside directors have an incentive to act as effective monitors as they want to protect their reputations for independence. (14)

I also considered using the percentage of shares owned by insiders to capture differences across firms in goal alignment between the firm and its shareholders or the percentage of shares owned by institutional investors to proxy for the intensity of institutional monitoring. In regressions not reported in the paper, I found no significant relationship between Discount and either of these variables. I also did not find a significant correlation in my overall sample or in subsamples based on less than 5%, between 5% and 25%, or greater than 25% insider ownership, which are partitions Wruck (1989) suggests.

Turning to information effects, following Hertzel and Smith (1993), I calculated Fraction as the fraction of the firm's common stock that is outstanding after the private placement. Private placements take place more quickly than general cash offers leaving less time for due diligence. As a result, there is a danger that due diligence might be less extensive than in a general cash offer. Under the information hypothesis, larger issues require more intensive information gathering and expose investors to greater asymmetric information costs. Since they have to expend more resources to assess firm value, they require a larger discount when the offering is relatively large suggesting a positive coefficient.

I considered three possible proxies for the severity of information asymmetries between the firm and outside investors. I calculated Risk, the standard deviation of the daily abnormal returns from fitting the Scholes-Williams (1977) beta-adjusted capital asset pricing model (CAPM) to stock returns for the period extending from 120 to 21 days prior to the initial announcement. I ended the period 21 days prior to the initial announcement to avoid contamination from private placement marketing that typically precedes the initial public announcement. The greater the value of Risk, the greater the information asymmetry and the greater the value of Discount. I also considered using ERR, calculated as the average absolute difference between stock analysts' forecasted earnings and the firm's actual earnings scaled by the firm's share price, or STDEV, calculated as the standard deviation of stock analysts' earnings forecasts scaled by the firm's share price. However, there were adequate stock analyst forecast data in the Institutional Brokers Estimate System (I/B/E/S) from Thomson Reuters for only 38 firms, which is too small a sample for a reliable regression analysis.

Information asymmetries are likely to be more severe for smaller firms as they tend to be more costly to evaluate. There are also economies of scale in the production of information implying that the size of the discount should be inversely related to the issue gross proceeds. I find that Discount is significantly inversely related to the market value of equity and also to gross proceeds. Gross proceeds are positively correlated with the market value of equity with a Spearman correlation coefficient of 0.74. A smaller firm is likely to have greater information asymmetry between the firm and its investors and, as such, greater heterogeneity in stockholder valuations, which will lead to a greater discount. Accordingly, a negative coefficient for the logarithm of gross proceeds Log (Proceeds) may reflect, in part, the cost of the greater information asymmetries for smaller firms supporting the information hypothesis. It could also reflect, in part, information gathering economies.

I use a dummy variable to test the possible significance of exchange listing. The variable Exchange takes a value of one if the registered shares are listed on the NYSE, the AMEX, the NASDAQ National Market, or the NASDAQ Small Cap Market at the time of the private placement and zero otherwise. Exchange-traded stocks and NASDAQ stocks generally have larger capitalizations, and firm disclosure is governed by exchange or NASDAQ regulations resulting in a freer flow of information to investors. I expect a negative coefficient.

Finally, turning to the overvaluation effects, the ratio of the market value to the book value of the firm's common stock immediately preceding the completion announcement may serve as a measure of the degree of over- or undervaluation. Hertzel et al. (2002) find that firms that issue equity privately have above average market-to-book ratios, which they attribute to investor overoptimism concerning the firm's growth prospects. Lehn, Netter, and Poulsen (1990) use the market-to-book ratio as a proxy for Tobin's q. McLaughlin, Safieddine, and Vasudevan (1996) interpret Tobin's q as a proxy for the firm's growth opportunities (Tobin k q > 1 signifying a high growth firm), and Spiess and Affleck-Graves (1995) find that high growth firms tend to be more prone to overvaluation than low growth, mature firms. However, the market-to-book ratio may also proxy for the fraction of the firm's equity market value attributable to intangible assets. The more significant the firm's intangible assets, the larger the market-to-book ratio and the more difficult it is for investors to assess the value producing the likelihood of a greater discount.

Since the market-to-book ratio varies across industries, I test for overvaluation by measuring the relative market-to-book ratio, Market/Book Deviation, as implemented by Rhodes-Kropf, Robinson, and Viswanathan (2005). Market/Book Deviation is the difference between the firm's market-to-book ratio and the average market-to-book ratio for the firm's industrial sector at the time of the private placement. (15) The larger (smaller) the Market/Book Deviation, the greater the degree of over- (under-) valuation and the greater (smaller) the discount. I expect a positive coefficient based on Hetzel et al.'s (2002) investor overvaluation hypothesis.

C. Additional Control Variables

In addition to the variables Yield and Rate previously discussed, I controlled for the effect of the reduction in the length of the initial Rule 144 holding period to one year from two years in February 1997 by including the dummy Post, which takes a value of one following February 1997 and zero prior to that point. I expect the sign of Post to be negative.

I also controlled for whether there were options on the firm's stock outstanding at the time of the private placement by including the dummy variable Options, which takes a value of one if there were options and zero if there were not. Options proxies for the existence of hedging opportunities, which should reduce the discount. I expect its sign to be negative.

In addition, I controlled for the existence of registration rights or a commitment to register the stock following the private placement because of the earlier finding that the discount is smaller when the firm registers the stock soon after the private placement. Due to the time required to prepare and file a registration statement with the SEC, I assume that it was planned at the time of the placement if the firm registers the shares within 45 days of the closing. I introduced the dummy variable Registered Stock to control for the effect of a credible commitment to register the shares, which takes a value of one if the shares were registered within 45 days of the completion announcement and zero otherwise. I also introduced the dummy variable Registration Rights" to control for the granting of registration rights, which takes a value of one if the firm disclosed that it had granted mandatory, demand, or piggyback registration rights and zero otherwise. Livingston and Zhou (2002) find that granting registration rights lowers the cost of Rule 144A debt. I expect both dummies to have a negative coefficient.

D. Regression Results

I ran three cross-sectional regression models to investigate the factors that are responsible for the private placement discount. Regression Model 1 has the four transfer restriction independent variables and the control variables Post, Options, Registration Rights, and Registered Stock: Model 1:

Discount = [a.sub.0] + [a.sub.1] Volatility x [square root of T] + [a.sub.2] Time + [a.sub.3] Yield + [a.sub.4] Rate + [a.sub.5] Post + [a.sub.6] Options + [a.sub.7] Registration Rights + as Registered Stock. (6)

Regression Model 2 contains only ownership concentration, information, and overvaluation independent variables along with the control variables. There are six information, ownership concentration, and overvaluation variables (Risk, Direct, Log(Proceeds), Fraction, Exchange, and Market/Book Deviation). The model is:

Model 2:

Discount = [a.sub.0] + [a.sub.1] Risk + [a.sub.2] Direct + [a.sub.3] Log(Proceeds) + [a.sub.4] Fraction + [a.sub.5] Exchange + [a.sub.6] Market/Book Deviation + [a.sub.7] Post + [a.sub.8] Options + [a.sub.9] Registration Rights + [a.sub.10] Registered Stock. (7)

Regression Model 3 combines both sets of independent variables and the control variables: Model 3:

Discount = [a.sub.0] + [a.sub.1] Volatility x [square root of T] + [a.sub.2] Time + [a.sub.3] Yield + [a.sub.4] Rate + [a.sub.5] Risk + [a.sub.6] Direct + [a.sub.7] Log(Proceeds) + [a.sub.8] Fraction + [a.sub.9] Exchange + [a.sub.10] Market/Book Deviation + [a.sub.11] Post + [a.sub.12] 0ptions + a[a.sub.13] Registration Rights + [a.sub.14] Registered Stock. (8)

I examined the bivariate relationships between Discount and each independent variable (not reported). All the variables have the predicted signs. Of the four transfer restriction variables, Volatility x [square root of T] has the most significant Pearson correlation coefficient, which is consistent with the option characterization of the transferability discount. Volatility x [square root of T] has a Pearson correlation coefficient that is significant at the 1% level, the Pearson correlation coefficients for Rate and Time are significant at the 5% level, and the Pearson correlation coefficient for Yield is not significant, which is not surprising given the small fraction of stocks in the sample that were dividend paying at the time of the private placement. These results are consistent with Kahl et al.'s (2003) finding that the stock's volatility and the length of the restriction period are the key drivers of the discount in their restricted stock model.

Of the ownership concentration, information, and overvaluation variables, the Pearson correlation coefficients for Risk, Log(Proceeds), Exchange, and Market/Book Deviation are significant at the 1% level, and those for Direct and Fraction are not significant.

Table V contains the cross-sectional regression results. Models 2 and 3 have 202 observations. Data were not available for Direct for 14 of the 236 firms, and the market-to-book ratio was not meaningful for the 20 firms with negative book equity. White's (1980) specification test indicates heteroskedasticity, so I report White heteroskedasticity-consistent estimators and t-statistics.

The coefficients of Volatility x [square root of T] and Time have the predicted signs in Model 1 and Model 3. The coefficient of Volatility x [square root of T] is significant at the 1% level in both models. The coefficient of Time is significant at the 1% level in one model and at the 5% level in the other, which is consistent with Hypothesis 3 and supports the option characterization of the marketability discount. The coefficient of Yield has the wrong sign in both models, although neither of these coefficients is statistically significant. Only 16 of the firms in the sample of 236 firms had declared a cash dividend within the 12 months immediately preceding the private placement.

All the coefficients of the ownership concentration, information, and overvaluation variables have the predicted signs in Models 2 and 3. The coefficient of Risk is significant at the 1% level, and the coefficients of Log(Proceeds) and Market/Book Deviation are significant at the 5% level in Model 2. The coefficient of Market/Book Deviation is significant at the 5% level, while the coefficient of Risk is only weakly significant in Model 3. The significant positive coefficient for Market/Book Deviation in Models 2 and 3 is consistent with Hertzel et al.'s (2002) overvaluation hypothesis.

The adjusted [R.sup.2] and F statistics indicate that Model 1 and Model 2 have similar explanatory power. Model 3 explains approximately 30% of the variation in Discount. The coefficients of both transfer restriction variables Volatility x [square root of T] and Time are significant, while only the coefficient of Market/Book Deviation is significant and that of Risk is weakly significant in Model 3. The partial F-statistics, which are significant at the 1% level for the ownership "concentration, information, and overvaluation variables and at the 5% level for the transfer restriction variables, indicate that the incremental contribution of the former is greater than the incremental contribution of the transfer restriction variables. Overall, the regression results confirm that all four sets of factors examined in this paper, transfer restrictions and ownership concentration, information, and overvaluation effects, play a role in explaining the private placement discount. Among the latter three effects, information and overvaluation effects are statistically significant, while ownership concentration effects are not significant in the regression results reported in the paper.

The coefficient of Post has the expected sign only in Model 2, although it is not statistically significant. Thus, there is only very weak evidence that the reduction in Rule 144's initial holding period in 1997 reduced the private placement discount. The coefficients of Registration Rights and Registered Stock have the expected signs in all three models, and the coefficient of Registered Stock is significant at the 5% level or better in all three regressions. The significant negative coefficient of Registered Stock supports Hypothesis 1 and indicates that the firm's commitment to register the shares promptly partly mitigates the effect of the negative PIPE signal by reducing the expected restriction period.

E. Effect of the Type of Investor

Allen and Phillips (2000) find that selling a block of stock to a nonfinancial firm leads to significant excess returns when the investment is coupled with a strategic product market relationship. Strategic investors would be expected to have deeper knowledge of the firm's prospects than financial investors. They should be less prone to overoptimism regarding the firm's prospects and more cognizant of the risk of future underperformance documented by Hertzel et al. (2002). A strategic partner should demand a smaller discount if its industry expertise gives it a comparative advantage in performing due diligence. It might even agree to pay a premium if it expects to develop a strategic relationship that will provide synergistic benefits that it can capture and if buying the shares in the open market would force up the price. Alternatively, it should demand a greater discount if its private information enables it to determine that the issuer is likely to underperform in the absence of the strategic relationship or if it will provide special monitoring services and advice that can add value. Allen and Phillips (2000) find that 59% of the private placements to strategic buyers take place at a premium and that strategic buyers typically pay a 6% private placement premium. Table III reports that the average discount is greater when shares are placed privately with strategic investors and not registered promptly than when they are placed with (unrelated) institutional investors.

To test for the effect of strategic benefits on the private placement discount, I use the dummy variable Strategic, which takes a value of one when the firm announces that it placed the shares with another corporation that could be identified as a strategic partner because of a marketing or development agreement of some kind. I classified the buyer as a strategic partner if a significant business relationship between the two was noted either in the offering announcement or in the issuer's Form 10-K report for that year. I use the dummy variable Related that takes a value of one when the firm announces that it placed the shares with a related party, such as an officer, director, 5% shareholder, or a member of their family.

I expect positive coefficients for Strategic and Related if the private placement is a cheaper means of achieving control benefits than buying the stock in the public market and a negative coefficient if the transfer restrictions are more costly to insiders due to their valuable private information about the firm's prospects. Since the proportion of institutional ownership, and presumably the intensity of institutional monitoring, will increase when new shares are placed entirely with institutions, I use the dummy variable Investment that takes a value of one when the issuer announces that the shares were placed with institutional investors. Placing the shares with institutional investors also decreases the percentage of shares held by insiders. The issuers of 123 of the 236 discounted private placements made such an announcement. I expect a negative coefficient for Investment if the institutional investors' greater liquidity as compared to private investors generally makes the transfer restrictions less costly, but a positive coefficient if they require compensation for their monitoring.

To test the effect of the type of buyer on the private placement discount, I reran Model 3. I interacted each of Investment, Strategic, and Related with Fraction as I expect that the significance of the buyer type will also depend upon the relative size of the offering (reflecting potential ownership concentration effects). I confirmed that the results are stronger with the interaction. In unreported results, I found that the coefficient of Strategic x Fraction is positive, but not statistically significant, and the coefficient of Related x Fraction is negative, but not statistically significant. The coefficient of Investment x Fraction is negative and significant at the 1% level, consistent with a discount-reducing liquidity effect. The private placement discount is smaller for institutional investors than for other types of private placement purchasers.

VI. Comparison of Model-Predicted and Empirical-Predicted Discounts

The regression results for Model 1 and Model 3 in Table V confirm that the private placement discount depends, in part, on the loss of timing flexibility implicit in the Rule 144 transfer restrictions, which is consistent with the marketability hypothesis (Hypothesis 3). Next, I use option-based models of the transferability discount to test whether model-predicted values of the transferability discount are consistent with the empirical-predicted discounts that I obtain by adjusting the actual discounts observed in private placements for ownership concentration, information, and overvaluation effects.

A. Marketability Discount Option Models

Longstaff (1995) proposes a lookback put option model, and Finnerty (2012) proposes an average-strike put option model that can be used to quantify the loss of timing flexibility. I compare these two models and then test whether model-predicted discounts are consistent with empirical-predicted discounts using my sample of 236 discounted private placements.

Longstaff (1995) develops the following upper bound on the marketability discount [D.sup.*] (T) for a nondividend paying restricted share under the assumption that the holders of restricted shares have perfect market-timing ability:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (9)

This special timing ability could be due to valuable private information regarding the issuing firm's future prospects. Such shareholders would presumably time their sales of unrestricted shares so as to maximize the sales proceeds. Thus, Longstaff's (1995) model can also be interpreted to apply to insiders with valuable private information, such as senior executives. Many publicly traded firms prohibit their executives from buying or selling shares except during limited periods (e.g., a brief period commencing a few days following an earnings announcement). Longstaff's (1995) model might be used to measure the impact of such blackout period restrictions.

Alternatively, Finnerty (2012) obtains the following formula for an upper bound on the value of the marketability discount D(T) for a share that pays dividends at the constant proportional rate q when investors do not have any special market-timing ability:

D(T) = [V.sub.oe.sup.-qT] [N([upsilon][square root of T]/2) - N(-[upsilon][square root of T]/2)], (10)

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. (11)

In these models, N(*) is the cumulative standard normal distribution function, exp(*) is the exponential function, [V.sub.0] is the initial share price, [sigma] is the stock's volatility, and T is the length of the restriction period. The discount is proportional to the current share price. It increases with the length of the restriction period and with the stock's volatility, but is independent of the riskless rate. It varies inversely with the dividend yield q in Equation (10). Both option models are consistent with the regression results reported in the previous section for Models 1 and 3. The private placement discount depends upon the stock's volatility and the other option parameters to the extent transfer restriction risk is priced.

B. Comparison of the Lookback and Average-Strike Put Option Models

The lookback put option Model (9) assumes that investors have perfect market-timing ability, whereas the investor is not assumed to have any special timing ability in the average-strike put option Model (10)-(11). instead, it is assumed that the investor would, in the absence of any restrictions, be equally likely to sell the shares anytime during the restriction period. The last assumption is consistent with evidence that outside investors, at least on average, do not have any special ability to outperform the market (Barber and Odean, 2000; Chevalier and Ellison, 1999).

Empirical evidence indicates that private information enables insiders to time the market and realize excess returns (Seyhun, 1988; Gompers and Lerner, 1998). A buyer of unregistered common stock may require a greater discount if they have valuable private information about the firm's prospects. In that case, the resale restrictions will interfere with their ability to exploit their information advantage to time the market. I found some weak empirical support for that proposition in Section V, although the small strategic investor and related investor sample sizes may not have permitted a reliable test of that hypothesis.

Why would such an investor buy a private placement? They might derive strategic benefits (Allen and Phillips, 2000) or ownership concentration benefits (Wruck, 1989). If the stock is relatively illiquid, accumulating a large block could ultimately be more expensive as it is likely to drive up the market price. A strategic or related investor might also require additional compensation due to the transferability restrictions if the investor's valuable private information makes those restrictions more costly for that investor than for private buyers generally. The firm would still be willing to sell the shares privately rather than publicly so long as Inequality (4) holds. The lookback put option model may be more appropriate in the presence of asymmetric information for equity placed with strategic or related investors, while the average-strike put option model seems more appropriate for (unrelated) institutional investors, who have greater liquidity and are much less likely to have valuable private information about the firm.

Table VI compares the mean actual private placement discounts, the mean marketability discounts predicted by the lookback put and average-strike put option models, and the mean empirical-predicted marketability discounts calculated by adjusting the actual private placement discounts for the ownership concentration, information, and overvaluation effects and the other control variables in Model 3. I calculate the Empirical-Predicted Discount from the actual private placement discount (Discount):

Empirical-Predicted Discount = Discount - ([a.sub.0] + [a.sub.1] Risk + [a.sub.2] Direct + [a.sub.3] Log(Proceeds) + [a.sub.4] Fraction + [a.sub.5] Exchange + [a.sub.6] Market/Book Deviation + [a.sub.7] Post + [a.sub.8] Options + [a.sub.9] Registration Rights + [a.sub.10] Registered Stock + [a.sub.11] Investment x Fraction + [a.sub.12] Strategic x Fraction + [a.sub.13] Related x Fraction). (12)

Since some of the coefficients on the right-hand side are expected to be positive, but others are expected to be negative, the Empirical-Predicted Discount may be greater than or less than the actual private placement discount.

If there is a difference between the two option models, I expect that it will be evident from comparing these predictions for a subsample of information-intensive private placements and a subsample of noninformation-intensive private placements. I distinguish information-intensive placements as those with either: (1) Volatility above the median and Risk above the median for the overall sample or (2) placed with strategic investors (Strategic = 1) or related investors (Related = 1). I characterize private placements with: (1) Volatility below the median and Risk below the median and (2) Strategic = Related = 0 as noninformation-intensive placements.

The average-strike put option model closely approximates the mean actual private placement discount for the full sample, whereas the lookback put option model substantially overstates it in Table VI. The mean actual private placement discount and the mean empirical-predicted discount are both significantly greater for information-intensive private placements than for noninformation-intensive placements. Both option models predict substantially greater discounts for the information-intensive placements. However, the lookback put option model consistently substantially overstates both the actual discounts and the empirical-predicted discounts, and the overstatement is more severe for the information-intensive placements. I also find that the lookback put option model similarly overstates the discounts for offerings to financial institutions, strategic investors, and related investors (not reported). Finally, in Panel C, the average-strike put option model very closely approximates the empirical-predicted marketability discounts for the full sample, as well as for both information-intensive and noninformation-intensive private placements, while the lookback put option model substantially overstates it in all three cases.

Table VII compares the ability of the lookback and average-strike put option models to explain actual private placement discounts. I regress the difference between the actual discount and the model-predicted discount on the explanatory variables that measure the ownership concentration, information, and overvaluation effects. I test for two possible effects. First, if the lookback put option model explains the discounts in the information-intensive subsample better than the average-strike put option model, then the coefficients of the information intensity variables Risk, Strategic x Fraction, and Related x Fraction should be less significant in the lookback put option model than in the average-strike put option model for the information-intensive subsample, and the coefficient of Risk should be less significant in the lookback put option model for the information-intensive subsample than the full sample because the information effect is already captured in the lookback model discount. Likewise, if the average-strike put option model explains the discounts in the noninformation-intensive subsample better than the lookback put option model, then the coefficient of Risk should be negative and more significant in the lookback put option model than in the average-strike put option model regression for the noninformation-intensive subsample because the lookback model's discount estimation errors will be more negative, and they will vary with the value of Risk (as indicated in Table V). Moreover, the lookback put option model should have a relatively lower mean squared error than the average-strike put option model for the information-intensive subsample as compared to the full sample if the lookback model is better at explaining the information-intensive subsample's discount.

Comparing the regression results in Table VII, the coefficients of Risk, Fraction, and Related x Fraction reverse sign in the lookback put option model regression on the information-intensive subsample, but not in the average-strike put option model regression on the same subsample. This reversal of sign does not occur for Risk in the lookback put option model regression on the noninformation-intensive subsample. The coefficient of Risk is positive and highly statistically significant (insignificant) in the average-strike (lookback) put option model regression for the information-intensive subsample. Additionally, the coefficients of Risk, Exchange, and Options reverse sign in the average-strike put option model regression on the noninformation-intensive subsample, but not in the lookback put option model regression on the same subsample. This reversal of sign does not occur for Risk in the average-strike put option model regression on the information-intensive subsample. The coefficient of Risk is negative and highly (weakly) statistically significant in the lookback (average-strike) put option model regression for the noninformation-intensive subsample, which essentially reverses the relationship for the information-intensive subsample. Moreover, the mean squared error increases (decreases) for the average-strike (lookback) put option model for the information-intensive subsample as compared to the full sample. This evidence reinforces the evidence in Table VI that the average-strike put option model is less suitable for information-intensive private placements because it understates those marketability discounts to a much greater extent. However, the lookback put option model errs in the opposite direction. Its pricing errors are actually greater for information-intensive private placements than for the full sample. It substantially overstates the marketability discount even when the shares are placed with strategic or related investors.

The Adjusted [R.sup.2] and F values in Table VII suggest that the average-strike put option model performs relatively better (worse) on the noninformation-intensive (information-intensive) subsample and that the lookback option model does the reverse. However, the evidence in Tables VI and VII suggests that the average-strike put option model explains actual marketability discounts much better than the lookback put option model, which exhibits a severe upward bias even for information-intensive restricted stock transactions.

I also compared the average-strike put option model's ability to explain the empirical-predicted discounts for the information-intensive and noninformation-intensive subsamples (results not reported). I expect that the average-strike put option model's prediction errors would be greater for the information-intensive placements. I regressed the difference between the average-strike put option model-predicted discount and the empirical-predicted discount on the ownership concentration, information, and overvaluation variables separately for each subsample. The coefficients of Risk and Market/BookDeviation were the only coefficients significant at the 5% level in either regression. The coefficient of Risk is negative and significant at the 1% level for the information-intensive subsample, but positive and significant at the 5% level for the noninformation-intensive subsample, which is consistent with the tendency to understate the discount for information-intensive placements observed in Table VI. (16) The mean squared error was more than twice as high in the information-intensive regression, again indicating that the average-strike put option model explains the noninformation-intensive placement discounts better than it explains the information-intensive placement discounts.

C. Comparison of the Model-Predicted and Empirical-Predicted Discounts

I performed two additional tests of the average-strike put option marketability discount model's ability to explain actual marketability discounts. Table VIII compares the Empirical-Predicted Discounts from Equation (12) and the Model-Predicted Discounts predicted by the average-strike put option model in Equations (10)-(11) for various stock volatilities. The Model-Predicted Discounts somewhat understate the Empirical-Predicted Discounts for volatilities under 30% and between 90% and 105% for a two-year restriction period. They also somewhat overstate the Empirical-Predicted Discounts for volatilities between 45% and 75% for a two-year restriction period. The Model-Predicted Discounts fit the Empirical-Predicted Discounts much more closely for the one-year restriction period that has applied since February 1997. With the exception of low volatility stocks (under 45%) and stocks with volatilities between 90% and 105%, the Model-Predicted Discounts track the Empirical-Predicted Discounts rather closely once the observed discounts are adjusted for the accompanying information, ownership concentration, and overvaluation effects.

Additionally, I regress the Empirical-Predicted Discount on the Model-Predicted Discount to investigate whether the average-strike put option model has a systematic tendency to over- or understate the discount for T = 1 or T = 2. I fit the regression equation:

Empirical-Predicted Discount = [a.sub.0] + [a.sub.1] Model-Predicted Discount. (13)

If the Empirical-Predicted Discounts perfectly track the Model-Predicted Discounts, then [a.sub.0] = 0 and [a.sub.1] = 1. If investment bankers and business appraisers tended to apply discounts within the 25%-35% range prior to February 1997 and within the 15%-25% range since February 1997 with little, if any, adjustment for volatility, then I would expect [a.sub.0] > 0 and [a.sub.1] < 1 because then the Empirical-Predicted Discounts would tend to overstate (understate) the Model-Predicted Discounts for low (high) volatilities. The slope al would indicate how sensitive the discount is to differences in volatility and to variation in the other parameters in the model.

Neither of the intercepts [a.sub.0] is significantly different from zero and neither of the slopes [a.sub.1] is significantly different from one at the 10% level (results not reported). (17) This is further evidence that the Model-Predicted Discounts according to the average-strike Model (10)-(11) appear to fit the Empirical-Predicted Discounts rather well after adjusting for ownership concentration, information, and overvaluation effects. Investment bankers and appraisers seem to adjust for volatility and they also seem to have adjusted for the shortening of the Rule 144 restriction period. With the exception of relatively low volatility ([sigma] under 45%) stocks, the average-strike put option Model (10)-(11) predicts actual discounts for lack of free transferability reasonably well as of the pricing date (Day 0).

VII. Conclusion

The private placement discount results partly from Rule 144 transfer restrictions and partly from the equity ownership concentration, information, and overvaluation effects that accompany a common stock private placement. The cost of transfer restrictions can be priced as the value of an average-strike put option. The average-strike put option model calculates marketability discounts that are consistent with the discounts observed empirically in letter stock private placements, although there is a tendency to understate the discount when the stock's volatility is under 45%. The observed private placement discounts appear to reflect differences in stock price volatility as option theory and the average-strike put option model predict. The average-strike put option model fits empirically observed discounts better than the lookback put option model, which substantially overstates the discount even when common stock is privately placed with strategic or related investors.

The stock market's reaction to a private placement announcement is more complex than previous studies suggest. In contrast to the typical positive announcement effect, I find that the announcement can elicit a negative reaction if the stock has recently exhibited positive momentum or if the firm commits to register the shares promptly. In both cases, the firm appears to be placing shares privately to take advantage of a window of opportunity, and the market reacts to the overvaluation signal just as it would to a public offering announcement. Indeed the ability to sell shares quickly by postponing the time consuming registration process is one of the benefits cited by PIPE promoters.

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The author would like to thank Bill Christie (Editor). an anonymous referee, Larry Darby, Esq., Carl Felsenfeld, Esq., Wenxuan Hou, Peter Jurkat, Susan Long, Francis Longstaff Haim Mozes. Gordon Phillips, Richard Smith, and Larry Thibodeau for helpful comments on earlier drafts and Jack Chen, Sherry Chen, Ernie de Rosa, Pablo Alfaro, Dina DiCenso, Elpida Tzilianos, Peter Eschmann, Alberto Chang, and Xiaoling Wang for research assistance. Financial support was provided by a summer research grant from the Fordham University Graduate School of Business. Earlier versions of the paper were presented at the annual meetings of the American Finance Association, the Financial Management Association, and the Southern Finance Association.

(1) Letter stock is not registered for resale under the Securities Act of 1933 and, therefore, cannot be publicly traded. It must be placed privately with accredited (sophisticated) investors. Under Rule 144, the holder cannot sell the shares during a specified minimum holding period measured from the issue date except through another exempted transaction. This requires an opinion of counsel satisfactory to the firm that the proposed transaction will be exempt from registration. After the minimum holding period, the shares can be sold in the public market without registration, but only after the firm agrees to remove the restrictive stock legend on the share certificate, which usually requires an opinion from counsel that the sale complies with Rule 144. During the sample period for this study, Rule 144 sales were also subject to a further one-year restriction on the volume of sales (Anderson and Dyl, 2008). Prior to February 1997, the minimum holding period for a nonaffiliated stockholder was two years; thus, the shares could be sold beginning three years after issue without any restrictions. The SEC amended Rule 144 in 1997 to allow non-affiliates to sell their shares after just one year followed by the one-year restriction on the volume of sales. The SEC shortened the Rule 144 minimum holding period to six months in December 2007 and eliminated the one-year sales volume restriction. In both cases, the SEC shortened the holding period in order to lower the cost of raising equity privately (SEC, 2007).

(2) There is also evidence from other securities markets that lack of free transferability may lead to significant price discounts. Amihud and Mendelson (1991) and Kamara (1994) find that the yields on illiquid Treasury notes average more than 35 basis points higher than the yields on liquid Treasury notes with the same remaining maturity. Boudoukh and Whitelaw (1991) determine that the yield spread between the designated benchmark Japanese Government bonds and less liquid nonbenchmark Japanese Government bonds of like maturity averages more than 50 basis points. Brenner, Eldor, and Hauser (2001) confirm that over-the-counter currency options sell for about 21% less than similar exchange-traded options.

(3) Longstaff's (1995) model provides an upper bound on the marketability discount as it assumes that investors have perfect market-timing ability.

(4) The Rule 144 restriction period was shortened to one year from two after their study was published.

(5) Equation (1) is obtained directly from Wruck's (1989) Equation (A.5). This new information concerns new as well as existing projects, which also accommodates the information effect Hertzel and Smith (1993) model.

(6) PIPE offerings can take other forms, such as preferred stock convertible into common stock, direct sale of registered shares, and equity lines of credit (Dresner and Kim, 2006). An equity line gives investors the right to purchase additional registered shares from the firm on a formula basis (number of shares and price) at set intervals. These purchases are usually contingent on the stock's trading volume and price being above stated thresholds.

(7) Rule 144 under the Securities Act of 1933 restricted the type of hedging a purchaser of restricted shares might employ until the hedging restrictions were relaxed in 1990. Rule 144 barred purchasing a put option, selling a call option, or selling short against the box to hedge the price risk exposure in holding unregistered shares (Federal, 1980; Hicks, 1998; SEC, 1997b).

(8) Only 48 of the stocks in the 275 private placements in my sample had listed options at the time of the offering, and just two of these were long-term equity anticipation securities (LEAPS). The use of equity swaps to hedge the price risk of stocks has fallen out of favor since a 1997 tax law change deemed such transactions a constructive sale of the hedged shares (Bettis, Bizjak, and Lemmon, 2001).

(9) Almost all of the offerings dropped because of missing financial data were by firms whose shares were quoted on the OTC Bulletin Board or in the Pink Sheets. Firms often have their shares relegated to these markets when they fail to file timely financial reports with the SEC or otherwise fail to meet the NYSE, ASE, or NASDAQ listing requirements.

(10) Hertzel and Smith's (1993) and Wruck's (1989) samples also include private placements that appeared to occur at a premium. Based on discussions with investment bankers, I suspect that some of the calculated premia might reflect a measurement problem. If the privately offered shares are priced before the initial announcement date or based on a formula using pre-offering market prices (as sometimes happens) and the market price subsequently decreases sufficiently, the issue will appear to be priced at a premium when the new issue price is compared to the market price just prior to the announcement even though it was actually priced at a discount when the price or formula was set.

(11) I also ran the regressions using the discount calculated based on the closing market price 10 days after the private placement as the dependent variable to give the market time to adjust fully to the private placement announcement's information effect. The regression results are similar to the results reported in the paper. Details are available upon request from the author.

(12) I rescaled the estimated volatility linearly by mapping volatilities between 90% and 540% (the maximum estimated volatility) to between 90% and 120%. The 120% upper limit is arbitrary. When I varied it between 100% and 150% and reran the regressions, I obtained qualitatively similar results to those reported in the paper. Details are available on request from the author.

(13) Discount might also tend to vary inversely with Rate to the extent the nonmarketable stock's higher total return (the riskless rate in a risk neutral world) partially compensates for the opportunities missed due to the stock's marketability restrictions. This compensation reduces the portion of the opportunity cost that must be covered by the discount.

(14) Brickley, Coles, and Terry (1994) find significantly positive abnormal returns among poison pill-adopting firms when outside directors comprise a majority on the board, but significantly negative returns when outside directors are a minority. Brickley and James (1987), Byrd and Hickman (1992), Rosenstein and Wyatt (1990), and Weisbach (1988) furnish additional evidence regarding the link between the proportion of outside directors and shareholder wealth.

(15) The industry sectors are the 12 Fama-French industry classifications (Rhodes-Kropf et al., 2005). I thank the anonymous referee for suggesting the use of Market/Book Deviation to detect the overvaluation effect.

(16) The coefficient of Risk is -1.271 (t-statistic -5.35) in the information-intensive regression and 2.339 (t-statistic 1.83) in the noninformation-intensive regression. The coefficient of Market/Book Deviation is -5.819 (t-statistic -3.73) in the information-intensive regression and -0.848 (t-statistic -0.63) in the noninformation- intensive regression. Complete regression results are available on request from the author.

(17) Details are available on request from the author.

John D. Finnerty *

* John D. Finnerty is a Professor of Finance at Fordham University, New York, NY and also the Managing Principal of Finnerty Economic Consulting, LLC.
Table I. Sample Descriptive Statistics

The letter stock sample consists of 275 private placements by NYSE,
AMEX, NASDAQ NM (NASDAQ National Market), NASDAQ SC (NASDAQ Small
Cap Market), and OTC firms from April 1, 1991 to March 8, 2007. The
SEC reduced the Rule 144 resale-restriction period to one year from
two years on February 20, 1997. Market value was obtained from
Bloomberg L.P. and is measured as the closing price on the day
immediately preceding the announcement for NYSE, AMEX, and NASDAQ
quoted stocks and as the average of the closing bid and ask prices
for OTC stocks whose shares are not quoted in NASDAQ. The number of
shares outstanding prior to the offering and the issuer's assets,
sales, net income, and cash flow as of the latest fiscal year end
were obtained from Compustat.

Panel A. Listing Information

By Exchange: NYSE AMEX NASDAQ NASDAQ
 NM SC

All observations 17 23 149 21
Discounts only 14 22 126 17

By Exchange: OTC Pink Total
 Sheets

All observations 38 27 275
Discounts only 33 24 236

Panel B. Chronological Distribution

Year All Discounts
 Observations Only

1991 1 0
1992 8 8
1993 14 12
1994 8 7
1995 8 7
1996 8 7
Pre-Feb 1997 5 5
Post-Feb 1997 2 2
1998 10 7
1999 17 15
2000 32 24
2001 31 25
2002 27 20
2003 32 30
2004 33 30
2005 19 17
2006 14 14
2007 6 6
Total 275 236

Panel C. Descriptive Statistics fir the Issuers

 N Mean Median Minimum

Market value of 275 $203.33 $93.31 $0.06
 equity (millions)
Total assets 275 223.24 43.18 0.24
 (millions)
Total sales 275 76.90 15.00 0.00
 (millions)
Net income 275 -11.15 -4.32 -543.30
 (millions)
Cash flow from 275 3.56 0.07 -50.11
 operations
 (millions)

Panel C. Descriptive Statistics fir the Issuers

 Standard
 Maximum Deviation

Market value of $2,460.96 $347.19
 equity (millions)
Total assets 18,170.30 1,169.24
 (millions)
Total sales 1,986.74 200.93
 (millions)
Net income 161.36 44.94
 (millions)
Cash flow from 356.88 29.66
 operations
 (millions)

Table II. Description of the Private Equity Placements

The letter stock sample consists of 275 private placements by NYSE,
AMEX, NASDAQ, and OTC firms from April 1, 1991 to March 8, 2007.
The SEC reduced the Rule 144 resale-restriction period to one year
from two years on February 20, 1997. The number of shares
outstanding prior to the offering was obtained from Compustat. The
gross proceeds and number of shares issued were obtained from
Bloomberg. The gross proceeds were exclusive of the private
placement agent's fee and other expenses of the offering. The
fraction issued was calculated as the number of shares placed
divided by the sum of the number of shares placed and the number
outstanding prior to the offering. The percentage discount was
calculated from Equation (5) using the closing price on the day
prior to the offering date. A negative value indicates a premium.
The t-statistics for the differences in average discount between
Pre and Post for shares placed at a discount and the z-statistic
for the Wilcoxon signed rank test for the differences in median
discount between Pre and Post for shares placed at a discount are
given in parentheses beneath the differences.

 N Mean Median Minimum

Panel A. Gross Proceeds and Fraction Issued

 Pre-Feb 1997

Gross proceeds (millions) 52 14.16 9.09 0.01
Fraction issued (%) 52 16% 13% 0%

 Post-Feb 1997

Gross proceeds (millions) 223 20.40 9.60 0.01
Fraction issued (%) 223 12% 10% 0%

Time Period N Mean Median Minimum

Panel B. Average Percentage Discount for the Full Sample

 Pre-Feb 1997

Discount (day prior) 52 20.82 19.78 -26.32

 Post-Feb 1997

Discount (day prior) 223 14.62 11.89 -78.57

Panel C. Average Percentage Discount for Shares Placed at a Discount

 Pre-Feb 1997

Discount (day prior) 46 24.78 20.19 1.70

 Post-Feb 1997

Discount (day prior) 190 20.41 13.75 0.00

 Differences between Pre and Post

Discount (day prior) 4.37 6.44 ** 1.70
 (1.482) (2.161)

 N Maximum Standard
 Deviation

Panel A. Gross Proceeds and Fraction Issued

 Pre-Feb 1997

Gross proceeds (millions) 52 98.08 19.26
Fraction issued (%) 52 62% 13%

 Post-Feb 1997

Gross proceeds (millions) 223 235.00 31.68
Fraction issued (%) 223 88% 12%

Time Period N Maximum Standard
 Deviation

Panel B. Average Percentage Discount for the Full Sample

 Pre-Feb 1997

Discount (day prior) 52 68.00 19.42

 Post-Feb 1997

Discount (day prior) 223 85.14 23.16

Panel C. Average Percentage Discount for Shares Placed at a Discount

 Pre-Feb 1997

Discount (day prior) 46 68.00 16.69

 Post-Feb 1997

Discount (day prior) 190 85.14 18.20

 Differences between
 Pre and Post

Discount (day prior) -17.14 -1.51

** Significant at the 0.05 level.

Table III. Impact of the Commitment to Register the Stock on the
Discount

This table reports the average length of time it took the firm to
register the privately placed common stock and the relationship
between the length of time to effect registration and the average
discount. Panel A provides the number of firms that registered
stock by type of investor. Institutional denotes financial
institutions. Strategic denotes an industry partner with a
disclosed business relationship with the issuer. Related denotes an
officer, director, or 5% shareholder. Panel B presents the average
discounts for the [less than or equal to]30 and >90 days
registration periods. Panel C reports the difference in average
discount between the >90 and [less than or equal to]30 days
registration periods. The t-statistics are provided in parentheses
beneath the differences in Panel C.

Panel A. Number of Days to Registration by Type of Investor

 Institutional Strategic Related

[less than or 51 1 2
 equal to]30 Days
31-60 Days 13 0 1
61-90 Days 7 0 0
>90 Days 16 4 2
Not registered 36 8 18
Total 123 13 23

Panel B. Average Discount

[less than or equal Institutional Strategic Related
to]30 Days

 N=51 N=1 N=2
Discount (day prior) 15.27 1.87 12.04

>90 Days or Not Reg Institutional Strategic Related

 N=52 N= 12 N=20
Discount (day prior) 23.64 25.46 25.54

Panel C. Difference in Average Discount Between Registration
Within 30 Days and More than 90 Days

 Institutional Strategic Related

Discount (day prior) 8.37 ** 23.59 13.50
 (2.558) (1.045) (0.826)

Panel A. Number of Days to Registration by Type of Investor

 Other Total

[less than or 25 79
 equal to]30 Days
31-60 Days 5 19
61-90 Days 5 12
>90 Days 17 39
Not registered 25 87
Total 77 236

Panel B. Average Discount

[less than or equal Other Total
to]30 Days

 N=25 N=79
Discount (day prior) 16.21 15.32

>90 Days or Not Reg Other Total

 N=42 N= 126
Discount (day prior) 26.72 25.14

Panel C. Difference in Average Discount Between Registration
Within 30 Days and More than 90 Days

 Other Total

Discount (day prior) 10.51 ** 9.82 ***
 (2.327) (3.857)

*** Significant at the 0.01 level.

** Significant at the 0.05 level.

Table IV. Cumulative Abnormal Returns Around the Initial
Announcement of Private Placements of Restricted Stock

Mean and median cumulative abnormal returns (CARs) are calculated
using a market model and the Scholes-Williams (1977) procedure to
estimate beta. % Positive is the percentage of positive CARs. The
sample includes 275 private placements of letter stock that took
place in the US from April 1, 1991 to March 8, 2007. The initial
announcement date (the earlier of the offering announcement date,
when one occurs, and the completion announcement date) is Day 0 in
all three panels. The comparison period extends from 120 trading
days through 21 trading days prior to the initial announcement
date. The t-statistic for the difference of means test for the Mean
CAR, the z-statistic for the Wilcoxon signed rank test for the
median CAR, and the z-statistic for % Positive are given in
parentheses.

Panel A. Stock Registered within 30 Days

Period Relative to the Announcement Day (Day 0)

 N (-10,0) (-5,0) (-3,0)

Overall results 81
 Mean CAR -1.03 -1.68 -1.01
 (-0.54) (-1.40) (-0.93)
 Median CAR -2.37 -1.43 -0.41
 (-1.12) (-1.16) (-0.98)
 Positive 44.44 44.44 45.68
 (-0.67) (-0.67) (-0.53)

Panel B. Stock Not Registered within 90 Days

Overall results 159
 Mean CAR 2.73 1.69 2.50 **
 (1.29) (1.12) (2.40)
 Median CAR 0.47 -0.30 0.59 *
 (0.61) (-0.32) (1.81)
 Positive 50.94 49.06 54.72
 (0.13) (-0.13) (0.68)

Panel C. Test of Differences in Mean and Median

Difference in mean 3.76 3.37 3.51 **
 (Not Reg. vs. (1.15) (1.47) (2.12)
 Reg.)
Difference in 2.84 1.13 1.00 *
 median (Not Reg. (1.16) (0.87) (1.81)
 vs. Reg)

Panel A. Stock Registered within 30 Days

Period Relative to the Announcement Day (Day 0)

 N (-1,0) (-1,1) (-3,3)

Overall results 81
 Mean CAR -1.60 ** -1.45 -0.61
 (-2.02) (-1.63) (-0.44)
 Median CAR -1.47 * -1.51 -0.26
 (-1.83) (-1.58) (-0.27)
 Positive 39.51 40.74 46.91
 (-1.23) (-1.10) (-0.38)

Panel B. Stock Not Registered within 90 Days

Overall results 159
 Mean CAR 0.99 2.48 ** 4.50 ***
 (1.11) (1.99) (2.63)
 Median CAR -0.04 0.03 0.92*
 (-0.66) (0.62) (1.96)
 Positive 49.06 50.31 54.72
 (-0.13) (0.04) (0.68)

Panel C. Test of Differences in Mean and Median

Difference in mean 2.59 * 3.93 ** 5.11 *
 (Not Reg. vs. (1.89) (2.11) (1.97)
 Reg.)
Difference in 1.43 * 1.54 1.18
 median (Not Reg. (1.90) (1.57) (1.41)
 vs. Reg)

Panel A. Stock Registered within 30 Days

Period Relative to the Announcement Day (Day 0)

 N (-5,5) (-10,10)

Overall results 81
 Mean CAR -0.67 -0.60
 (-0.40) (-0.21)
 Median CAR 1.58 -1.35
 (0.03) (-0.67)
 Positive 54.32 45.68
 (0.57) (-0.53)

Panel B. Stock Not Registered within 90 Days

Overall results 159
 Mean CAR 3.38 * 6.33 **
 (1.76) (2.10)
 Median CAR -0.17 2.18
 (-0.54) (1.60)
 Positive 48.43 56.60
 (-0.22) (0.96)

Panel C. Test of Differences in Mean and Median

Difference in mean 4.05 6.93
 (Not Reg. vs. (1.37) (1.48)
 Reg.)
Difference in -1.75 3.53
 median (Not Reg. (-0.24) (1.37)
 vs. Reg)

*** Significant at the 0.01 level.

** Significant at the 0.05 level.

* Significant at the 0.10 level.

Table V. Cross-Sectional Regression Results

This table tests the impact of transfer restrictions and the
ownership concentration, information, and overvaluation effects on
the private placement discount. Discount in Equation (5) is
regressed on variables that proxy for the transfer restriction
effects and on variables that proxy for the ownership
concentration, information, and overvaluation effects. Regression
Model 1 is Equation (6), which includes the four transfer
restriction variables, Volatility x [square root of T], Time,
Yield, and Rate. Regression Model 2 is Equation (7), which includes
the six ownership concentration, information, and overvaluation
variables, Risk, Direct, Log(Proceeds), Fraction, Exchange, and
Market/Book Deviation. Regression Model 3 is Equation (8), which
includes the four transfer restriction variables plus the six
ownership concentration, information, and overvaluation variables.
Discount measures the percentage discount relative to the closing
market price of the issuer's registered common stock on the trading
day immediately preceding the completion announcement date.
Volatility is the annualized standard deviation of the total return
of the issuer's common stock as estimated by the GARCH model.
Volatilities above 90% were rescaled to between 90% and 120%.
Volatility is interacted with [square root of T] where T is the
length of the Rule 144 lockup period (T = 2 prior to February 1997
and T = 1 thereafter). Time is the ratio of the number of shares
offered to the common stock's trading volume during the three month
period ending on the last trading day immediately preceding the
initial announcement date. Yield is the annualized dividend yield
based on the latest quarterly cash dividend. Rate is the interest
rate on the one year (post-February 1997 offerings) or two year
(pre-February 1997 offerings) Treasury notes as of the initial
announcement date. Risk is the standard deviation of the daily
abnormal returns from fitting the Scholes-Williams (1977)
beta-adjusted CAPM to stock returns for the period extending from
120 to 21 days prior to the initial announcement. Direct is one
minus the fraction of directors that are also managers.
Log(Proceeds) is the log of the gross proceeds of the offering.
Fraction is the number of shares placed divided by the sum of the
number of shares placed and the number outstanding prior to the
offering. Exchange is equal to one for those companies listed on
the NYSE, American Stock Exchange, NASDAQ National Market, or
NASDAQ Small Cap Market and zero otherwise. Market/Book Deviation,
which is the difference between the firm's market-to-book ratio
(the market value of equity divided by the book value of equity)
and the industrial sector average market-to-book ratio at the time
of the private placement, measures the
overvaluation/underperformance signaling effect. I include Post,
Options, Registration Rights, and Registered Stock as control
variables in each model. Post is equal to one for issues that
occurred after February 1997 and zero otherwise. Options is equal
to one for those stocks that had options outstanding as of the
offering year and zero otherwise. Registration Rights is equal to
one for those offerings that provide for mandatory, piggyback, or
demand registration rights and zero otherwise. Registered Stock is
equal to one for those stocks that the firm registered with the SEC
within 45 days of the offer date. The regressions are fitted using
ordinary least squares. The sample includes 236 US private
placements from April 1, 1991 to March 8, 2007. And 34 observations
had to be dropped from the regressions that include the variables
Direct and Market/Book Deviation as 14 firms' historical proxy
statements could not be obtained and the book value of equity of 20
other firms is negative. The predicted sign is provided next to
each variable. All t-statistics (in parentheses below coefficients)
are calculated using heteroskedasticity-consistent standard errors.
In addition to the F-statistic for each regression, the Partial
F-statistic is reported when the equity ownership concentration,
information, and overvaluation variables, Risk, Direct,
Log(Proceeds), Fraction, Exchange, and Market/Book Deviation are
added to Model 1 [Partial F(Own/In/Over)] and when the transfer
restriction variables, Volatility x [square root of T], Time,
Yield, and Rate are added to Model 2 [Partial F(Transfer)].

Dependent Variable Model 1 Model 2 Model 3
 Discount Discount Discount
 (Day Prior) (Day Prior) (Day Prior)

Number of observations 236 202 202
 Intercept 0.061 51.822 *** 26.503
 (0.0105) (3.7048) (1.4734)
Volatility x [square 0.241 *** 0.160 ***
 root of T](+) (5.6403) (3.3866)
Time (+) 0.065 *** 0.050 **
 (8.8350) (2.1299)
Yield (-) 0.215 0.261
 (1.1398) (1.3252)
Rate (+) 0.135 0.307
 (0.1997) (0.4314)
Risk (+) 0.951 *** 0.527 *
 (3.3988) (1.7228)
Direct (+) 6.164 7.442
 (1.1313) (1.4131)
Log (Proceeds) (-) -2.198 ** -1.683
 (-2.2787) (-1.5663)
Fraction (+) 16.740 3.677
 (0.9651) (0.2015)
Exchange (-) -5.067 -3.042
 (-1.3098) (-0.8030)
Market/book 2.681 ** 2.448 **
 deviation (+) (2.2514) (2.2034)
Post (-) 3.676 -4.352 0.495
 (1.1683) (-1.5064) (0.1539)
Options (-) -1.807 3.295 2.194
 (-0.8356) (1.2974) (0.8378)
Registration rights (-) -2.118 -0.612 -0.442
 (-1.0884) (-0.2557) (-0.1947)
Registered stock (-) -5.785 *** -5.309 ** -5.287 **
 (-2.9275) (-2.3346) (-2.4011)
Adjusted [R.sup.2] 0.2349 0.2686 0.2989
MSE 246.876 219.803 206.300
F-value 10.02 *** 8.38 *** 7.12 ***
White's test 2.41 *** 1.69 *** 3.27 ***
Partial F (Own/In/Over) 14.06 ***
Partial F(Transfer) 3.39 **

*** Significant at the 0.01 level.

** Significant at the 0.05 level.

* Significant at the 0.10 level.

Table VI. Test of the Predictive Accuracy of the Average-Strike and
Lookback Put Option Models

The Mean Actual Discount is the mean percentage discount calculated
relative to the closing market price of the issuer's registered
common stock on the trading day immediately preceding the
completion announcement date. The Mean Empirical-Predicted Discount
is calculated by adjusting the actual discounts for the ownership
concentration, information, and overvaluation effects and the other
control variables in Model 3, as shown in Equation (12). The Mean
Model-Predicted Discount is calculated from the lookback put option
model in Equation (9) and from the average-strike put option model
in Equations (10)-(11). Information-intensive placements are
characterized by either (1) Volatility above the median and Risk
above the median for the overall sample or (2) placed with
strategic investors (Strategic = 1) or related investors (Related =
1). Noninformation-intensive placements are characterized by (1)
Volatility below the median and Risk below the median and (2) not
placed with strategic investors or related investors (Strategic =
Related = 0). And 32 placements were neither information-intensive
nor noninformation-intensive. Difference is the difference between
the average discounts for the information-intensive and
noninformation-intensive subsamples. The t-statistics are provided
in parentheses beneath the differences.

 Full Information-
 Sample Intensive
 Subsample

Number of observations 202 91

Panel A. Mean Model-Predicted Discounts

Average-strike put 17.01% 20.07%
 option model
Lookback put option model 73.29% 88.46%

Panel B. Tests Based on the Actual Discount

Mean actual discount 20.76% 26.68%

Mean actual discount - mean model-predicted discount:
Average-strike put 3.75% *** 6.61% ***
 option model (3.391) (3.289)
Lookback put option model -52.53% *** -61.78% ***
 (-30.841) (-24.492)

Panel C. Tests Based on the Empirical-Predicted Discount

Mean empirical-predicted 15.59% 17.38%
 discount

Mean empirical-predicted discount - mean model-predicted discount:

Average-strike put -1.42% -2.69%
 option model (-1.466) (-1.603)
Lookback put option model -57.70% *** -71.08% ***
 (-32.906) (-29.558)

 Noninformation- Difference
 Intensive
 Subsample

Number of observations 79

Panel A. Mean Model-Predicted Discounts

Average-strike put 12.75% 7.32% ***
 option model (10.555)
Lookback put option model 51.40% 37.06% ***
 (13.486)

Panel B. Tests Based on the Actual Discount

Mean actual discount 13.43% 13.25% ***
 (5.093)
Mean actual discount - mean model-predicted discount:
Average-strike put 0.68%
 option model (0.518)
Lookback put option model -37.97% ***
 (-17.358)

Panel C. Tests Based on the Empirical-Predicted Discount

Mean empirical-predicted 11.67% 5.71% ***
 discount (2.579)

Mean empirical-predicted discount - mean model-predicted discount:

Average-strike put -1.08%
 option model (-0.858)
Lookback put option model -39.73% ***
 (-17.972)

*** Significant at the 0.01 level.

Table VII. Comparison of the Predictive Accuracy of the
Average-Strike and Lookback Put Option Models

This table compares the discounts predicted by the average-strike
put option Model (10)-(11) and the lookback put option Model (9) to
the actual private placement discounts. The sample includes 236 US
private placements from April 1, 1991 to March 8, 2007. And 34
observations had to be dropped from the regressions that include
the variables Direct and Market/Book Deviation because 14 firms'
historical proxy statements could not be obtained and the book
value of equity of 20 other firms is negative. Risk is the standard
deviation of the daily abnormal returns from fitting the
Scholes-Williams (1977) beta-adjusted CAPM to stock returns for the
period extending from 120 to 21 days prior to the initial
announcement. Direct is equal to one minus the fraction of
directors that are also managers. Log (Proceeds) is the log of the
gross proceeds of the offering. Fraction is the number of shares
placed divided by the sum of the number of shares placed and the
number outstanding prior to the offering. Exchange is equal to one
for those firms listed on the NYSE, American Stock Exchange, NASDAQ
National Market, or NASDAQ Small Cap Market and zero otherwise.
Market/Book Deviation, which is the difference between the firm's
market-to-book ratio (the market value of equity divided by the
book value of equity) and the industrial sector average
market-to-book ratio at the time of the private placement, measures
the overvaluation/underperformance signaling effect. Post is equal
to one for issues that occurred after February 1997 and zero
otherwise. Options is equal to one for those stocks that had
options outstanding as of the offering year and zero otherwise.
Registration Rights is equal to one for those offerings that
provide for mandatory, demand, or piggyback registration rights and
zero otherwise. Registered Stock is equal to one for those stocks
that the firm registered with the SEC within 45 days of the offer
date. Investment is equal to one for those stocks the issuer
announced were placed with institutional investors. Strategic is
equal to one for those stocks where the issuer announced that the
shares were sold to another corporation that could be identified as
a strategic partner. Related is equal to one for those stocks where
the issuer announced that the shares were sold to someone related
to the issuer. The regressions are fitted using ordinary least
squares. The table reports the heteroskedasticity-consistent
estimator for each coefficient. Information-intensive placements
are characterized by either (1) Volatility above the median and
Risk above the median for the overall sample or (2) placed with
strategic investors (Strategic = 1) or related investors (Related =
1). Noninformation-intensive placements are characterized by (1)
Volatility below the median and Risk below the median and (2) not
placed with strategic investors or related investors (Strategic =
Related = 0). And 32 placements were neither information-intensive
nor noninformation-intensive. t-statistics are provided in
parentheses beneath the regression coefficients.

Dependent Full Sample
Variable

 Actual Actual
 Discount- Discount-
 Average- Lookback
 Strike Put Put Option
 Option Model-
 Model- Predicted
 Predicted Discount
 Discount

Number of 202 202
 observations
Intercept 14.095 -70.397 ***
 (0.9427) (-2.8710)
Risk 0.524* -1.039
 (1.6748) (-1.5199)
Direct 7.022 9.727
 (1.2647) (1.1305)
Log -1.220 1.184
 (Proceeds) (-1.2389) (0.7639)
Fraction 37.350 *** -0.834
 (2.9557) (-0.0510)
Exchange -3.354 4.571
 (-0.9328) (0.9517)
Market/book 3.424 *** 3.421 ***
 deviation (3.5654) (2.6759)
Post 3.654 -1.719
 (1.3453) (-0.3949)
Options -0.252 -7.412 *
 (-0.1024) (-1.7037)
Registration 1.067 4.153
 rights (0.5379) (1.1606)
Registered -5.307 ** -6.635 *
 stock (-2.4082) (-1.7838)
Investment x -60.966 *** -74.083 ***
 Fraction (-4.4724) (-4.0499)
Strategic x 0.297 3.393
 Fraction (0.0058) (0.0553)
Related x -36.978 -18.722
 Fraction (-0.9222) (-0.4017)
Adjusted 0.1959 0.1299
 [R.sup.2]
MSF 194.331 496.705
F-value 4.77 *** 3.31 ***

Dependent Information-Intensive
Variable Subsample

 Actual Actual
 Discount- Discount-
 Average- Lookback
 Strike Put Put Option
 Option Model-
 Model- Predicted
 Predicted Discount
 Discount

Number of 91 91
 observations
Intercept -16.180 -114.754 ***
 (-0.8886) (-4.9459)
Risk 1.292 *** 0.614
 (5.5057) (1.2134)
Direct 8.321 19.684
 (0.7144) (1.4533)
Log 0.318 2.383
 (Proceeds) (0.2261) (1.3060)
Fraction 45.034 *** 11.657
 (2.8861) (0.5480)
Exchange -5.898 0.451
 (-1.2413) (0.0826)
Market/book 5.988 *** 6.324 ***
 deviation (3.8766) (3.7778)
Post 1.169 -6.915
 (0.2610) (-1.1793)
Options 2.559 6.262
 (0.5483) (0.9599)
Registration 4.623 7.859
 rights (1.1419) (1.2553)
Registered -9.690 ** -16.874 **
 stock (-2.2357) (-2.6335)
Investment x -74.498 *** -76.779 ***
 Fraction (-3.1813) (-2.8151)
Strategic x 12.376 78.320
 Fraction (0.2234) (1.3895)
Related x -12.120 80.829
 Fraction (-0.2963) (1.5832)
Adjusted 0.2647 0.2075
 [R.sup.2]
MSF 253.577 430.918
F-value 3.49 *** 2.81 ***

Dependent Noninformation
Variable Intensive
 Subsample

 Actual Actual
 Discount- Discount
 Average- Lookback
 Strike Put Put Option
 Option Model
 Model- Predicted
 Predicted Discount
 Discount

Number of 79 79
 observations
Intercept 51.139 -11.071
 (1.4004) (-0.2288)
Risk -2.552 * -7.044 ***
 (-1.9812) (-3.1137)
Direct 6.658 4.852
 (1.0572) (0.5801)
Log -3.279 -1.094
 (Proceeds) (-1.4726) (-0.3701)
Fraction 9.044 5.270
 (0.4784) (0.2177)
Exchange 3.417 8.144
 (0.8708) (1.1315)
Market/book 0.619 0.965
 deviation (0.4671) (0.4865)
Post 1.876 4.452
 (0.4909) (0.7479)
Options 2.522 -6.345
 (0.6041) (-1.0620)
Registration 1.836 1.810
 rights (0.6234) (0.3925)
Registered -1.009 -1.498
 stock (-0.3451) (-0.3420)
Investment x -17.014 -62.731 *
 Fraction (-0.8912) (-1.8501)
Strategic x
 Fraction
Related x
 Fraction
Adjusted 0.1211 0.2694
 [R.sup.2]
MSF 113.143 264.433
F-value 1.98 ** 3.61 ***

*** Significant at the 0.01 level.

** Significant at the 0.05 level.

* Significant at the 0.10 level.

Table VIII. Empirical-Predicted Discount Versus Model-Predicted
Discount for Different Volatilities

The Empirical-Predicted Discount is calculated by adjusting the
actual discounts for the ownership concentration, information, and
overvaluation effects and the other control variables in Model 3,
as shown in Equation (12). The Model-Predicted Discount is
calculated from the average-strike put option model in Equations
(10)-(11). Panel A applies to those offerings that were announced
prior to February 1997, and Panel B applies to those offerings that
were announced after February 1997. The sample includes 236 US
private placements from April 1, 1991 to March 8, 2007. 34
observations had to be dropped from the original sample because 14
firms' historical proxy statements could not be obtained and the
book value of equity of 20 other firms is negative. Volatilities
above 90% were rescaled to between 90% and 120%

Panel A (T = 2 Years)

Volatility N Mean Mean
range (%) model- empirical-
 predicted predicted
 discount discount
 (T = 2) (day prior) Difference

0.0-29.9 3 7.16% 14.61% -7.45%
30.0-44.9 0 - - -
45.0-59.9 9 16.05 10.79 5.26
60.0-74.9 7 20.56 13.33 7.23
75.0-89.9 9 23.44 23.17 0.27
90.0-104.9 7 25.51 34.09 -8.58
105.0-120.0 2 28.60 26.13 2.47
Average: 37 20.45% 19.83% 0.62%

Panel B (T = 1 Year)

Volatility N Mean Mean
range (%) Model- Empirical-
 Predicted Predicted
 Discount Discount
 (T = 1) (Day Prior) Difference

0.0-29.9 6 5.13% 8.80% -3.67%
30.0-44.9 20 8.27 11.50 -3.23
45.0-59.9 19 12.10 9.95 2.15
60.0-74.9 34 14.81 12.54 2.27
75.0-89.9 33 18.08 15.74 2.34
90.0-104.9 27 19.67 13.28 6.39
105.0-120.0 26 23.89 24.62 -0.73
Average: 165 16.23% 14.65% 1.58%
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Author:Finnerty, John D.
Publication:Financial Management
Date:Sep 22, 2013
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