Summary And Research Inspirations

Published Date: 02 Nov 2017

In this chapter, we thoroughly review the literature on in Chinese capital market, equity financing capacity and market performance, actual equity financing and stock-price performance of equity issuing and competitor (non-issuing) firms and theories on equity financing and stock-price performance in this chapter, respectively. In the last two decades, these research strands have made great advances and generated plenty of research findings and profound practical implications. Despite of their achievement, there are still several limitations or expanding spaces that this dissertation can add to make a significant contribution.

First, we examine the relation between equity financing capacity and stock returns, which has received very little attention in the empirical finance literature. More importantly, our study is based on a unique setting where the capacity to issue equity and debt to the public by firms listed in China is determined by the Chinese securities market regulation. Previous studies were failed to identify financial capacity, which is created by Chinese security regulations on seasoned equity financing. According to best of the knowledge, this study could be the first study that examines the relationship between financial capacity and stock-price performance. The requirements for becoming eligible to raise external capital essentially creates two types of firms - those eligible to raise external capital and hence have external financial capability and those that are not eligible and hence have constrained external financing. We specifically examine whether the capacity to make rights and public offerings of equity is priced in the market in terms of future returns. The capacity to raise external capital is an important intangible option available to the firm and could conceivably affect stock returns. We will able to enrich the existing literature on financing behavior and stock returns by showing how equity financing capacity is related to stock returns in a highly regulated emerging capital market.

Second, we also investigate how actual equity financing affect stock return. We find that unqualified firms also had obtained approval from Security Regulation Commission. Hence, we study the effect of both qualified and unqualified firms equity issuance on stock return. Previous studies of equity financing and stock returns do not consider this aspect and they study as one pool sample of equity issuing firms. Our study, we separated this pool sample into two category and investigate regulations effects. Hence, we will able to enrich the existing literature on financing behavior and stock returns by showing how qualified and non-qualified equity issuing are related to stock returns in a highly regulated capital market.

According to the literature, private equity financing mechanism became very popular. Recently, it becomes primary source of equity re-financing method in Chinese listed firms. Researches on private equity financing have been very popular in more developed and mature markets. Chinese capital is a young market comparatively and there is no adequate research on private equity financing. Hence, third, we investigate whether announcements of the private equity placement application, withdrawal, rejection, approval, and completion affect returns of Private Equity issuing firms. We also examine the factors that impact on the announcement effect in private equity placement events by examining the cross-sectional differences in stock-price performance. Chinese regulation process of equity finance includes application, approval and rejection/withdrawals and completion of equity issue. According to the security regulation commission, these processes take minimum of 2 months to maximum of 24 months for this approval process. Hence, this information comes to the market time to time. Previous studies have investigated the issuing firms' announcing effect only and they didn't consider other important events of Chinese equity finance regulation process. Accordingly, our study is more comprehensive than previous studies. Hence, we will be able to fill this research gap and enrich the existing literature on financing behavior and stock returns by showing how important events of Chinese equity regulations affect stock-price performance. Fourth, previous Chinese private equity financing studies does not cover the long-run stock-performance of private equity issuing and competitor firms and don’t observed that spillover effect relevant to PEP in China. Compared to other countries, Chinese PEPs have common features, such as non-public offering to specific targets and existence of certain lock-in periods. Further, they have few unique characteristics, such as various purchasing methods with cash or assets, regulation of lower limits on offering price, and different lock-in periods for different investors, and CSRC administrative regulations on PEP (Lu et al., 2011)[65]. Findings of this study will enhance the literature on long-run market performance of private equity issuing and competitor firms in China.

Fifth, private equity offering become most popular re-equity financing mechanism in listed Chinese firms. Hence, private equity offering could affect non-issuing (competitor) firms’ market performance. According to our literature survey, no past research investigated the effect of private equity financing event on competitor firms in Chinese context. The first is to measure the market performance of non-PEP firms around PEPs in their industries. If non-PEP firms can successfully compete against PEP firms, then we would expect the non-PEP firms to perform better after the PEP event. We will demonstrate announcement effects of PEPs on non-PEP firms in their respective industries. We discuss that application, withdrawal and rejection, approval announcements and completion of PEPs affect non-PEP firms in their industry. We also investigate the market performance of non-PEP firms by examining the cross-sectional differences in stock performance both in the short- and long-term. According to best of our knowledge, still there is no previous study about effect of private equity offering on non-issuing (competitor) firms in Chinese context due to PEP was recently introduced into regulatory framework. This study is innovative due to inclusive of institutional backgrounds and regulation incorporated. We will be able to enrich the existing literature on private equity financing behavior and market performance of non-issuing (competitor) firms in Chinese context by demonstrating how private equity financing process is related to stock-price performance of competitor (non-issuing) firms in a highly regulated emerging capital market.

Theoretical Analysis and Research Hypotheses

In this chapter, we describe the relevant theories in detailed and based on our theoretical results and extant related literature. First, we will drive our hypotheses to be examined in the empirical research. First, we introduce institutional theory and explain Chinese capital market has different institutional background and regulations compared to other capital markets. Second, we present relevant theories related to the equity financing capacity and stock-price performance, and their hypotheses. Third, we describe seasoned equity financing and stock-price performance, and then its hypotheses. Next, we present private equity placements and stock-price performance and their hypotheses. Final, we present private equity placements and stock-price performance of competitor firms.

Institutional Theory

In addition to firm- and industry- levels characteristics, scholars suggest that firms must consider wider state and social influences when designing and implementing strategies (DiMaggio and Powell, 1999; Oliver, 1997; Peng, 2002)[13,15,16]. These influences are considered broadly to be the institutional framework (North, 1990; Scott, 1995)[14,154], a perspective applied to strategic research regarding the Institutional Based View (IBV) of business strategy theory (Peng and Heath, 1996; Peng, 2002)[16,155] . Hence, researchers must study institutional frameworks: how, why, and when they matter (Powell, 1996)[156].

Institution theory provides strong insight for studies of business in developing countries (Peng et al., 2009; Peng, Wang and Jiang, 2008)[157,158] and Asia (Hoskission et al., 2000)[159]. Asia’s emerging economy is not uniform, and its formal institutions fall short of supporting low-transaction-cost business operations in three critical areas: credible legal framework, stable political structure, and functioning strategic market factors (Khanna and Palepu, 1997; Peng and Heath, 1996; Peng, 2002)[16,155,160]. From business’s viewpoint, institutional literature focuses on formal laws, rules, and regulations, (La Porta et al., 2008)[70]. Underdevelopment of formal institutions in emerging economies causes much uncertainty regarding supply and demand conditions and sudden changes in government policies (Hoskission et al., 2000; Wright et al., 2005)[159,161]. Formal institutions encourage market competition, reduce information issues, and enhance legal effectiveness (Zhou and Peng, 2010)[162]. In developed economies, specialized organizations such as stock markets, research firms, law firms, and courts as a collection of formal institutions handle costly activities including allocating capital, obtaining information, and enforcing contacts (Peng, 2002)[16].

China’s institutional environment

Studies have established dimensions of the institutional environment in China’s transitional economy: capital market, labor market, product markets, government regulations, and contract enforcements (Khanna and Palepu, 1987)[160]; political, legal and regulatory effects (Newman, 2000)[163]; and regulatory, political, and financial effects (Li and Ferreira, 2011)[164]. Governments in many transition countries control key resources because it is the remaining power of the command economy and sluggish development of market-supporting institutions (Li et al., 2008)[33]. Many obstacles are confronted by private entrepreneurs in transition economies. They are often denied access to external finance and other key resources that are largely reserved for SOEs or they are faced to heavy government regulations or "extralegal" fees (Guriev, 2004; Johnson et al., 2000; McMillan and Woodruff, 2002)[34,36,165].

By promulgating and enforcing economic policies and regulations, governments can directly change competitive environments (Hillman et al., 1999, Mahon and Murray 1981; Shaffer, 1995)[37-39]. Government regulations create external uncertainties for the firm’s operations (Lang and Lockhart, 1990)[40] and restrict capabilities for acquiring external resources (Khwaja and Mian, 2005)[41]. In China, compared with more-developed countries, the state holds a significant stake and greatly influences company operations, exerting enormous power in resource allocation and regulation enforcement (Nee, 1992; Peng, 1997; Tsai, 2008; Wu and Cheng, 2011)[42-45]. SOEs benefit from privileged position in obtaining bank loans and other key inputs (Brandt and Li, 2003; Che, 2002; Chow et al., 2010; Li et al., 2008 ;Poncet et al., 2010)[33,46-49], while private firms are often denied access to bank loans (Brandt and Li, 2003; McMillan, 1997; Nee 1992)[42,46,166]. Government struggles to create fair market conditions so that private firms can compete (Li et al., 2008)[33].

In regions where marketization processes are moving more rapidly, as noted, government intervention is reduced and legal environments are stronger. Better institutional and legal environments in regions have faster marketization (Fan et al., 2009)[167], but various Chinese regions have very different historical and geographical conditions and policies (Du and Xiu, 2009)[168]. China’s market-supporting institutions are imperfect and likely to remain flawed (Li et al., 2008)[33]. Market reforms have yielded decisive progress, but large institutional development gaps still exist regionally (Fan et al., 2003)[169]. Listed firms in China show conspicuous regional disparities; eastern and coastal regions are rich, while western and central regions are poor because China’s long-term unbalanced development strategy gave priority to the eastern and coastal regions (Sun and Yamori, 2009)[170] .

Equity Financing Regulations in China

We focus on Chinese listed firms that raise external capital from Seasonal Equity Offerings. They can obtain equity capital through existing shareholders (right offerings) and/or the public (public offerings). In China, firms must meet regulation requirements before an SEO, and they have unequal rights when raising capital through secondary public and rights stock offerings. Equity financing represents a luxury available only to a few listed Chinese firms, although the ability to issue shares is a valuable intangible asset (Zou and Xiao, 2006)[76].

China Securities Regulatory Commission regulates the issuance of securities in China. The regulatory requirements are mostly decided by quantitative and qualitative criteria based on accounting-based measurements. One of main accounting-based criterion is profitability, which stated that a firm must meet a minimum profitability threshold during a defined period. A detailed listing of the past fulfillment of the requirements are shown in Error: Reference source not found. The permitted method for raising equity was rights offerings made to existing shareholders in Chinese listed firm on a pro-rata basis at a price below-market price before 2000. In the 1990s, rights issues were fully subscribed by shareholders due to the excessive demand for shares from the investing public in China. In 1993, CSRC issued first guidelines on right issues for requiring that firms must should profitable in the previous two years. In 1994, the regulation was tightened by requiring three years of profitability and a minimum three-year average ROE of 10%. Further tightening of the criteria to a minimum three-year average ROE of 10% and a minimum ROE of 6% in each of the previous three years significantly reduced the number of firms meeting the requirements for rights issues. The profitability requirement has been relaxed gradually over the years, and since 2006 the profitability requirement is that the ROE should be greater than zero. Error: Reference source not found shows CSRC’s regulation from 1993 to 2000. During the sample period from 2000 - 2009, there are three regulatory regimes linked to right equity issues.

Listed Chinese companies in were not permitted to make seasoned equity offerings until 2000. The CSRC allowed companies with profits in each of the previous three years to apply for permission to issue shares to the public in 2000. Initial regulations on pulic equity issue were much less rigorous than the then existing criteria for applying and approving rights issues. As a result this less stringent regulation, a large number of firms applied and got approved public offerings of equity. In 2001, this criterion was tightened and made consistent with the condition for right offerings by requiring that the three-year average ROE be at least 6%, and in 2002 the eligibility for public offers of equity was further restricted with the condition that the three-year average ROE as well as the ROE in the previous year be at least 10%. Howeve, the final revision in 2006 relaxed the profitability requirement to a minimum three-year average ROE of 6%. Hence, during our sample period there were four regulatory regimes governing the eligibility to apply for permission to make public offers of equity.

Directional issuing of seasonal equity is named as "private equity placement" (PEP), which is used approach in mature markets with higher degree of market orientation to play a key role for assets allocations. In 2006, private equity placement (PEP) is placed on the regulatory constraints in China's capital market. CSRC stated that purposes of PEP regulations are to reduce the related party transactions, avoid competition, and enhance independence and it also helps to improve asset quality, improving the financial condition, and enhance the sustained profitability. Compared to other countries, Chinese PEPs have common features, such as non-public offering to specific targets and existence of certain lock-in periods. Further, they have few unique characteristics, such as various purchasing methods with cash or assets, regulation of lower limits on offering price, and different lock-in periods for different investors, and CSRC administrative regulations on PEP (Lu et al., 2011)[65]. In addition to regulations and above unique features, PEPs have been the predominant equity refinancing method by listed Chinese firms recently.

In this study, we investigate effect of PEP on issuing firms. Further, different categories of investors are buying private equity and it will result the changes of ownership structure. Hence, we can study how investors observe this information (as good or bad news) about issuing firms and how they react to the information.

New regulations of PEP use to ensure non-public offering legitimate benefits prohibit the disclosure of insider information about the firm and insider information of security trading or manipulating of the security price. Further, PEP offering firms should determine the issue price based on fair principles of justice and reflecting the best interests of all stakeholders and regulations state that how to determine the private equity price and prior approval must be obtained from the CSRC. Regulations also limit the category of institutional investors in PEP. Hence, PEPs attracts passive investors and regulation limits the number of institutional investors in a particular PE issuance. CSRC actively involves in private equity issuing process in China. Yu and Xu (2010) point out that PEP sustaining time is long and PEP process must be approved by CSRC[171]. PEP method becomes a prominent method of equity refinancing in terms of value and the number of firms seasonal equity financed in recent years. Hence, firms issue PE to obtain low cost capital, strategic investor and raising much needed funds leads better performance than competitors.

Prior to 2006, PEPs are categorized as an underwritten public offering, thus private placements are subjected to the same regulations for qualifying to issue private equity as are underwritten public offerings, and ROE and other regulatory requirements are same as underwritten public offerings. Hence, CSRC regulations are discriminated firms for PEPs and only eligible firms can apply and issue PEP. This Chinese institutional background is also different from other countries. Error: Reference source not found the regulation requirements for qualifying to issue private equity and other regulatory characteristics in China.

Theories on Equity Financing Capacity and Stock-price Performance

In this section, we describe relevant theories which use to explain the effects of equity financing capacity and stock-price performance. Some theories explain the reasons for positive relationship between firms' equity financing capacity and stock-price performance. On the other hand, other theories explain the reasons for negative relationship between firms' equity financing capacity and stock-price performance.

Neo Classical Investment theory

According to the the viewpoint of neoclassical investment theories, firms’ ability to acquire equity capital endow with financing flexibility and enables firms to exploit any emerging valuable investment opportunities that will lead to future cash flow growth and increase shareholder wealth. The profitable investments are recognized by the investors and there is a possibility of growth demand on such a stocks, which is leading to higher expected returns. Thus, neoclassical investment theories are predicting a positive relationship between capacity to raise equity and future returns. Fonseka et al. (2012) study the equity financing and their findings are not supported for consistent with neoclassical investment theories predictions[18].

Agency Theory, Signaling and Earnings-Management Hypotheses

Alternatively, agency, signaling, and earnings-management explanations are predicting a negative relation between equity financing and stock-price performance. Agency conflicts between managers and shareholders can be resulted an overinvestment problem, which leads to investing in unprofitable projects resulting in a negative NPV and loss of shareholder wealth (Jensen, 1986; and Jensen and Meckling, 1976)[50,51]. When firms issue equity, the market recognizes this overinvestment problem by way of lower expected returns. The signaling hypothesis expects that firms are issuing equity when they are overvalued and market prices adjust downward subsequently leading to a negative relation between equity issuance and stock returns (Loughran and Ritter 1995; 1997; 2000; Myers and Majluf, 1984; Ritter 2003)[52-56]. Earnings management explanations also argue that firms intending to issue equity opportunistically manage their earnings to alter financing proceeds in their favor (Cohen and Lys, 2006; Dechow, Richardson, and Sloan, 2008; Papanastasopoulos et al., 2011)[57-59]. When earnings management are recognized by the informative investors, a price drop can be subsequently observed in that particular stocks. In this study, we focus on firms that have not yet issued equity but have the capacity to do so is that the market recognizes the propensity for these firms to issue equity and over-invest, issue overvalued equity, or engage in earnings management activities leading to lower expected returns. This a key implication for this research and it is different from many other studies related to equity financing behaviour in China. Therefore, the capacity to issue equity capital will negatively relate to future stock-price performance.

Fonseka et al. (2012) find that the capacity for rights offering of shares is strongly negatively related with future stock-price performance of Chinese firms. This negative relationship between capacity to make rights issues and future stock-price performance is the stronger for firms that met the regulatory criteria a priori and then applied for regulatory approval[18]. Their finding is particularly important in that rights offers have been the most dominant form of equity financing by listed firms in China. Fonseka et al., (2012) also find that although the capacity for public offers of equity is consistently negatively related with future stock-price performance for firms that the qualified to issue shares to the public based on regulatory criteria, such evidence does not hold up for firms that applied for regulatory approval for public issues or made public issues[18]. They also investigate the subset of firms that in fact issued equity after obtaining regulatory approval and find even a stronger negative relation between the capacity to issue equity through rights and future stock-price performance. Thus, Fonseka et al., (2012) show clear and strong evidence of a negative relation between rights offering capacity and stock-price performance in China and these findings are consistent with agency, signaling as well as earnings-management hypotheses which predict a negative relation between equity issuance and subsequent returns[18].

Theories on Equity Issuing Firms and Stock-price Performance

In this section, we describe relevant theories which use to explain the effects of equity financing issuing and stock performance. Some theories explain the reasons for positive relationship between firms' equity financing capacity and stock performance. On the other hand, other theories explain the reasons for negative relationship between firms' equity financing capacity and stock-price performance.

We focus private equity placements of issuing firms. The divergence in the process of public and private issuances may lead to the different impact on market reaction. Most of researchers are focusing on factors which influence to issue equity privately, market and operation performances of issuing firms. They use earning performance, asymmetric information, monitoring, stock price run-up, agency cost and firm size explanations to find out why firms issue private equity. Monitoring, information, confirming, over feedback effects hypotheses use to explain the issuing firms’ stock-price performance. Our study we give special emphasis on information asymmetry and monitoring hypothesis. The asymmetric information and monitoring hypothesis are described in more detailed in following sections.

Asymmetric Information Hypothesis

Various studies indicate that the occurrence of major events or disclosure of information affects a company’s stock performance, which is called as "information content effect". Myers and Majluf (1984) pointed out that public offering pass a message to the market that managers consider that the firms are overvalued. They explained that the top level executives have precious and valuable information about the value of the firm than outside investors, firms may not issue equity to public as far as the proportion of existing assets transferred to the new shareholders are greater than the proportion of increased firm value retained by the existing shareholders[52]. Hence, underinvestment arising from the information asymmetry between informed managers and the market reduces the firm value. Therefore, if managers are economically able to convey inside information about the value of assets-in-place to the market, they can mitigate the underinvestment problem (Myers and Majluf, 1984)[52].

Asquith and Mullins (1986) and, Masulis and Ronald (1986) are also supported to this behavior of new equity issue relative to information asymmetry, which demonstrate that firms reported a negative abnormal returns after the announcement of new issues[87,94]. Myers and Majluf (1984)[52]’s model be unsuccessful to capture how timing of the information asymmetry affects new equity issue. This vaccume filled by Korajczyk et al. (1991)[90] and they stated that firms regularly disclose information in the form of earnings release and audit annual reports. Hence, firms issuing equity when the market is better informed tend to reduce the magnitude of negative abnormal returns at the time of announcement. Dierkens (1991) also displays that the size of the information asymmetry varies over the life of the firm and the information asymmetry is a significant variable for equity issues[172].

Wruck (1989) , Hertzel and Smith (1993), Kato and Schallheim (1993), and Wu et al. (2005) found that a positive announcement returns for firms conduct the private placements[61,62,128,173]. A strong relationship between discounts and information cost was found and they interpret that discount as a proxy for the information cost tends to compensate buyers (Hertzel and Smith, 1993)[61]. Hence, Hertzel and Smith (1993)[61] confirm that the information asymmetry is a better explanation for the private placements than monitoring effect proposed by Wruck (1989)[128]. In addition, Hertzel and Smith (1993) noted that firms can mitigate information asymmetry problems[61]. In contrast, Wu (2004) examined the determinants of equity-selling mechanisms relating to information asymmetry. Private placement firms are characterized by high information asymmetry and the firm that conduct private placement generally has gone public at an earlier life cycle stage, and then, less has been backed by venture capitalists after initial offer[174]. A higher degree of information asymmetry about value are more likely to choose private placements, if there is uncertainty about the value of a new investment opportunity (Cronqvist and Nilsson, 2005)[66].

Monitoring Hypothesis

Active investors such as mutual funds or other institutional investors who have the resources to monitor management are attracted to purchase private placements. Private equity placements alter ownership concentration and this leads to an improvement in monitoring, thus enhancing shareholders’ wealth (Wruck, 1989)[128]. Jensen (1986) and Jensen and Meckling (1976) argued similar to the incentive alignment hypothesis. The change in concentration of ownership after private placements reveals new information to the market, thus signaling an efficient allocation of scarce resources[50,51].

Alternatively, Myers and Majluf (1984) argue that private equity placements are undervalued and mitigates the under-investment problem of firms and wealth transfers to new shareholders are reduced. But, those are normally arised after public issue. They also suggested that the willingness of private investors to commit funds to a firm, together with management’s decision to forego public issue. This conveys as speacial information to the market that management believes that the firm is undervalued[52]. This view is also supported by Hertzel and Smith (1993)[61]. Furthermore, Kahn and Winton (1998) state that when the market expects a firm to do badly and/or there is uncertainty, it encourages intervention. Increased trading tends to push the firm’s return back in the unexpected direction and increases its trading profit[175].

Other studies that have argued against monitoring hypothesis proposed by Wruck (1989) include Wu (2004)[128,174] and Wu et al. (2005)[173]. As the managers’ play a crucial role in selecting those few sophisticated investors for private placements, investors that have a tendency to vote in favour of the managers or protect managers’ positions are likely to be selected (Wu, 2004)[188]. Wu (2004) reported that private placements are not motivated by monitoring and also the change in ownership structure does not show a significant change in monitoring as well[174]. Using Hong Kong market data, Wu et al. (2005) also reported that the positive announcement returns do not arise from ex post monitoring[173]. Furthermore, Wu et al. (2004)[174] provided evidence that the relationship between change in ownership and abnormal returns adjusted by event actually stems from the significant correlation arising from the additional term in announcement adjusted abnormal returns proposed by Wruck (1989)[128].

According to Barclay et al. (2007), the extent to which the placement helps management to become entrenched is a factor that influences the relationship between ownership concentration and firm value. They also concluded that private placements are often made to passive investors to help management to solidify their control over the firm[176]. Cronqvist and Nilsson (2005) argued that if the controlling owners are entrenched, then it is not necessary to assume that they will maximize shareholder value because entrenched owners are more likely to choose a flotation method that maximizes their private wealth[66].

Morck et al. (1988) argued that large concentrated owners tend to introduce private placements to enhance monitoring[177]. Fama and Jensen (1983) found that dispersion of equity tends to limit the power of individual agents acting as self-interest residual claimants[178]. As for China, this study investigates whether the SOEs prefer to conduct private placements as a means to control agency problems. If this hypothesis is proven, it can be argued that the private sale of equity leads to a more concentrated ownership structure and increases the effectiveness of monitoring. Xu and Wang (1999) suggested that the internal incentive structure of SOEs must be reformed by diversifying the state ownership. This can be done by introducing other forms of large shareholders such as institutional investors or venture capitalists[179]. Wu and Wang (2005) show that since state owners do not bear residual risk over the SOEs assets, a high ownership concentration for state should be avoided[180].

Agency Theory

According to Jensen and Meckling (1976), an increase in managerial ownership reduces their incentive to consume perquisites or expropriate shareholders’ wealth[51]. However, the focus of Jensen and Meckling (1976) was on reducing agency costs arising only from the managerial decision making and therefore did not address the agency problem arising from diffuse residual claimants and decision making by controlling principles (delegating agents)[51] . Fama and Jensen (1983) posit that the separation of decision management and decision control at all levels of the organization helps to control agency problems as it limits the power of individual agents to expropriate the interest of residual claimants[178].

Theoretically, there should be an inverse relationship between the ownership of largest shareholder of a company and the agency cost. As such, a family-owned company with more than 50 per cent controlling stake should have lower agency cost. On the other hand, agency cost should also have a positive relationship with the number of executive directors or shareholders who are also managers of the company. Similarly, agency cost should also be higher if a company is being managed by a non-shareholder. La Porta et al. (1998) concluded that the agency cost is quite severe in emerging market because of weak and inefficient legal protections and regulations[181]. Xu and Wang (1999) investigated how ownership structure are significantly affected to the performance of publicly listed firms in China and reported that ownership is highly concentrated with an average of about 58 per cent for the five largest shareholders[179]. Furthermore, Xu and Wang (1999) concluded that inefficiency of the state ownership and potential problems arising from the overly dispersed ownership structures are the reasons for the poor performance[179]. Wei et al. (2009) investigated the relationship between ownership structure and firm value privatized SOEs in China and they report that state ownership has a negative effect on the firm value[182].

Theories Equity Financing and Stock-price Performance of Competitor Firms

In this section, we describe relevant theories which use to explain the effects of equity financing of issuing on stock performance of Competitor Firms. There are two competing theories which explain the phenomena of equity financing of issuing firms and stock-price performance of competitor firms. Various studies indicate that the occurrence of major events or the disclosure of information affects the stock-price performance of its competitors, which is called as "information transmission effect". Very few studies have explored the information transmission effect of PEP announcements on the competitor firms even in developed markets. One theory explains the reasons for positive relationship between equity financing of issuing firms and stock-price performance. On the other hand, other theory explains the reasons for negative relationship between equity financing of issuing firms and stock-price performance of competitor firms. These competing theories are described in more detailed in following sections.

Contingents Effect Hypothesis

In general, the information transmission effect of PEP announcements can be categorized into "contagion effects" and "competitive effects." The contagion effect suggests that the PEP announcement by one firm positively affects the future prospects of the competitor firms. Therefore, investors are likely to establish a positive association between the stock prices of the announcer and its industry rivals in the market. Szewczyk (1992) explains that the positive association between the abnormal share price returns of the announcing firm and its competitors is known as the "contagion effect"[134]. Lang and Stulz (1992) find that with announcements of bankruptcy, the contagion effect generally dominates the competitive effect[142]. This means the share prices of competitors react in the same direction as that of the announcing firm.

Competitive Effect Hypothesis

Announcement of an event generate a spill-over effect on the returns of competitor firms. According to the Szewczyk (1992), the negative relationship between the abnormal share price returns of the announcing firm and its competitors is referred to as the "competitive" effect. In contrast to the "contagion effects", competitive effect implies that the information in a PEP announcement changes original competitive situations and leads to wealth redistribution of competitor firms in the same industry. Therefore, a PEP announcement by one firm negatively affects competitor firms in the same industry[134]. Szewczyk (1992) explores whether announcements of public offerings of ordinary stock elicit abnormal stock price reactions among firms in the same industry and finds that average abnormal returns are significantly negative for announcing and non-announcing firms[134]. This suggests that investors draw inferences about the general prospects of the industry as a whole rather than shifts in competitive advantage between the announcing firm and its industry rivals.

Zantout and Tsetsekos (1994) indicate that a firm’s voluntary announcement of increasing R&D investment adversely affects the abnormal share returns of the rivals, signaling a competitive effect[148]. Erwin and Miller (1998) suggest that a firm's announcement of a treasury stock repurchase results in a competitive effect[145]. Akhigbe and Martin (2000) point out that a firm’s announcement of overseas M&A plan leads to a positive spillover effect on the abnormal return on its competitors’ share prices[149]. In addition, there is evidence that the competitive effect dominates in announcements of new products launches (Sheng‐Syan et al., 2005) and the disclosure of capital expenditure by US[150].

Hypotheses Development

In this chapter, based on our theoretical analysis and extant related literature, we will first develop our hypotheses to be examined in the next empirical research model. Our all hypotheses are classified into three subsections and are described in detailed.

Hypotheses on Equity Financing Capacity and Stock-price Performance

In this section, we develop several hypotheses that form the basis for the empirical tests in the subsequent sections. Our hypotheses relate to how the stock-prices of companies react to the different equity-financing capacities which created by the regulations and stock-price performance. These different level of equity financing capacities includes qualified for both right offering and public offering, qualified for either right offering and public offering, applied for both right offering and public offering, applied for either right offering and public offering, and approved & issued both right offering and public offering, approved & issued for either right offering and public offering.

The hypothesis is tested in four different stages. The first hypothesis relates to the qualification for equity financing in accordance with the CSRC regulations. Firms which applied for equity financing have higher capacity than firms do not applied for equity financing and it is second level of equity financing capacity. Firms which applied, approved by CSRC and successfully completed have higher equity financing than firms do not success equity financing process.

Agency conflicts between managers and shareholders may lead to the overinvestment problem, which is investing in unprofitable projects resulting in negative NPV and loss of shareholder wealth (Jensen 1986, and Jensen and Meckling 1976)[50,51]. When firms issue equity, the market recognizes this overinvestment problem by way of lower expected returns. The signaling hypothesis posits that firms issue equity when they are overvalued and market prices adjust downward subsequently leading to a negative relation between equity issuance and stock returns (Loughran and Ritter, 1995; 1997; 2000; Myers and Majluf, 1984; Ritter, 2003)[52-56]. Earnings management explanations argue that firms intending to issue equity opportunistically manage their earnings to alter financing proceeds in their favor (Cohen and Lys, 2006; Dechow, Richardson, and Sloan, 2008; Papanastasopoulos et al., 2011)[57-59]. When investors recognize earnings management, the price drops subsequently. The key implication for firms that have not yet issued equity but have the capacity to do so is that the market recognizes the propensity for these firms to issue equity and over-invest, issue overvalued equity, or engage in earnings management activities leading to lower expected returns. Therefore, the capacity to issue equity capital will be negatively related with future stock returns.

According to the theoretical explanation and evidence of some empirical studies which related to actual financing and stock-price performance (Fonseka et al., 2012)[18], we predict equity financing capacities such as qualification for equity financing, applied for equity financing and applied, approved by CSRC and successfully completed equity financing and stock-price performance have negative relationship (Fonseka et al., 2012)[18]. Hence, we have following set of hypotheses for the empirical study:

Hypothesis 1A: Firms qualified for right equity offering is negatively related to stock-price performance in Chinese capital market.

Hypothesis 1B: Firms qualified for public equity offering is negatively related to stock-price performance in Chinese capital market.

Hypothesis 2A: Firms applied for right equity offering is negatively related to stock-price performance in Chinese capital market.

Hypothesis 2B: Firms applied for public equity offering is negatively related to stock-price performance in Chinese capital market.

Hypothesis 3A: Firms applied, approved and successfully completed for right equity offering is negatively related to stock-price performance in Chinese capital market.

Hypothesis 3B: Firms applied, approved and successfully completed for public equity offering is negatively related to stock-price performance in Chinese capital market.

Hypotheses on Private Equity Issuing Firms and Stock-price Performance

In this section, we develop several hypotheses that form the basis for the empirical tests in the subsequent sections. Our hypothesis relates to how the stock prices of PEP issuing companies react to the different kind of regulator’s announcement. While PEP is applied to CSRC, there is no guarantee all PEPs approved by CSRC. The PEP rejection is thus expected to have an impact on issuing firm's stock-price performance. Further, PEP is approved some time before the intended announced and registered, there is substantial uncertainty at that point of application about whether it will in fact be completed successfully. PEP withdrawals can be occurred at any point between time of application and approvals as well as approvals and successfully completions. The PEP rejection, approval, announcement of CSRC decisions and its subsequent completion or withdrawal are expected to have an impact on issuing firms' stock-price performance.

The hypothesis is tested in four different ways. The first hypothesis relates to the initial application of that PEP at CSRC. The initial application is the earliest event in the PEP process in this study and thus applies to PEPs that will eventually succeed as well as to PEPs that will eventually be withdrawn or get a rejection from CSRC. The initial application should have a similar effect as the completion of PEP, since it is likely that the PEP firm will eventually compete successfully. Hence, application of PEP may have a positive impact on PEP issuing firms' stock-prices:

Hypothesis 4: The initial applying of PEP has a positive stock-price impact on publicly listed PEP issuing firms in short-term.

It is good news for the investors if an applied PEP does succeed from CSRC approval. CSRC approval or rejection is an initial important decision and it convey to the market. Hence, approved PEPs may have higher degree of magnitude compared to an applied PEPs do success from CSRC approval. Hence, the PEPs approved by CSRC may also have a positive impact on issuing firms’ stock prices:

Hypothesis 5: The successful approval of PEP received from CSRC has positive stock-price impact on public listed PEP issuing firms in short-term.

The PEP is expected to allow the issuing firm to compete more successfully against industry rivals; the successful completion of PEP may have a positive impact on PEP issuing firms’ stock prices:

Hypothesis 6: The successful completion of PEP has positive stock-price impact on public listed PEP issuing firms in short-term.

However, if it is good news for issuing firms to face a completed PEP and issuing firms obtained approval for issuing PEP and, it should be bad news for them if an expected PEP does not succeed. The PEP application could be a withdrawal by the firm before the completion or during the process of approval by CSRC. The unsuccessful completion of PEP may have a negative impact on issuing firms’ stock-prices:

Hypothesis 7: The withdrawal by the firm and rejection by CSRC of PEP have a negative stock-price impact on publicly listed PEP issuing firms in short-term.

The hypothesis focuses on the announcements of application, approval from CSRC, withdrawal before the successful completion or the rejection by CSRC, and successful completion of PEP. To investigate the explanation for announcement effects in China, we test the three hypotheses: (5) information effect (6) ownership structure effect hypotheses (7) agency theory, which were developed in the developed market (Hertzel and Smith, 1993)[61]. Hertzel and Smith (1993) point out that the size of market discount could explain this positive reaction and it is a part of information hypothesis[61]. Wruck (1989) find that changes in ownership concentration can partially explain the positive announcement effect and suggested that discounts on private placements reflect compensation for expert advice or monitoring services provided by private investors[128].

To provide evidence on the information effect hypothesis, we use the variables of the determinants of private placement discounts and stock price effects, and employees similar model, which is consistent with prior literature (Wruck, 1989; Hertzel and Smith, 1993; Lu et al., 2011)[61,65,128]. The discount reflects the "information price" and "cost of the placement" to the PE issuing firms (Hertzel and Smith, 1993)[61] Chung and Hwang (2010) point out that the value of information and information acquisition cost have a greater impact on the discount level in private offerings[183]. Hertzel and Smith (1993) used private placement discount, proceeds from PEP and heterogeneity investor characteristics to measure information effects. They find that stock price effects are based on the implication that information effects are larger for the PEPs where the potential degree of undervaluation is high. The proportion of ownership retained by existing shareholders under full information exceeds the proportion retained under asymmetric information in private placement and management makes use of PEP intentionally to signal that the firm is undervalued[61].

Overvalued firms are benefited by placing shares with investors who resell prior to revelation of true state of nature. The existing shareholders are benefited since net proceeds from the private placement would reflect the opportunity to resell the shares at an inflated price. Rational investors recognize this incentive and will discount their estimates of value unless information is made credible and credible information leads to undervaluation, which results positive stock price reaction. The extent of information creation is subject to economies of scale; the percentage discounts may be smaller for larger placements. Hence, both private placement discount and proceeds from private placement can use to test the information effect hypothesis. A smaller discount is also expected to be smaller if the buyer is a single investor and/or buyer is from insider (Hertzel and Smith, 1993[61].

Hypothesis 8: The higher degree of the information asymmetry will result negative market reaction in private Equity placement.

To provide evidence on the monitoring hypothesis, we use the variables of the determinants of ownership concentration and categorical variables of different categories of investors' buying, and employees’ similar model, which is consistent with prior literature (Hertzel and Smith, 1993;Wruck, 1989)[61,128]. Private placement discounts and stock price effects may signal changes in the ownership structure of the firm and attract outside institutional investors who monitors management or contributes expert advice (Demsetz and Lehn, 1985; Shleifer and Vishny, 1986)[124,184]. The monitoring argument implies that private placement discounts reflect compensation to private investors for expected monitoring services and that abnormal stock return reflect the additional monitoring benefits (Hertzel and Smith, 1993)[61].

We use Single investor indicator and different categories of investors (such as government and governmental institutions, corporate institutional, management and individual investors) variables in separated models. These categories of equity investors have different degree of monitoring. For an example, corporate institutional investor category has more efficient monitoring ability than individual investor category due to the difference of the management knowledge and other resources. On the other hand, Gomes and Novase (2001) and Zwiebel (1995) suggest that large shareholders can engage in sharing the private benefits of control and new investors may hardly bring additional monitoring[185,186]. In line with this argument, government and government-owned institutional investors do not add efficient monitoring mechanism to the firms. Wu (2004) finds that private placements in US do not appear to improve monitoring and it is willing to protect managerial perks in private placements[174].

We use the methodology which was suggested by Wruck (1989)[128] to investigate the ownership structure hypothesis, which test the effects of changes in ownership concentration on stock price that take place around private equity placement. An increase in ownership concentration can increase firm value if it aligns managers and shareholder interests, allows for more efficient monitoring (Hertzel and Smith, 1993; Jensen and Meckling, 1976; Shleifer and Vishny, 1986)[51,61,124]. On the other hand, an increase in ownership concentration can decrease firm value if it decreases the probability of takeover, or fosters misallocations of resources by entrenching management (Fama and Jensen, 1983; Hertzel and Smith, 1993; Stulz, 1988)[61,178,187]. Morck et al. (1988) point out that the effect on firm value of increase in ownership concentration depends on which factors dominate over a particular range of ownership concentration[177].

Hertzel and Smith, (1993) and Wruck (1989) find that block-holders generally serve to align the interests of managers and shareholders, in some cases increased ownership concentration promotes entrenchment[61,128]. Lu et al. (2011) find Fraction is significantly positive. They suggest that offering percentage has positive impact on announcement effects and most private placement target at institutional investors and block shareholders[65]. The Fraction is inadequate measurement to test change ownership concentration on announcement effects.

Hypothesis 9A: Change in the ownership concentration and stock-price of the market reactions are positively related in private equity placement.

Hypothesis 9B: Entrenched controlling owners and stock-price of the market reactions are negatively related in private equity placement.

To provide evidence on the agency theory hypothesis, we use the variables of the determinants of ownership concentration and categorical variables of different categories of investors' buying. Wei et al. (2005) studies how the ownership structure affect firm value using a sample of privatized firms in China and they show that state ownership is significantly negative effect on the firm value. Their finding implies that there exists a high degree of agency problems between state owners and private owners after privatization of SOEs in China[182]. Based on these previous studies, we hypothesis that ownership structure characteristics do have an impact on the choice for and it may negatively affect stock equity offering performance of issuing firms. Therefore, we present a hypothesis as follows:

Hypothesis 10: Agency cost and stock-price of market reactions are negatively related in private equity placement.

Along with the impact of stock-price reaction of PEP issuing firms’ in short-term, PEPs can have long-term impact on stock-price performance in long-term. The completion of PEPs are expected to give competitive advantage to PEP issuing firms. Thus, PEP issuing firms have positive stock-price performance after successful completion of PEP event. We hypothesis is as follows:

Hypothesis 11: Market reaction to announcement of PEP completion will result positive stock-price performance of PEP issuing firms in long-run.

Hypotheses on Private Equity Financing and Stock-price Performance of Competitor Firms

We develop several hypotheses that form the basis for the empirical tests on the effects of PEP activity on industry competitors. The steps in the CSRC process involve application for PEPs and subsequent approval or rejection. Some firms may withdraw the PEP at any point between time of application and approvals as well as after approval and before successfully completion. It is also possible that some firms may not be able to successfully complete an approved PEP. Thus all the events that include the announcement of PEP application, rejection, approval, and its subsequent withdrawal or completion have the potential to impact competitors’ stock returns.

The first hypothesis relates to the initial application of that PEP for CSRC approval. Since it is likely that the PEP will enable the firm to compete successfully against the existing firms in the same industry, the application of PEP may have a negative impact on rivals’ stock-price performance.

Hypothesis 12: The announcement of application of PEP has a negative impact on performance of stock-price of existing firms in the same industry.

As the PEP is expected to allow the issuing firm to compete more successfully against industry competitors, the approval and the successful completion of PEP may have a negative impact on public listed competitors’ stock-price performance.

Hypothesis 13: The announcement of the approval of PEP by CSRC has a negative effect of stock price performance of public listed firms in the same industry.

Hypothesis 14: The announcement of successful completion of PEP has a negative effect on stock-price performance of public listed firms in the same industry.

If the application, approval or completion of PEP is bad news for rival firms, then it should be good news for them if an expected PEP does not succeed. The unsuccessful PEP could be a rejection of application, withdrawal of application prior during the approval process or prior to completion subsequent to approval.

Hypothesis 15: The announcement of the rejection or withdrawal of the PEP application by CSRC has a positive stock-price impact on publicly traded firms in the same industry.

We can test the information transmission effect hypothesis in two ways. First, we assess whether the stock-price performance of the competitive firms deteriorates subsequent to a completion of PEP in the industry. Second, we assess the effect of the magnitude of PEPs on the market performance of competitors. Hertzel and Smith (1993), Wruck, (1989), and Lu et al. (2011) provide evidence of the information effect hypothesis; they used two variables (private placement discounts and PEP proceedings) as determinants of the information effect[61,65,128]. The discount reflects the "information price" and cost of the placement to the firm (Hertzel and Smith, 1993)[61]. Chung and Hwang (2010) point out that the value of information and information acquisition has a larger impact on the level of discount in private offerings[183]. Hertzel and Smith (1993) used private placement discount and proceeds from PEP to measure information effects and they find that stock price effects is based on the implication that information effects are larger for the placements where the potential degree of undervaluation is high[61]. In line with Wruck (1989)[128] and Hertzel and Smith (1993)[61] studies, we argue that private placement discount and proceeds from PEP at industry level affects competitor firms. On average of private placement discount and average proceeds from PEPs at industry level have information transmit effect and these information valuable to the investors, competitors and other stake-holders in the market and they react on these information.

Rational investors recognize this incentive and will discount their estimates of value unless information is made credible and credible information leads to overvaluation of competitor firms, which results negative stock price reaction. The extent of information transmission effect is also depend on to economies of scale, the size of discounts may be smaller in the industries which have larger placements. Hence, both private placement discount and proceeds from private offering can also use to test the information transmission effect hypothesis in addition to whether PEP present in a particular industry (a dummy variable). Based on above arguments and theory of information transmissions effect, we hypothesis following:

Hypothesis 16: Market reacts to the information transfer of the PEP issuing event, which will result negative stock-price performance of competitor firms.

Along with the impact on the stock price, a PEP should also have an impact on the stock-price performance of competing firms in the same industry in long-term. In particular, the completion of an PEP is expected to give the private equity issuing firm a competitive advantage over its competitors and thus negatively affect their market performance in long-term.

Hypothesis 17: Post-PEP stock-price performance of competitor firms will deteriorate after a successful completion of PEP in their particular industry.