Private placement is the sale of a company’s securities to a few, select investors as a means of raising the capital. The investors may include insurance companies, banks, pension funds, and mutual funds. Such a placement does not require registration with the Securities and Exchange Commission. This work appraises the market performance of a group of companies that announced their intention to sell private placement shares. The market considered herein is the NASDAQ Global Market. For this market, two companies (issuers) are considered -- NeurogesX, Inc. and Solar Capital Ltd. The information herein is current and is sourced from various sites including the individual company’s sites, Stock markets, DataStream, and General Business News.
Objective
This work is aimed at evaluating, analyzing, and comparing the market performance of the selected companies with respects to the companies’ share prices. It also explores the reasons behind price adjustments following the companies’ announcement of the intentions to sell private placement shares.
Literature Review
When a company is very risky or small for an IPO, it can be financed through private placements. A private placement is considered as a cheaper and faster means of financing as compared to a public offering.
According to the U.S Securities and Exchange Commission (SEC Rule 144), a private placement is defined as the selling of stocks or bonds (unregistered securities) to qualified institutional investors. Such investors include insurance companies (life insurance companies), pension funds, and investment companies. Since there is no need for registration of the securities, a private placement is much cheaper than a public offering. Also, the issuer of a private placement is not obliged to comply with the market’s accounting principles. The marketing costs are also less due to the fact that only a few institutional investors are involved.
According to the SEC Regulation D of 1982, a qualified institutional investor is defined as one, who understands or employs those who understand the securities’ returns and risks, and is willing and able to bear the risks. Whoever purchases the private placement signs the investment letter which specifically points out that the purpose of buying the securities is purely investment, and not for resale. A private placement does not require the issuer to give a prospectus to buyers; however, it must provide the relevant information that SEC considers important, in the form of a memorandum to the potential investors. Since a private placement involves few investors, the investors are free to negotiate the characteristics of the issues, thus more flexibility compared to public offering.
The announcements for the sale of private placements are more favorable for the companies with better performance and greater liquidity prior to the announcement, in order for the company to survive. According to Hertzel and Smith (1993), firms with financial difficulties are positively treated following their announcement for the private placements of equity. From the prior studies, it is evident that majority of the companies that sell private placement shares have poor performance, in terms of earnings, prior to the announcement. Hence, the announcement is a reflection of an inadequacy in the pre-issue liquidity levels. Private placements announcement is meant to inject additional liquidity, which directly initiates an excess free cash flow problem for the poorest performing companies. It is important to note that private placement shares is one of the most expensive sources of liquidity, and should only be used when the projected benefits from the additional liquidity are justified by the sufficiency in marginal wealth enhancement (Smith,1986; Asquith and Mullins, 1986; and Mikkelson and Partch, 1986).
Private placement shares should be the least preferred when compared to public equity offerings and other debt and preferred stock alternatives. This is because of the high cost of issuance which comes as a result of the discounts given to the investors. As stated by Wruck (1989), private placement shares provide an avenue for the examination of the market responses to the corporate events.
When a company announces its intention to privately issue the shares, the decision is received favorably. The institutional investors give optimistic opinion relating to the company’s prospects and monitor management in accordance to their private placement purchase. According to Myers and Majluf (1984), the knowledgeable private placement investor facilitates the above objective. The private investors also bond their optimistic opinion to the extent that the resale of the shares is restricted. From prior studies, the good performance of the equity private placements is attributed to the announcement (desirable information release) and the improvements in the ownership structures of the issuing companies (Wruck, 1989; Fields and Mais, 1991; and Hertzel and Smith, 1993). According to Hertzel and Rees (1998), the subsequent increases in the earnings to private placements are directly and positively linked to the placements’ announcement period abnormal returns. As opposed to the public equity, the private equity placement announcement indicates more favorable future earnings (Hertzel and Rees, 1998). It is also noted by Goh, Gombala, Lee and Liu (1999) that the rise in earnings forecasts is directly and positively linked to the announcement period abnormal returns. The rise in earnings represents the value enhancing impacts resulting from the additional liquidity.
The market
Discussed herein is the NASDAQ Stock Market. NASDAQ is an American stock exchange which is an abbreviation for National Association of Securities Dealers Automated Quotations. It is the largest trading market for electronic equity securities in the United States of America, and the world’s second largest in terms of market capitalization. In January 13th, 2011, the market had 2,872 listings.
The competitive market structure of NASDAQ presents a lot of advantages to the companies and investors. The market structure provides a low cost, fair, efficient and fast marketplace. The superior market quality of NASDAQ is depicted by the key performance benchmarks as highlighted below.
Market share – NASDAQ is the key market where the NASDAQ-listed stocks are traded.
NASDAQ Listings - NASDAQ OMX Group, Inc. is the largest exchange company in the world with over 3,900 companies across the six continents. It delivers public company services and exchange technology and is at the top position in the worldwide listings. It offers capital raising solutions and trading across a variety of asset classes like structured products, derivatives, equities, and debts among others.
NASDAQ Trade Execution Speed – the orders in the listed stocks of NASDAQ are executed faster than the orders in other comparative stocks like the NYSE-listed stocks.
NASDAQ Trading Cost and Spreads – the average effective spreads of the listed stocks of NASDAQ are better than those of its peers like NYSE-listed stock. Thus NASDAQ offers lower trading costs for the investors due to its lower effective spreads.
Performance Benchmarks
Effective Spread – this is a measure of the difference between the price that the investors pay or receive for the stock verses the average buying price or selling price.
Quoted spread – this is a measure of the difference between the price that is advertised for stock verses the average buying price or selling price.
Execution Certainty – A faster execution means that the investor’s uncertainties are reduced. This decreases the possibility of the market shifting away from the price of the investor.
The issuers
Discussed hereunder are selected two companies that announced their intention to sell private placement shares in the above market.
NeurogesX, Inc.
This is a biopharmaceutical company based in San Francisco Bay Area. The company develops and commercializes novel pain management therapies. Its lead product, Qutenza, is available in United States, Europe and Asia.
On July 22, 2011 the company announced its intention to sell private placement securities to a group of qualified institutional investors. The company expected to raise a total of $20 million in gross proceeds, subject to the standard closing conditions. The company intended to sell a total of 11,749,552 shares of the common stock, and issue five-year warrants to purchase additional 5,874,782 NGSX common stock shares at an exercise price per share of $1.65.
For every unit of shares and warrants, the company proposed a selling price of $1.72. Each unit comprised of one common stock share and a warrant to purchase 0.5 common stock shares. This selling price was based on the NGSX common stock consolidated closing bid price of $1.65 per share on the NASDAQ Global Market. For this transaction, the exclusive placement agent was the Leerink Swann LLC. The financial advisors were Ladenburg Thalmann & Co. Inc. and Roth Capital Partners. The private placement securities had not been registered under the state securities laws.
The section that follows deeply looks into the factors that influence the price adjustments surrounding the announcements.
1. Proxies for Growth Options
Companies with more growth options are more likely to have projects with positive NPV. This calls for greater liquidity so that the company is less subjected to excess free cash flow problem. The variables used here are: the earnings-price ratio, new products, and the working capital.
The earnings-price ratio (E/P) is inversely related to the company’s growth opportunities. The higher the growth of the company, the lower the earnings-price ratio. Considering NeurogesX, Inc. E/P ratio is given as 1.72/1.65 (1.04: 1). This is a very high ratio which depicts a low growth of the company. From the company’s announcement, the share price before the announcement was low as compared to the proposed selling price. This is so because of the company’s low growth opportunities; thus, the need for additional liquidity necessitated the equity private placement.
The new product announcement is another indicator of growth option; and the expected reaction of the investor towards the announcement should be positive. According to Cooney and Kalay (1993), the equity issue announcement is received positively by the market if the announcement contains the proposals of increasing the capital expenditure. The capital spending plans of a company enhances the stock value.
The working capital is used to support the company’s operations and at the same time fund the growth options. When a company announces the funding of working capital through the placement proceeds, the market is most likely to respond positively.
2. The company’s existing liquidity and the liquidity to be supplied
Investors highly value liquidity. If the company was liquid during the announcement, then few investors are attracted; however, investors are more attracted to companies that are less liquid as at the time of the announcement. The sale of private placements enhances the company’s liquidity due to the liquidity supplied. At the time of this announcement, NeurogesX, Inc. was less liquid, and the announcement was intended at improving the liquidity.
3. Corporate Control Issues and Ownership Structure
If a company has abnormal returns at the announcement of the placement, then it reflects an expectation of diminished or improved monitoring and decreased or increased discretion by the management.
Solar Capital Ltd
This is a closed-end investment firm – as provided in the Investment Company Act of 1940 -- that has chosen to be considered as a business development company. The company invests majorly in the form of equity securities, mezzanine loans, and senior secured loans in other companies (leveraged, middle market companies).
The announcement
This announcement is sourced from the Business Wire, New York.
On November 22, 2010, Solar Capital Ltd. announced its intention to sell 1,800,000 common stock shares to a group of institutional investors based on a private placement transaction. The management also expressed the intention of acquiring an incremental 115,000 shares.
In the private placement, the investors agreed to purchase the shares at a price of $22.94 per share. This would result into net proceeds of approximately $44 million. The company expected to use the net proceeds herein and the additional borrowings within its credit facility for the repayment of its outstanding 8.75% Senior Unsecured Notes.
According to Michael Gross, the Chairman and CEO of Solar Capital Ltd., the private placement offering together with the additional borrowings under the company’s credit facility, would enable the company to reduce the cost of its capital. Gross further stated that the redemption of the company’s Senior Unsecured Notes would enhance the company’s net investment income. Redemption of the notes had no penalty associated to it; also, the additional borrowings together with the repayment were at approximately 5.00% lower rates than the coupon on the debt to be retired.
The sale of the common stock shares discussed above involved securities’ sale in private transactions that would not be registered under the Securities Act of 1933, and would be subjected to resale restrictions as provided in the act. Solar Capital Ltd. agreed to prepare the registration statement and file it with the Securities and Exchange Commission so as to give a provision for the resale of the common shares that are sold in the private placement. Without the registration or the applicable exemption from the registration, such securities may not be sold or offered in the United States.
The announcement however revealed that it did not constitute a solicitation of a securities’ buying offer or the selling offer. It also prohibited the sale of any security in unlawful manner before the registration or qualification as stated in the securities laws. The company anticipated that the private placements would be completed in time, subject to the customary closing conditions.
Evaluation
Based on this announcement, the performance of Solar Capital Ltd can be evaluated.
Without any reasonable doubt, Solar Capital Ltd had a poor performance in terms of earnings, before the announcement. This is evident from the company’s intention to use this money in repaying its outstanding 8.75% Senior Unsecured Notes. This announcement reveals the inadequacy in the pre-issue liquidity levels as it is meant to inject additional liquidity. It also shows that the net investment income of the company was low and based on this sale, it would greatly be improved.
As stated above in the case of NeurogesX, Inc., the factors influencing the price adjustments surrounding the announcements can also be established. Proxies for growth options play an important role in price adjustment. Considering the working capital, the company announced to use these sales so as to fund the working capital. This announcement goes well with the investors and is received positively. The cost of the company’s capital would therefore be reduced. This is the reason why the suggested price per share is high as compared to the prior one.
It is also evident that Solar Capital Ltd had poor liquidity prior to the announcement. This is the reason for the proposed high share prices since more investors are most likely to be attracted. The company liquidity is thus enhanced.
Summary
The private placement shares provide a platform for the evaluation of a company’s performance with respect to its liquidity. Based on prior research, private placement does not show an evidence of excess free cash flow problem, except for the poorest performing companies. If a company has better performance and great liquidity, then the announcement for the sale of private placement is more favorable. However, companies with financial difficulties are treated positively shall they make such an announcement. This work shows that the majority of the companies that sell the private placement shares are poor performers in terms of the earnings, before the announcement. Such an announcement is thus intended for the generation of additional liquidity. The companies should have it in mind that private placement shares is one of the most expensive sources of liquidity, and should only be used when the projected benefits from the additional liquidity are justified by the sufficiency in the marginal wealth enhancement.
Reference
"NASDAQ Performance Report". NASDAQ Newsroom. The Nasdaq Stock Market, 13 February 2011. Retrieved at http://www.nasdaq.com/newsroom/stats/Performance_Report.stm#item_2
“NeurogesX, Inc. Announces $20 Million Private Placement,” PR Newswire. July 22, 2011. Retrieved at http://finance.yahoo.com/news/NeurogesX-Inc-Announces-20-prnews-1259460823.html?x=0&.v=1
“Solar Capital Ltd. Announces Private Placement Offering of 1.9 Million Shares and Intent to Repay a Portion of Its Senior Unsecured Notes.” Business Wire. November 22, 2010. Retrieved at http://www.businesswire.com/news/home/20101122005816/en/Solar-Capital-Ltd.-Announces-Private-Placement-Offering
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