Hedge Funds as Investors of Last Resort?

Abstract

Hedge funds have become important investors in public companies raising equity privately. Hedge funds tend to finance companies that have poor fundamentals and pronounced information asymmetries. To compensate for these shortcomings, hedge funds protect themselves by requiring substantial discounts, negotiating repricing rights, and entering into short positions of the underlying stocks. We find that companies that obtain financing from hedge funds significantly underperform companies that obtain financing from other investors during the following two years. We argue that hedge funds are investors of last resort and provide funding for companies that are otherwise constrained from raising equity capital. (JEL G14, G23, G32)Hedge funds have recently become an important source of funding for public companies raising equity privately. Financing young companies with severe information asymmetries is an important investment strategy for some hedge funds. Since 1995, hedge funds have participated in more than 50% of the private placements of equity securities and have contributed about one-quarter of the capital raised in such equity issuances, a total investment that has exceeded the contributions of other investor classes. This paper sheds light on the role of hedge funds in such private placements.In perfect financial markets it should be irrelevant whether a firm obtains funding from hedge funds or from other investors. To investigate whether the identity of the investors matters, we use a unique dataset that

Hole in the Wall: Informed Short Selling Ahead of Private Placements*

“…Consistent with Dai (2007), Brophy et al (2009), Duca et al (2012 and Floros and Sapp (2012), we find that the share price reaction to the announcement depends strongly on the involvement of hedge funds. For the sample with no hedge fund participation, the average abnormal returns are significantly positive.…”

“…Within private placements, Dai (2007) shows that hedge funds differ from other investors by keeping their stakes for shorter periods of time and by being less likely to obtain board seats. Brophy et al (2009) show that hedge funds are typically considered as investors of last resort, which implies that they invest in companies that find it difficult to attract other buyers and that offer relatively large discounts. As such, a relatively large discount makes it more likely that hedge funds participate in the private placement (obtain a long position), but a larger discount also implies a more negative prediction for the announcement effect, due to signaling and dilution, which makes it more profitable to short in the pre-announcement period.…”

“…It is also known that companies with high information asymmetry tend to place more securities with hedge funds (see for example Brophy et al, 2009). We include the Durnev et al (2003) psi variable as a proxy for the level of information asymmetry.…”

“…For example, Brophy et al (2009) conclude that firms issuing to hedge funds are substantially different from firms issuing to non-hedge funds. Ideally, we want to keep the characteristics of the issuer constant and then examine what happens to pre-announcement short selling when there is a higher participation of hedge funds.…”

Are the Discounts in UK Open Offers and Placings Due to Inelastic Demand?

“…It seems that hedge funds are more willing to make risky, speculative investments, but require a higher expected return via a deeper discount and via other features that enhance expected returns, such as warrants. (Brophy, Ouimet and Sialm, 2006;Dai, 2007;Dai, Jo and Schatzberg, 2010).…”