nd of the day due to the camouflage effect, notes Mann. “Other people may think it’s possible you just don’t have value in owning it. Another owner can make better use of it, and so is willing to pay a decent price for it.”
The correlation effect highlights a second case for selling assets instead of equity. When a firm issues equity, not only does it fetch a low price for the new equity that is issued (because the market suspects a “lemon”), but also the low price affects the old shares that are already outstanding. Because stock in the firm as a whole is a carbon copy of the new shares, any discount applied to the new offering affects all of the existing shares in exactly the same way. The whole company faces loss in value.
In contrast, if a firm accepts a low price for a non-core asset, the low valuation says nothing about remaining assets. The crux is that any correlation is muted. The asset for sale is not a carbon copy of the rest of the firm. Even if the market decides that the asset is a lemon, this conclusion won’t extend to other assets or the firm as a whole, the researchers note.
Say that a bank wants to sell its aircraft leasing business, but fails to convince the market that it’s selling only because aircraft leasing falls outside the firm’s core banking business: Then the camouflage effect goes away. That conveys the impression that aircraft leasing is a “lemon” and therefore warrants a lower price. Nevertheless, market knowledge that the aircraft leasing business is troubled conveys nothing about the quality of the bank’s core business of lending and deposit taking. In that case, the bank can raise cash without hurting its stock price. The rest of the firm does not suffer.
The power of certainty
A hunch about the camouflage and correlation effects motivated Edmans and Mann to embark on their paper. The certainty effect emerged after they started to build their model.
When companies issue stock, new shareholders receive a stake in the entire firm. Resulting stakes include not only core and non-core assets in place before the offering, but also the cash raised by issuing stock. Because the value of the new cash is certain, it offsets the information asymmetry of other assets in place. If a pharmaceuticals company is raising $5 billion of equity, for example, the new equity investors will get a share of not only the company’s current drug pipeline (whose value is highly uncertain), but also the $5 billion of equity that they inject (whose value is certain – it is $5 billion). Hence the label of the “certainty” effect. The bigger the equity offering, the weightier the certainty effect becomes relative to information asymmetry.
In contrast, an asset buyer retains a claim to that asset alone. The claim enjoys no benefit from the certainty effect of cash because there is no residual stake in the seller. If a conglomerate sells its pharmaceuticals division for $5 billion, the purchaser obtains only the pharmaceuticals division and not a share of the $5 billion of cash that has just changed hands.
Weighed alongside the camouflage and correlation effects that tend to favour the sale of assets over equity, the certainty effect favours equity over asset sales when raising cash. The certainty effect is surprisingly robust. Edmans and Mann show that it persists even if the cash raised is intended for an uncertain purpose – for example, a new venture.
At the end of the day, how should corporate managers treat the camouflage, correlation and certainty effects? There is no single formula that, once popped into an Excel spreadsheet, will say whether to sell assets or sell equity, the researchers note. “You can’t quantify these decisions,” Edmans says, applying a consumer analogy: How someone chooses to live depends, for instance, on the desired size of a house and the proximity of schools. “We can’t take a third of this and a half of that and say you should pay an extra $10,000 for a house one meter closer to the beach.”
Even absent a formula, takeaways are consequential when companies mull financing options. The camouflage and correlation effects give an edge to selling assets over issuing equity. Conversely, the certainty effect expresses a case for issuing equity, especially as higher cash needs amplify the certainty effect, the researchers say. With billions of dollars at stake these days even in routine financings, three new lenses can help managers see their way to better decisions.
