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Evidence on the Trade-Off between Risk and Return for IPO and SEO Firms


  • We would like to thank Malcolm Baker, Bill Christie (the editor), Adlai Fisher, John Graham, Jasoon Greco, Manju Puri, Jay Ritter, an anonymous referee, and seminar participants at Duke University, the University of Maryland, Washington University in St. Louis, and the 2006 NBER Corporate Finance Summer Institute for comments and suggestions. Roberts gratefully acknowledges financial support from the Rodney L. White Center and an NYSE Fellowship. Brav and Zarutskie gratefully acknowledge the Hartman Center for the Study of Medium-Sized Enterprises for financial support.


Do the low long-run average returns of equity issuers reflect underperformance due to mispricing or the risk characteristics of the issuing firms? We shed new light on this question by examining how institutional lenders price loans of equity issuing firms. Accounting for standard risk factors, we find that equity issuing firms' expected debt return is equivalent to the expected debt return of nonissuing firms, implying that institutional lenders perceive equity issuers to be as risky as similar nonissuing firms. In general, institutional lenders perceive small and high book-to-market borrowers as systematically riskier than larger borrowers with low book-to-market ratios, consistent with the asset pricing approach in Fama and French (1993). Finally, we find that firms' expected debt returns decline after equity offerings, consistent with recent theoretical arguments suggesting that firm risk should decline following an equity offering. Overall, our analysis provides novel evidence consistent with risk-based explanations for the observed equity returns following IPOs and SEOs.

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