Richard L. Smith

Evidence on the Determinants of Credit Terms Used in Interfirm Trade

Trade credit is created whenever a supplier offers terms that allow the buyer to delay payment. In this paper we document the rich variation in interfirm credit terms and credit policies across industries. We examine empirically the firms basic credit policy choices: whether to extend credit or to require cash payment; and, if credit is extended, whether to adopt simple net terms or terms with discounts for prompt payment. We also examine determinants of variations in two-part terms. Results are supportive primarily of theories that explain credit terms as contractual solutions to information problems concerning product quality and buyer creditworthiness. Copyright The American Finance Association 1999.

Opportunity Cost of Capital for Venture Capital Investors and Entrepreneurs

We use a database of recent high tech IPOs to estimate opportunity cost of capital for venture capital investors and entrepreneurs. Entrepreneurs face the risk-return tradeoff of the CAPM as the opportunity cost of holding a portfolio that necessarily is underdiversified. For early stage firms, we estimate the effects of underdiversification, industry, and financial maturity on opportunity cost. Assuming a one-year holding period, the entrepreneurs opportunity cost generally is two to four times as high as that of a well-diversified investor. With a 4.0% risk-free rate and 6.0% market risk premium, for the sample average, we estimate the cost of capital of a well-diversified investor to be 11.4%, which equates to 16.7% before the management fees and carried interest of a typical venture capital fund. For an entrepreneur with 25% of total wealth invested in the venture, our corresponding estimate of cost of capital is 40.0%.

Why Does Book Building Drive Out Auction Methods of IPO Issuance? Evidence from Japan

We examine Japans 1997 introduction of book building as an alternative to a previously required hybrid auction method. Despite higher cost for some issuers, all issuers in Japan now select book building. Book building enables more accurate valuation of firms, but gains from accurate valuation are partly redistributive. Thus book building can drive auction-method offerings from the market even if it yields no aggregate benefit. Compared to the auction regime, book building reduces issue costs for large issuers. Auctioning is less costly for small issuers, but appears to foreclose some small firms from issuing. The aggregate costs of book building and auctioning are similar. Copyright 2004, Oxford University Press.

Banking Relationships and Access to Equity Capital Markets: Evidence from Japan’s Main Bank System

We study the role of banking relationships in IPO underwriting using a sample of 484 Japanese IPOs. Among other issues, we consider whether bank relationships lead to increased access to public equity markets, especially for smaller, lesser-known firms. When a firm in Japan goes public, it can engage an investment bank that is related through a common main bank, or can select an alternative investment bank. The main bank relationship can be an efficient way for the investment bank to acquire information generated by the main bank, but may give rise to conflicts of interest. We use data from two different investment banking regimes in Japan (a hybrid auction-method regime and a book-building regime) and find that main bank relationships give small issuers increased access to equity capital markets, but that issuers of large IPOs switch to non-related investment banks that are capable of managing large offerings. While we find evidence that investment banks seek to exploit bargaining power with related issuers, we also find that issuers respond to expected high issue cost by switching to non-related investment banks. The net result is that total issue costs through related and non-related investment banks are similar. With respect to aftermarket performance and use of offer proceeds, we find no evidence of conflict of interest or self-dealing for either the main bank or the investment bank.

Why are IPOs underpriced? Evidence from Japan's hybrid auction-method offerings.

Until October 1997, firms wishing to go public in Japan were required to use a hybrid auction process where up to half of the issue (the auction tranche) was offered to investors via a discriminatory auction. Remaining shares (the public offer tranche) were sold a few days later by a firm commitment at a fixed price. We document underpricing and partial adjustment of IPO public offer prices in Japans auction regime, a regime where: investors are symmetrically informed or information differences are not important; roadshows are not held; preferential allocations to any investor are negligible; and institutional investing is low. The results raise important questions about theoretical interpretations of IPO underpricing in the U.S. We consider a broad range of competing, but non-mutually-exclusive, hypotheses about the reasons for underpricing and partial adjustment. Japans auction-method evidence is most consistent with a quasi-contractual allocation of risk related to initial mispricing. The risk allocation hypothesis is that, in exchange for guaranteeing a minimum price to the issuer, the underwriter participates indirectly in upside performance. The underwriter benefits from underpricing because underpriced IPOs are easier to place and because the underwriter can allocate small positions in the underpriced shares to preferred customers in implicit exchange for other benefits. As average underpricing in our sample is about three times as great as the underwriters fee, and as some IPOs are severely underpriced, we cannot exclude the possibility that underpricing is affected by agency cost and prospect theory considerations similar to those suggested by Ritter and Welch (2002) in their review of the U.S. IPO market.

What's in Your 403(B)? Academic Retirement Plans and the Costs of Underdiversification

Many college and university 403(b) plans restrict investment choices to the funds offered by TIAA-CREF, the current manager of over half of all 403(b) contributions. In the face of 2006 Internal Revenue Code changes some sponsors are dropping alternatives to TIAA-CREF. Using historical data, we study the efficiency of the TIAA-CREF opportunity set relative to a larger set that includes several standard index funds. Assuming optimal rebalancing, depending on loss-aversion, financial sophistication, and diversification constraints, over a forty-year work-life, an employee who is restricted to TIAA-CREF could lose more than half of terminal wealth, compared to investing in the expanded menu. Even when a naïve diversification strategy of equally weighting (1/n) all available funds is used, the expanded menu outperforms the restricted portfolio by about one-third over the employees work-life.

The Application of Errors-in-Variables Methodology to Capital Market Research: Evidence on the Small-Firm Effect

Errors in variables due to nonsynchronous trading and benchmark error are significant problems for capital market research. This paper develops the use of direct and reverse regression to bound true coefficient estimates when the data exhibit error structures arising from these two sources both separately and jointly. The approach appears to have broad applicability for capital markets research. As an example, the paper reexamines the small-firm effect to show that it cannot be attributed to nonsynchronous trading or benchmark error in the estimated variance of the market portfolio. This result is shown to hold even when the tax-selling effect is controlled for by excluding January returns.