One of the primary rationales in favor of regulating disclosure is that more information may create positive externalities, or spillover effects, by helping investors learn about industry- or economy-wide trends and growth opportunities. In this way, a firm’s public disclosures informs investors not only about that specific firm’s prospects, but also about the prospects of related, peer firms. Thus, the more firms within an industry disclosing regular, publicly available information, the less uncertainty exists among investors regarding the value of all firms in that industry. Although the idea is intuitive, it has been difficult to empirically examine the existence of disclosure externalities. In a recent paper, we examine whether peer-firm disclosures affect the cost of capital of related firms in an industry and when such effects (if any) are most important.
We propose that disclosure externalities are time-varying in nature. That is, peer-firm disclosure is important when firm-specific disclosure is scarce. But as firm-specific disclosure increases, peer-firm disclosure becomes less important. One way to think about our argument is that peer-firm disclosures provide a signal about a related firm’s value, but this signal is noisy. Thus, the value of the signal obtained from peer-firm disclosures depends on investors’ other sources of information. Our intuition is that investors are more likely to rely on the signal generated by peer-firm disclosures when there is relatively less disclosure provided directly by a firm (either because the firm is newly public or because of regulatory constraints on its disclosures). However, investors valuing firms that disclose more information themselves and that have a longer time series of public disclosure are likely to put lesser weight on the signal generated from peer-firm disclosures.
We focus on the effect of peer-firm disclosures on related firms’ cost of capital to test our prediction. In particular, we use our insight to investigate how peer-firm disclosures affect a firm’s cost of capital the first time it accesses public debt and equity markets. Since private firms are not subject to SEC reporting requirements until they raise public capital, there is relatively little firm-specific information available about them in the public domain prior to their capital raising event. But once the firm has issued publicly traded securities, it is required to generate significant firm-specific information. Thus, there a significant change in the amount of firm-specific information available to investors from the time a firm initially raises capital to the subsequent years, making it a particularly powerful setting to examine the time-varying nature of disclosure externalities.
We begin by examining private firms that issue public bonds for the first time. We find that in industries with greater peer-firm disclosures, the initial bond yields for these newly public firms are substantially lower than yields for firms in industries with lower peer-firm disclosures. We then track bond yields over time as the securities are traded on the secondary market, and we find that over the three years following registration with the SEC, the effect of peer-firm disclosures on the yield fades away into insignificance. Specifically, we find that peer-firm disclosures lower bond yields by 15% for first-time capital raisers in the year of issuance but this effect declines to 2% by the third year post issuance. This result is consistent with peer-firm disclosures reducing investor uncertainty when there is relatively little firm-specific information available, but becoming less important as more firm-specific information is produced.
We show a similar effect in the equity market, where firms transition from private to public via an initial public offering of equity (IPO). In the first year after going public, IPO firms in industries with greater peer-firm disclosure have significantly lower bid-ask spreads than their counterparts in industries with less peer-firm disclosure. But this effect fades away during the three years following the IPO date. This is exactly the same pattern we observe in the bond market setting.
Finally, we test whether the effect of peer-firm disclosure increases when firm-specific information decreases due to exogenously imposed disclosure restrictions. We examine the period surrounding seasoned equity offerings (SEOs), during which firms are restricted from freely disclosing information due to gun-jumping laws (before 2005). Prior research finds that investor uncertainty increases during this SEO “quiet period,” which manifests in higher bid-ask spreads. We find that peer-firm disclosure becomes more important during the quiet period, substantially mitigating the rise in the bid-ask spread. Further, we find that the effect of peer-firm disclosure during the quiet period disappears following the enactment of the Securities Offering Reform in 2005, which relaxed the quiet period disclosure restrictions.
Our findings are important because they provide evidence that peer-firm disclosures have externalities and because they highlight a novel feature of disclosure externalities – i.e., their time-varying nature. Our evidence points to specific times when peer-firm disclosure is most valuable to investors, and we are able to better identify the existence of disclosure externalities with respect to the cost of capital.
The preceding post comes to us from Nemit Shroff, Associate Professor of Accounting at MIT Sloan School of Management, Rodrigo S. Verdi, Associate Professor of Accounting at the MIT Sloan School of Management and Benjamin P. Yost, PhD candidate at the MIT Sloan School of Management. The post is based on their article, which is entitled “Inter-Temporal Variation in the Externalities of Peer-Firm Disclosures” and available here.