Lemons, or low-quality products that ruin markets, have shown up in numerous settings after economist George Akerlof introduced the concept in a landmark 1970 paper, using the market for used cars as his backdrop. The newest destination for lemons is the market for external finance, where firms issue equity capital to finance their investments.
In a recent paper, Wharton finance professor Thomas Winberry and colleagues show how private information that equity-issuing firms have about their quality (the true value of their assets) creates an information asymmetry between them and external investors.
That asymmetry creates a lemons problem because low-quality firms would like to raise equity in the same market as higher-quality firms to raise capital at more attractive prices. Investors anticipate this and treat equity issuance with suspicion, discounting the share price they offer. The ultimate consequence is that high-quality firms pull back on their equity issuance to avoid being pooled with the low-quality issuers, leaving good investment projects unfunded.
Winberry co-authored the paper, titled “Firm Heterogeneity and Adverse Selection in External Finance: Micro Evidence and Macro Implications,” with Xing Guo, principal researcher at the Bank of Canada, and economics professors Pablo Ottonello from the University of Maryland and Toni Whited from the University of Michigan.
The authors developed a methodology to measure the magnitude of the lemons problem and quantify its impact on the economy. The idea is simple: If stock prices reflect public information, then the change in a firm’s stock price when the firm announces it is raising equity reflects what the market just learned about its quality. To implement this idea, the authors tracked how prices change during 3,178 equity offerings between 1985 and 2018.
The findings of the study reveal how high-quality equity issuers face knocks on multiple fronts, which then lead to bigger macroeconomic impacts. The main result of the study is that “lemons shocks,” or changes in the distribution of private information over time, are an important determinant of aggregate investment fluctuations.
- A firm’s stock price falls by an average of 3.5% when it issues new equity. That price drop indicates that investors perceive that issuing equity is a negative signal about the firm’s quality, which reflects the lemons problem.
- Those perceptions prevent high-quality firms from taking full advantage of the equity market. If they were to issue the ideal amount of equity they would like, investors would assume the firm is lower quality than it claims. They accordingly price down the stock, which forces the firm to issue more shares for the same amount of capital it seeks. “[That happens because] investors worry about a worst-case scenario with lemons in the market,” Winberry explained.
- For a firm with the second-highest level of quality, that repricing is equivalent to a 4% tax, where a firm worth $100 per share would be able to raise only $96, according to the study. That tax jumps four-fold for a firm with the highest level of quality.
- The macroeconomic losses from this tax, or “lemons wedge,” are large. In the long run, this tax from private information lowers the aggregate capital stock in the economy by more than 5% and lowers GDP by more than 2%. In the short run, the dispersion of private information tripled during the 2007-2009 Great Financial Crisis. Lemons shocks caused a 7% decline in investment in that period, which accounted for 40% of the total decline in investment.
“Most of this lost investment is concentrated among the small, highly-productive firms that face the largest lemons wedge,” the paper stated. Therefore, heterogeneity among firms is critical to assessing the aggregate impact of private information, it noted.
“When a high-quality firm signals to external investors that it is actually a good firm and not a lemon, that is a costly signal because it isn’t raising as much money as it ideally would like to.”— Thomas Winberry
A Signaling Game on Capital Quality
“The presence of private information creates a signaling game between firms, who observe their capital quality, and external investors, who do not,” the paper stated. If a firm tries to raise a large amount of equity, investors wonder why the existing shareholders are willing to give up such a large stake in their firm. They rationally infer that insiders know the quality of their firm is low and offer an accordingly low price per share. The high-quality firms have too much to lose from being underpriced, so they raise less equity than they would under full information. That approach signals to the market that the quality of the firm’s existing assets is high.
“But when a high-quality firm signals to external investors that it is actually a good firm and not a lemon, that is a costly signal because it isn’t raising as much money as it ideally would like to,” Winberry said. “So there are these investment opportunities that go unfunded and are left on the table.”
As more and more high-quality firms pare down their equity flotations, the incentive for low-quality firms to issue alongside them weakens, and eventually disappears. The resulting inefficiencies in capital allocation is a “lemons wedge,” as the paper put it, which is the difference between market settings with full information and those with private information.
Could the information asymmetry problem be solved? “In our model, firms would love to provide the information to the market that they’re high quality,” Winberry said. “But there isn’t a credible way to do that other than not asking for too much money.”
Macroeconomic Impacts of Lemons
The macroeconomic consequences of that lemons spiral are depressed aggregate investment, reduced capital formation, and lower productive capacity, all of which hurt economic activity. The paper pointed out that aggregate investment is one of the most volatile components of GDP, especially during financial crises. Fluctuations in aggregate investment are concentrated among small firms which rely heavily on external finance for their investments, it added.
“The average stock price drop for firms issuing new equity gets a lot bigger in recessions.”— Thomas Winberry
Lemons shocks lead to significant declines in aggregate investment during recessions, as the authors found in their study of three recession episodes in the sample period, especially during the Great Financial Crisis. “The average stock price drop for firms issuing new equity gets a lot bigger in recessions,” Winberry said. “We view this contribution as large given the myriad other shocks hitting the economy at the same time,” the authors stated. Bouncing back from the Great Financial Crisis was not easy for the capital market: The study showed that investment fell approximately 18% peak-to-trough and took nearly four years to return to its pre-recession level.
Information Asymmetry a Timeless Challenge
Winberry said their paper’s findings bring clarity to a “timeless question” on the short-run and long-run costs of asymmetric information. “Asymmetric information is always there in the market, and it’s something that investors and firms try to work around in various ways,” he added. “There’s a vast amount of heterogeneity across firms in terms of their productivity and their capital structure, that it almost has to be that the firms have some private information about themselves that outsiders can’t observe.”
A proposal being considered in the U.S. to do away with quarterly reporting requirements for publicly listed firms would of course worsen the information asymmetry in the capital markets. “Information asymmetry has real costs for the economy in terms of lost investment,” Winberry said. “To the extent that [the] proposal would make the asymmetric information larger because firms don’t have to report as frequently, those would have larger costs,” Winberry said. If there are some benefits to be had from that proposal, they have to be weighed against the costs to increasing information asymmetries, he added.
