Despite good stock performance before private equity placements and positive market reaction to placement announcements, equity-placing firms display particularly poor post-placement performance. To explain this investor overoptimism at the time of private placements of equity, we present a projection argument in which investors project the performance observed for other firms onto firms with highly uncertain growth opportunities. Consistent with our argument, we find private equity issues concentrated among firms whose values consist largely of uncertain growth opportunities. Equity issuers frequently are relatively small, have
little history, and are in the developmental stage of their life cycles. As projection
is more likely when there are many examples of extraordinary performing firms
encouraging optimism in investors, we create an investor optimism proxy based on
the prevalence of exceptionally good performers in the market. In support of the
projection argument, we find that the market reaction to placement announcements
is more favorable and post-placement underperformance is larger when the market
is most optimistic.
Our findings contribute to the understanding of how investor biases affect stock prices and how those biases are formed. The method of predicting market overoptimism based on the past experience of other firms can be applied to examine stock price underperformance after other events and to examine overoptimism in the market in general.