The European Corporate Equity Puzzle

Why do equity issuances by non-financial companies in Europe remain minor? Using experimental data on firms from Europe, we analyse how firms trade off between debt and external equity financing. We find that firms are willing to pay a substantial premium on debt when presented with an equity participation as an alternative. Companies are willing to pay an interest rate that is about 8.8 pp higher than the cost of equity to obtain a loan instead of external equity. This preference for debt cannot be explained only by the more favourable tax treatment for debt, by fear to lose corporate control rights or growth expectations on their own. In fact, while remaining important explanations, those elements can explain only some 72% of the gap. There is thus something independent from profitability that might have to do with companies’ preference for already tested financing strategies. In fact, we observe a larger premium for those firms that are more suited to receive bank loans. This suggests that, at least to some extent, a financial sector dominated by bank finance has spurred a culture of debt. This in turn has led to a strong selection towards those firms that are most capable of flourishing under debt financing and, thus, have the strongest preference for this type of finance.