Unobservable Risk Preferences and Value of Information in Financial Markets with Adverse Selection

Abstract

We demonstrate the existence of a partially separating equilibrium based on the level of equity retention when a project of unknown value is taken public by an entrepreneur whose risk preferences are unobservable. We show that any such equilibrium results in some (endogenous) strictly positive level of equity retention. The value of a second public signal corresponding to audited reports required under the 1933 Securities Act is also analyzed. We show that this second signal derives informational value from the presence of unobservable risk preferences even though it only concerns cash flows and is completely independent of risk characteristics. The paper concludes with some empirical implications.