Earnings Management and Stock Performance of Reverse Leveraged Buyouts via CSInvesting
De-Wai Chou
Assistant Professor of Finance
Yuan Ze University
Michael Gombola
Professor of Finance and Department Head
Drexel University
E-mail:
Feng-Ying Liu
Professor of Finance
Rider University
Date: January 30, 2005
Abstract
This study provides further evidence of earnings management around security offerings. We find positive and significant discretionary current accruals coincident with offerings of reverse LBOs. Issuers in the most “aggressive” quartile of earnings management have a one-year aftermarket return that is between 15 percent and 25 percent less than the most “conservative” quartile. We also find a negative and significant relation between abnormal accruals and post-issue abnormal returns within the first year after the offering. The relation remains even after controlling for book-to-market ratio, firm size, offering size and involvement of buyout specialists or management. Although earnings management has been used to explain post-issue long-term underperformance of IPOs and SEOs, our study shows that earnings management can explain post-offering returns of reverse LBOs, even in the absence of post-offering underperformance.
Earnings Management and Stock Performance of Reverse Leveraged Buyouts – Introduction
Evidence of poor long-run stock price performance following security offerings is documented for IPOs (Ritter (1991)), SEOs (Loughran and Ritter (1995), and Spiess and Affleck-Graves (1995)), and private placements of equity (Hertzel, Lemmon, Linck, and Rees (2002)). One explanation for the poor post-offering performance is the managerial opportunism hypothesis of earnings management presented by Teoh, Welch and Wong (1998a), (1998b), which posits that information asymmetry between investors and equity issuers provides opportunity for managers of issuing firms to manipulate, or at least manage, earnings upward around the offering in order to report higher earnings and sell equity at a higher price. Because higher pre-offering earnings must be borrowed from future income, the stock price suffers when earnings management reverses and future earnings are lower. This hypothesis therefore predicts a negative relation between pre-offering earnings management and post-offering stock returns.
Evidence of earnings management around IPOs is provided by Teoh, Welch and Wong (1998a) and DuCharme, Malatesta and Sefcik (2004), around SEOs by Rangan (1998), Teoh, Welch and Wong (1998b), Shivakumar (2000), and DuCharme, Malatesta and Sefcik (2004), and for management buyouts by Perry and Williams (1994). Furthermore, Teoh, Welch, and Wong (1998a), (1998b) indicate that earnings management leads to, at least in part, the poor long-run post-offering underperformance of IPOs and SEOs. They report a negative and significant relation between the proxy for earnings management and post-issue stock price performance.
Reverse LBOs are a special form of IPO, where a company that has been taken private returns to public trading. In contrast to the underperformance following IPOs, SEOs, and private placements of equity, reverse LBOs do not experience long-run stock price underperformance following the equity offering. Degeorge and Zeckhauser (1993), Mian and Rosenfeld (1993), and Holthousen and Larcker (1996) find no evidence of underperformance following reverse LBOs. To the contrary, there is even some evidence of positive abnormal performance following a reverse LBO, as shown by Mian and Rosenfeld (1993) and Degeorge and Zeckhauser (1993).
This study is motivated, in part, by the sharp contrast in post-offering stock performance between reverse LBOs and other forms of equity issuance. Since Teoh, Welch, and Wong (1998a), (1998b) attribute the poor post-offering stock performance of IPOs and SEOs to earnings management around the offering, absence of poor post-offering performance for reverse LBOs could suggest absence of earnings management prior to the offering. The answer to the question whether managers of reverse LBO firms manage earnings to inflate offering prices becomes less obvious in the absence of poor post-offering performance for these companies. It is an empirical question whether managers of reverse LBO firms manage earnings.
If earnings management is observed around reverse LBOs, the question remains whether earnings management is attributable to managerial opportunism, as suggested by Teoh, Welch and Wong (1998a), or whether it is in response to investor expectations of earnings management around security offerings, as suggested by Shivakumar (2000). Since there is no evidence of underperformance following reverse LBOs, it is even more interesting to examine whether managers of reverse LBO firms manage earnings just like managers of firms issuing other types of equity (IPOs and SEOs), and whether earnings management and post-offering stock performance are cross-sectionally associated.
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