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Journal of Banking & Finance
journal homepage: www.elsevier.com/locate/jbf
Earnings management, market discounts and the performance of private equity placements An-Sing Chen a, Lee-Young Cheng a,*, Kuang-Fu Cheng b, Shu-Wei Chih c a
National Chung Cheng University, Department of Finance, 168 University Rd, Min-Hsiung, Chia-Yi, Taiwan, ROC Kao Yuan University, Department of International Business, 1821 Jhongshan Rd, Lu-Jhu, Kao-Hsiung, Taiwan, ROC c Deloitte, 2 Chungcheng Rd, Kao-Hsiung, Taiwan, ROC b
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Private equity placement data allow us to determine whether sophisticated investors can uncover the true value of ﬁrms. This can be done by deﬁning sophisticated investors as those who meet the stringent participation requirements of the private equity market. Our results show private equity issuing ﬁrms overstate their earnings in the quarter preceding private equity placement announcements and that sophisticated investors do not ask for a fair discount when purchasing the shares of the private issuing ﬁrms. We also ﬁnd evidence showing that the reversal of the effects of pre-issue earnings management is a signiﬁcant determinant of the long-term performance of private issues. Results further show that post-issue stock performance and operating performance of ﬁrms using ‘‘aggressive” earnings management signiﬁcantly underperform those using more ‘‘conservative” earnings management. Ó 2010 Elsevier B.V. All rights reserved.
Article history: Received 28 February 2008 Accepted 29 December 2009 Available online 4 January 2010 JEL classiﬁcation: G14 G24 G30 Keywords: Private equity placements Earnings management Long-run stock performance Operating performance
1. Introduction Valuation of corporate securities can inﬂuence the decision and timing of ﬁrm’s ﬁnancial transactions. Extant studies in the securities issuance literature (Myers and Majluf, 1984) argue that when raising capital in the presence of information asymmetry, overvalued ﬁrms may choose to raise equity capital. Ritter (1991) and Loughran and Ritter (1995) argue that windows of opportunity exist when a ﬁrm’s equity is overpriced with respect to managers’ private information. They claim that long-run stock underperformance may result from the selling of overpriced equity and the failure of market participants to incorporate all information conveyed in the announcement. However, unlike the public offerings that have both negative short-term and long-term abnormal stock returns, private equity placements have better short-term but poor long-run stock returns (Hertzel et al., 2002; Krishnamurthy et al., 2005).1 Hertzel * Corresponding author. Tel.: +886 5 272 0411x34207; fax: +886 5 272 0818. E-mail addresses: ﬁnasc@ccu.edu.tw (A.-S. Chen), ﬁnlyc@ccu.edu.tw (L.-Y. Cheng), firstname.lastname@example.org (K.-F. Cheng), Jamesschih@deloitte.com.tw (S.-W. Chih). 1 One possible explanation for this anomaly, suggested by Hertzel et al. (2002), is that the poor long run performance may be caused by the overvaluation at the time of the private placements. Other possible explanations for the post-placement underperformance include: (1) agency problems (Barclay et al., 2007) and (2) overoptimism (Marciukaityte et al., 2005). 0378-4266/$ - see front matter Ó 2010 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankﬁn.2009.12.013
et al. (2002) ﬁnd that the mean three-year buy-and-hold abnormal return after private equity placement is À23.78%. The negative long-run abnormal stock returns are so large that one wonders why investors2 buy these stocks. By deﬁning sophisticated investors as those who meet the stringent participation requirements of the private equity market, private equity placement data combined with accurate measures of earnings management allow us to determine whether sophisticated investors can uncover the true value...