Earnings Management and Long-Run Stock Underperformance of Private Placements

INTRODUCTION This study seeks to accomplish two goals regarding the issuance of seasoned private placements of common equity (hereafter, private placements): (1) to investigate managers' earnings manipulation behavior of U.S. issuers around the time of the issuance; (2) to examine whether such earnings manipulation behavior helps explain the long-term post-issue stock underperformance. Private placements, together with seasoned public offerings of common equity (SEO), are two important vehicles by which public firms obtain equity financing. Contrary to seasoned public offerings of common equity, which issue new equity to the general public, private placement issuers sell new equity to a restricted number of investors. More than 30 percent of seasoned equity financing from external investors in recent years has come from private placements (Federal Reserve Bulletin, see Appendix A). While there is a sizeable body of literature on earnings management around the time of seasoned public offerings and on the issuers' post-issue stock underperformance, research on these issues related to private placements is scarce. Studies on earnings management constitute an important research stream in the literature about the quality of earnings. Typical research methodology on earnings management first identifies a firm-specific event around which managers' incentives to engage in opportunistic earnings manipulation appear to be strong, then employs various accrual models to test the researchers' earnings management hypotheses (Healy and Wahlen 1999). In response to the call of Dechow and Skinner (2000) for further research on earnings management incentives around the time of securities issuance, this study examines, among other things, earnings management around the time of private placement, an important corporate event. Earnings have been widely used by investors to assess firm value and security offerings provide a direct incentive to manipulate earnings (Dechow and Skinner 2000). Managers of an issuing firm could use the accounting methods allowed under generally accepted accounting principles (GAAP) to inflate reported earnings at the time of the issuance in an attempt to portray a rosy picture of the firm's prospects. To the extent that such income-increasing accounting choices are not detected by investors, managers may obtain more favorable terms when selling new shares, thus gaining direct monetary benefits for themselves and the firm. Existing literature provides an abundance of evidence of earnings management around the time of various types of security issues, particularly initial public offerings (Aharony et al. 1993; Friedlan 1994; Teoh et al. 1998a; DuCharme et al. 2001), seasoned public equity offerings (Teoh et al. 1998b; Rangan 1998), convertible bond issues (Margetis 2004), and stock-for-stock mergers (Erickson and Wang 1999). Since private placement is one of the most important sources of corporate financing, this study predicts that managers of the issuing firms have strong economic incentives to inflate reported earnings around the time securities are issued. This study finds that managers of U.S. private placement issuers tend to engage in income-increasing earnings management around the time of the issuance. The mean and median of the discretionary accruals, the proxy for earnings management, of 348 sample firms from 1989 to 2001 are 3.27 percent and 2.49 percent of total assets in the year prior to the issue year. To eliminate the impact of other influencing factors, the study employs a control sample consisting of firms matched on size and leverage in the same industry of the issuing firms. In the year prior to the private placements, the discretionary accruals of the issuing firms significantly exceed their non-issuing peers by 3.99 percent in mean and 1.98 percent in median. Issuing private placements could be an endogenous choice. To mitigate this self-selection bias, the study also adopts the propensity score matching method to form the control sample. …