Swedroe: Beware IPO Earnings Management

It’s logical to believe that corporate managers have a preference for issuing equity at times when they perceive that their company’s stock price is overvalued, or high relative to some benchmark (such as price-to-earnings ratio or book-to-market ratio). What’s more, the academic research on the subject supports this hypothesis—seasoned equity offerings (SEOs) tend to be preceded by unusually high stock returns.

The literature also shows that there are incentives (such as concerns about current-period performance-based compensation, prospects for promotion, future employment, post-retirement benefits such as directorships, the potential for termination, and the hope that subsequent positive events will allow them to “bury” the negative news) that can lead to a tendency among corporate managers to hoard bad news. They withhold and accumulate bad news for an extended period of time, keeping stock prices temporarily higher (think of WorldCom and Enron).

One way to delay bad news is through the use of accruals. And one of the most well-known anomalies in finance is that stocks with high accruals underperform stocks with low accruals. However, bad news cannot be postponed indefinitely. When the accumulated bad news is eventually revealed (such as when accruals are reversed) the stock price crashes.

Understanding Managed Earnings
Yonca Ertimur, Ewa Sletten, Jayanthi Sunder and Joseph Weber—authors of the December 2015 study “When and Why Do IPO Firms Manage Earnings?”—contribute to the literature on companies delaying the publication of negative news by separately considering the incentives stemming from the two significant events that IPO firms experience within a short span of time: the IPO itself, and the lockup expiration (typically six months after the IPO). To do this, the authors examine quarterly (rather than annual) abnormal accruals before and after the IPO, enabling them to pinpoint the timing of the earnings management.

They begin by noting: “Initial public offerings (IPOs) are characterized by the inflow of significant capital. Approximately six months after the IPO, there is large-scale exit of pre-IPO shareholders when firm-imposed selling restrictions, known as lockups, expire. IPOs also entail high levels of information asymmetry between new investors and IPO firm insiders. Thus, the quality of financial reporting is particularly important for new investors. Opportunistic reporting by the IPO firm can lead to wealth transfers from new investors when they buy shares at the IPO or from pre-IPO shareholders at lockup expiration.”

The Timing Of Earnings Management

Ertimur, Sletten, Sunder and Weber then hypothesized: “IPO firms manage earnings before lockup expiration, not before the IPO, because pre-IPO shareholders can sell or distribute their holdings only upon lockup expiration. Thus their gains are increased by inflating the stock price at lockup expiration, rather than at the IPO, which affects the proceeds to the offering firm.”

The authors, who had data covering the period 1990 through 2013, first examined quarterly abnormal accruals around the IPO issue date. Consistent with prior studies, they didn’t find evidence of positive abnormal accruals in the quarter immediately preceding the IPO. But they did find “significant [at the 1% level] positive abnormal accruals in the quarter preceding and in the quarter of the lockup expiration.”

Firm Visibility Matters

The authors also performed an interesting test. They partitioned their sample into two groups based on visibility (as captured by firm size and analyst following). Their hypothesis was that more visible companies (those in the top quartile) would be subject to greater scrutiny. Thus, earnings management by these firms is more likely to be detected. Therefore, management would be less likely to engage in earnings manipulation through abnormal accruals.

They found “evidence of higher abnormal accruals in the quarter before and the quarter of the lockup expiration only among the less visible firms.” And the data was significant at the 1% level.

On the other hand, the authors found no statistically significant evidence of higher accruals for the high-visibility firms. Specifically, they found that firms subject to low scrutiny have positive abnormal accruals in excess of 1% of the firm’s average quarterly assets, while abnormal accruals at firms classified as subject to high scrutiny represent less than 0.1% of average assets.

Incentives Influence Behavior

Using a model to predict the amount of selling by pre-IPO investors, the authors also found evidence of a strongly positive relationship between abnormal accruals and the selling incentives of pre-IPO shareholders.

In this way, they provide “evidence of positive abnormal accruals at an opportune time but also link these accruals to an incentive for earnings management: inflating the selling price when pre-IPO shareholders sell shares.”

First-time sales by pre-IPO shareholders generate a large spike in trading volume, which initially increases to 185% of the previous average volume, before eventually settling at a level approximately 40% higher than the lockup period volume.

Interestingly, the authors found evidence of significant (at the 5% level) positive abnormal accruals in the quarter immediately before lockup expiration, when there is no insider trading activity. However, they did not find “a relation between abnormal accruals in the quarter before lockup expiration and incidence of net selling of shares by officers.”

Thus, they concluded that “managers do not seem to inflate earnings to benefit from trades personally, perhaps because of particularly high litigation risk associated with ‘pumping and dumping.’ Instead, their decision to inflate earnings is likely influenced by large, powerful pre-IPO shareholders and by the desire to maintain a positive outlook for the company at the time of expected high selling pressure.”

The authors hypothesize: “Executives are unlikely to pursue earnings management for their own trading profits, as they are subject to strong litigation risk. Consistent with litigation making the strategy of managers’ inflating earnings for their own benefit much less attractive, executives sell infrequently and only small quantities after lockup expiration.”

The authors also examined earnings management in the quarter of the lockup expiration. Their hypothesis was that “firms may manage earnings in the quarter of lockup expiration only when pre-IPO shareholders cannot sell enough shares between lockup expiration date and the next quarterly earnings announcement. Many firms impose so-called ‘blackout’ restrictions on trading by insiders. Influential pre-IPO shareholders, such as venture capitalists, angel investors and private equity funds, commonly serve on boards of directors, potentially subjecting them to blackouts. Blackouts typically begin at or before the end of the fiscal quarter and end after earnings are announced. When the period between lockup expiration and the fiscal period-end is not sufficiently long, pre-IPO shareholders will have to postpone most of their selling to the subsequent quarter. Thus, in these cases, we expect earnings management to shift from the quarter before lockup expiration to the quarter afterward.”

They found evidence of this behavior and concluded: “The shift in positive abnormal accruals from the quarter before to the quarter of lockup expiration, depending on when trading is likely to happen, underlines the importance of selling incentives in earning management around lockup expiration.”

Long-Term Performance

Ertimur, Sletten, Sunder and Weber also examined whether the management of earnings affected the long-run performance of IPOs. Their hypothesis was that accruals eventually reverse, leading to long-run negative abnormal returns.

They found: “Firms with high accruals earn significantly negative returns over the one, two, and three years following lockup expiration. Firms with low accruals do not experience significantly negative returns, and the difference in returns between the two groups is significant over all windows.” For example, the difference in returns between firms with below-median accruals and firms with above-median accruals in the first year was greater than 18%.

Conclusion

The findings in this study provide strong evidence that companies manage earnings around the lockup expiration date, rather than before the IPO. This enables pre-IPO shareholders to sell their shares at more favorable prices.

However, the evidence of positive abnormal accruals holds only in cases when pre-IPO shareholders are expected to sell shares; the timing of these accruals shifts depends on when the sales are likely to happen. The research shows as well that companies take into account litigation risk and market scrutiny when making reporting choices—the most visible firms do not manage earnings.

The important takeaway is that “the incentive to manage earnings in anticipation of sales by pre-IPO shareholders implies that positive abnormal accruals result in inflated stock prices.” Over time, as more information about “true earnings” is released, stock prices will be negatively impacted. Thus, firms with high abnormal accruals in the period prior to the end of the lockup will tend to have lower long-run returns compared with firms with low abnormal accruals. Buyer beware.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.