Earnings Management and Corporate Governance Mechanisms prior to Leveraged Buyouts in the UK

Abstract

This research examines the use of accruals (AEM) and real earnings management (REM), and how they are affected by corporate governance mechanisms preceding leveraged buyouts in the UK. The sample includes all UK leveraged buyouts of listed firms between 1997 and 2011, which covers the second wave of leverage buyouts in the UK. The research considers management buyouts (MBOs) and institutional buyouts (IBOs) separately, because managerial incentives regarding earnings management are expected to differ in these two settings.

The first empirical study investigates the existence of AEM, and how audit committee characteristics and external auditing quality affect AEM, prior to MBOs and IBOs. The findings suggest that managers engage in negative AEM prior to MBOs, possibly to reduce the perception of firm value, and thus depress the purchasing price of MBOs. The research finds no evidence that firms subsequently targeted in IBOs engage in AEM to a greater degree than non-buyout firms. This finding might be related to the fact that managers are unable to predict IBOs. Moreover, the research suggests that quality of audit committees and external auditing has a greater impact on AEM in IBO than in MBO firms.

The second empirical study explores the use of REM preceding MBOs and IBOs, and how block ownership and board characteristics affect it. Surprisingly, the findings suggest that managers pursue positive REM prior to both IBOs and MBOs. As firms targeted by IBOs tend to be undervalued compared to non-buyout firms, managers might engage in positive REM to improve the firm’s share price to reduce the risk of IBO bids. Positive REM prior to MBOs may serve to enhance prospective external financiers’ perceptions of the firm’s value to secure financing for MBOs, even though it is likely to increase the purchasing price of MBOs. The research also indicates a positive relationship between insider and outsider block ownership and REM.

While the findings for firms targeted by IBOs in first two empirical projects are consistent with the expectation that managers try to improve the perception of the performance and value of their firms, the findings for MBOs appear inconsistent and rather baffling. The third empirical study thus explores the puzzle of how decisions about AEM and REM are related in firms prior to IBOs and MBOs. The research reveals that, while AEM and REM have a complementary relationship preceding IBOs, prior to MBOs, AEM and REM have a substitutive relationship.

This thesis contributes to our understanding of earnings management prior to IBOs and MBOs. Moreover, the findings highlight that the impact of firms’ corporate governance characteristics on earnings management differs depending on the setting. This might be related not only to different managerial incentives but also to a lack of context awareness by directors or auditors.