Ebook Earnings management during lockup in explaining post-IPO operating underperformance
Research on initial public offerings (IPOs) generally suggests that company performance deteriorates after going public. For example, Aggrawal and Rivoli (1990) find that IPO long-run performance is worse than the market performance. They argue that the IPO long-run under performance may be result from fads or speculative bubbles in the early aftermarket stage. Ritter (1991) and Loughran and Ritter (1995) document that IPOs in the U.S. under perform significantly relative to non-issuing matching firms for three to five years after the listing date. Loughran, Ritter and Rydqvist (1994) even consider the IPO under performance is an international phenomenon. Many researchers have also documented a long-run decline in firms’ post-IPO operating performance. Jain and Kini (1994 and 1995), Mikkelson, Partch and Shah (1997) and Pagano, Panetta and Zingales (1998) have done so for the U.S. market. They indicate that long-run return performance is also accompanied by poor accounting performance post-IPO relative to pre-IPO performance and/or industry conditions. The received wisdom is that IPO firms tend to perform poorly after the offerings in the operating respect.
This study conjectures that earnings management behavior during lockup is crucial to the pattern of aftermarket operating under performance. The lockup ensures that the insiders wealth is connected to the fortunes of the IPO firm for a regulated period of time, and thus prompts insiders to overstate their profitability in lockup period by engaging earnings management (Teoh, Wong and Rao, 1998; Huang and Lin, 2007). In addition, Teoh et al. (1998) and Teoh, Welch and Wong (1998a) document significant positive discretionary accruals (DA) in the IPO year and the following year. Both the insiders incentive to preserve investors confidence in the newly established firm and the evidence of post-issue earnings management motivate the hypothesis that stock lockup plays an important role in explaining the pattern of post-issue deterioration in operating performance.
Intuitively, firms intensively window-dress their accounting numbers during lockup may have less capability of engaging in the same doings post lockup. Furthermore, the high reported earnings in lockup through DA management must be borrowed from future income. When earnings during lockup attributable to DA cannot be sustained, the reversal effect will leads to lower future earnings. Teoh et al. (1998) and Balsam, Bartov and Marquardt (2002) find a negative relationship between DA and post-issue stock returns, suggesting that investors naively fixate on pre-issue earnings without correcting for DA. Based on the similar reasoning, this study tests this relationship around lockup and hypothesizes that the DA in lockup is negatively correlated with the operating performance after lockup expiration.
In U.S., lockups are not required by law, but essentially almost all IPOs feature them. According to Rule 144 promulgated by U.S. Securities and Exchange Commission in 1988, insiders must fully expose the information publicized at present before the sale of restricted stock. Due to this stipulation, the issuing firm and the underwriter begin to set up the lockup as the means of self-regulation to ease the information asymmetry in the IPOs. Although the lockup period typically lasts for 180 days, it varies from IPO to IPO. Brav and Gompers (2003) find that firms associated with greater potential informational asymmetries lockup their shares for a longer period of time. Therefore, the U.S. IPO sample provides researchers an excellent opportunity to examine the association between earnings management and operating performance around lockup period. Our sample is 274 U.S. IPOs with lockup over the period of 1998 to 2006. We measure the magnitude of earnings management with DA in accordance with the performance-matching model developed by Kothari, Leone and Wasley (2005). Following Jain and Kini (1994), Barber and Lyon (1996), Loughran and Ritter (1997), Teoh et al. (1998a) and Shiah-Hou (2005), we select operating return on assets (OPROA) to proxy operating performance. The results indicate that the two-quarter period DA before lockup expiration is significantly higher than that after lockup expiration. Moreover, DA in lockup is negatively correlated with the OPROA after lockup expiration, revealing that the reversal of accruals in lockup plays a key role in explaining post-lockup under performance. We further find this negative association is mostly concentrated in IPOs (1) with smaller size, (2) not backed by venture capital, (3) operating in high-tech industry, and (4)issued in hot market.
This paper contributes to the literature at least in three ways. First, this is the first study examines the relationship between managers strategic behavior on lockup earnings management and the operating performance after lockup expiration, and thus increases the research perspectives for IPO earnings management, IPO under performance and stock lockup. Second, Jain and Kini (1994), Mikkelson et al. (1997) and Teoh et al. (1998) identify better operating performance in the offering year relative to the following two to four years. Besides, Teoh et al. document significant positive DA in the IPO year, but provide no motivation for the earnings manipulation behavior in the post-offering period. The evidence of the lockup earnings management found in this paper may help in explaining the above phenomenon. Third, the subsamples with the reverse relationship between lockup earnings management and the subsequent operating performance are in accordance with IPOs that literature has found to have the worse IPO performance, indicating the key role of lockup earnings management played in the aftermarket under performance. Overall, the evidence found in this paper shows that the earnings management in lockup is crucial to explain the post-lockup decline in operating performance. The next section describes the research method, variables and the sample. Section 3 presents the empirical results. Section 4 offers a conclusion.
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