Earnings management and performance of management buyouts

Abstract

Purpose The purpose of this paper is to examine the effect of pre-acquisition earnings management on the performance of private firm management buyouts. Design/methodology/approach The study examines 291 UK private firms acquired by their managers between 2004 and 2012. Earnings management is investigated by means of cross-sectional discretionary accruals models, and estimated discretionary accruals are regressed on performance changes in the three years following acquisition. Findings Management buyouts of private firms are preceded by earnings overstatement and followed by performance deterioration. Private equity sponsored firms engage less in earnings management and remain more profitable than non-sponsored buyouts. Upward earnings managers cease to outperform industry after second post-buyout year, while aggressive earnings managers do not outperform industry at all. Discretionary total accruals are inversely associated with performance changes in the three years after buyout, and explain over 4 per cent of the changes in performance. Research limitations/implications Pertinent to the utilisation of private firms and their exemption from publishing cash flow statement, the study relies on accrual-based models for tests of earnings management. Originality/value The paper contributes to the mergers and acquisitions literature and value creation debate in buyouts by providing the first tests of earnings management and post-acquisition performance in private firm management buyouts.