Accounting Performance Inflated by Private Equity before IPOs: Evidence from Chinese Firms

How does private equity (PE) investment affect recipient firms? Existing research based on firms in mature financial markets (hereafter mature firms) has documented three possible mechanisms: First, PE investment brings in new financing to the firm, which releases financial constraints faced by the firm and supports the firm’s real activities (e.g., Brown and Floras, 2012). Second, PE investment improves corporate governance of the recipient firm because PE investors being the firm’s new shareholders will strengthen the monitoring of managers and influence the firm’s decision making (e.g.,Wright et al.,2009). Third, PE investment sends a positive signal about the recipient firm’s future perspectives to outside potential investors (e.g., Megginson and Weiss, 1991;Janney and Folta, 2003). Among these possible mechanisms, the governance role of PE has been at the center of discussion in the standard PE literature based on mature firms. This governance role is particularly documented for PE investment in the form of management buyouts (MBOs), in which top managers purchase the firm using private equity funds. Consequently, PE investors often hold a reasonably large amount of equity of the recipient firm after the transaction; hence MBOs normally result in a higher degree of ownership concentration of the recipient firm, which provides shareholders, including PE investors as the firm’s new shareholders, with stronger incentives to monitor the management (e.g., Wright et al., 2009).