Going-Private Restructuring and Earnings Expectations:

A Test of the Release of Favorable Information for Target Firms and Industry Rivals*

Jeremy Goh

Associate Professor of Finance

Singapore Management University

Michael Gombola**

Professor of Finance

Drexel University

Feng-Ying Liu

Professor of Finance

Rider University

De-Wai Chou

Assistant Professor of Finance

National Chung Cheng University

Printing Date: September 30, 2002

*A previous version of this paper received the award for “Outstanding Paper in Corporate Finance” by the Eastern Finance Association at its 2002 annual meeting.

**Corresponding author: Michael Gombola, Department of Finance, Drexel University, Philadelphia, PA 19104. Tel. (215) 895-1743. Fax (215) 895-2955.

E-mail:.

Going-Private Restructuring and Earnings Expectations:

A Test of the Release of Favorable Information for Target Firms and Industry Rivals

Abstract

This research documents that analysts significantly revise upward their forecasts of earnings for targets of going-private bids subsequent to the announcement of going-private restructuring. These upward forecast revisions are significantly related to the stock price reaction to the announcement. Potential tax savings and the reduction of agency costs associated with going private restructuring do not appear to explain these upward forecast revisions. Analysts also significantly revise upward their forecasts of earnings for industry rivals of targets of going-private bids. Furthermore, these upward forecast revisions for rivals are significantly related to the stock price reaction for rivals. Forecast revisions for rivals are not related to proxies for agency costs or potential tax benefits of leverage. Overall, our results provide evidence supporting the hypothesis that going-private announcements convey favorable information about future earnings of targets of going-private bids as well as their industry rivals.

Key words: Going-private restructuring; Information transfer; Earnings expectations

Going-Private Restructuring and Earnings Expectations:

A Test of the Release of Favorable Information for Target Firms and Industry Rivals

1. Introduction

Previous empirical studies examining the announcement effects of going-private restructuring on stock returns document a positive announcement period abnormal stock return. (e.g., DeAngelo, DeAngelo and Rice (1984), Lehn and Poulsen (1989), Marais, Schipper and Smith (1989) and Slovin, Sushka and Bendeck (1991)). This empirical finding is consistent with several explanations or hypotheses. These explanations include: (i) revelation of favorable private information about the future earnings and cash flows of the company to be taken private (the information hypothesis); (ii) mitigation of agency problems of free cash flow to be realized when the company is taken private (the free cash flow hypothesis); (iii) potential tax savings associated with financing the transaction (the tax benefits hypothesis); and (iv) wealth redistribution from bondholders to stockholders as the bondholders bear more risk of the private company (the wealth transfer hypothesis). The observed positive abnormal stock returns could result from any of these hypotheses or a combination of them.

In this study, we examine the information content of going-private transactions. We test the hypothesis that announcements of going-private transactions convey favorable information to the market about earnings prospects for targets of going-private bids. To test the hypothesis, we use analysts’ forecasts of future earnings as a proxy for investor expectations, and examine monthly revisions of analysts’ forecasts of future earnings around the going private announcement. Examining analysts’ revisions of earnings forecasts can provide direct evidence on the information hypothesis - that the wealth effect of going-private transactions results from information about earnings prospects for companies to be taken private.

This hypothesis predicts an upward revision of earnings forecasts by analysts subsequent to announcement of going-private restructuring. A positive correlation between the announcement-period stock returns and earnings forecast revisions would provide further support for the information hypothesis. A positive correlation, however, cannot completely rule out the contribution of other explanations to the observed positive stock price return associated with a going-private announcement. In further analyses, we control for the potential effect of mitigation of agency problems, tax savings, and potential contaminating information.

We find significant and positive abnormal forecast revisions for current-year earnings of target firms. We also find a significant positive relation between abnormal earnings forecast revisions for target firms and the abnormal stock return around the announcement of going-private transactions. This relation remains even after controlling for the potential effects of free cash flow and tax benefits of debt, as well as other contaminating information. Furthermore, results show that neither the announcement period stock returns nor the earnings forecast revisions subsequent to the announcement can be explained by the target’s free cash flow or its potential tax benefits of debt. Our results provide strong support for the hypothesis that going-private announcements convey favorable information about earnings prospects of target firms.

Slovin, Shushka, and Bendeck (1991) argue that financial markets could perceive the private information revealed in the announcement of going-private restructuring as industry-wide, rather than firm-specific. They document a significant announcement-period abnormal return of 1.32 percent for industry rival firms and conclude that the financial market perceives the information conveyed in the announcement of going-private transactions as industry-wide. As indicated by Slovin, Shushka and Bendeck (1991), their finding of intra-industry valuation effect of a going-private announcement could result from any of three contributing factors: (1) private information revealed about improved earnings and cash flows for industrial rivals (i.e., intra-industry information effects), (2) increased probability of takeover bids for rival firms in the same industry (i.e., intra-industry takeover probability effects), and (3) the potential for ameliorating the agency problems of free cash flow for other firms in the industry, in response to a takeover bid (i.e., intra-industry agency problem effects). The observed positive stock price reaction to a going-private buyout bid for industry rivals could be consistent with any of these effects or a combination of them.

In this study, we test the hypothesis of intra-industry information effects by examining revisions in analysts’ earnings forecasts for rivals of going-private bids. By testing earnings forecast revisions of rival firms, we extend the study by Slovin, Shushka and Bendeck (1991) in narrowing down the factors contributing to stock price effects on rival firms. Upward earnings forecast revisions for rival firms would provide direct evidence supporting the intra-industry information transfer explanation. An information transfer to rivals must originate with information about target firms. Therefore, evidence in support of an intra-industry information transfer effect would also provide support for the information hypothesis for target firms. Upward earnings forecast revisions for rivals would not support the other two explanations of a positive stock price reaction. An increased probability of takeover for industry rivals could produce a positive price reaction for these firms, but should not produce an upward revision in earnings forecasts for rivals, particularly for current-year earnings. The potential for industry-wide reduction in agency problems of free cash flow could possibly be associated with eventual improvements in earnings forecasts if management preemptively improves earnings performance in response to increased takeover probability. Although eventual earnings improvements could be observed, it is doubtful that analysts would immediately revise earnings forecasts upward due to the possibility that management could potentially reduce agency problems and improve earnings in an attempt to thwart a takeover.

Consistent with Slovin, Shushka and Bendeck (1991), we find significant, positive abnormal returns for rival firms around the announcement of buyout bids. We also find rival firms experience significant upward revisions in analyst forecasts of current-year earnings and five-year earnings growth. In addition, we find a significantly positive relation between forecast revisions (both current-year earnings and 5-year earnings growth) and abnormal returns for rival firms. This relation remains significant even after controlling for other variables, including the free cash flow of rivals, debt capacity of rivals, relative size of targets and rivals, and identity of the acquirers, as well as potentially contaminating information. Overall, our results for rival firms provide strong support for the hypothesis that going-private announcements convey industry-wide favorable information about earnings prospects.

2. Hypotheses and Related Literature

2.1. Hypotheses for Shareholder Gains of Target Firms

2.1.1.Mitigation of Agency Problems

Jensen (1986) suggests that corporate restructuring, such as going private transactions, can be motivated by value enhancement engendered by reduction of agency costs otherwise prevalent in firms owned by atomistic shareholders. By taking a firm private, the new concentrated ownership group imposes discipline resulting in reduced overinvestment, and reduced management perquisites unrelated to job performance. When investors recognize the prospect of increased efficiency in investment and management, the market reacts positively to the going-private announcement.

In a test of this hypothesis, Lehn and Poulsen (1989) report a significant relation between a firm's free cash flow and the takeover premium. They also find that free cash flow is a predictor of the probability of a firm being taken private. A later study by Halpern, Kieschnick, and Rotenberg (1999) examines a sample of firms with dysfunctionally low managerial ownership prior to going private and finds no evidence of agency problems of free cash flow. To the contrary, this group of firms exhibits lesser investing activity and lower free cash flow than a matched sample of public firms or a matched sample of target firms in mergers.

Examining a sample of firms with high managerial ownership prior to going public, Halpern, Kieschnick, and Rotenberg (1999) also find no evidence that mitigation of agency problems is a major motivating factor in taking these firms private. Instead, managers increase their proportionate holdings in the firm while at the same time they reduce their dollar holdings in the firms taken private. By substituting external debt for their own equity, managers “cash out” of the firm taken private and increase their ability to diversify personal portfolios.

2.1.2.Tax savings

Wealth gains observed in going-private transactions could result from tax advantages associated with this form of corporate restructuring. As detailed by Kaplan (1989), and Lowenstein (1985), these tax advantages include the deductibility of interest payments associated with increased debt, increased deduction for depreciation, and the tax advantages of financing the transaction with employee stock ownership plans. Kaplan (1989) finds that tax benefits are an important source of the wealth gains for a sample of management buyouts. He concedes, however, that companies could obtain many of the same tax benefits without going private.

Further analysis of tax consequences of going-private transactions by Weston, Siu, and Johnson (2001) reveals potential tax disadvantages of going-private transactions. These disadvantages include capital gains tax paid by selling shareholders and taxes paid by the firm on gains from asset sales as well as higher income taxes paid by the firm if it can increase its earnings through efficiencies. Consequently, they conclude that the overall tax consequences of a going-private transaction could be indeterminate.

Unused tax advantages of debt financing do not appear to be unique to firms taken private. Examining a sample of firms taken private, Halpern, Kieschnick, and Rotenberg (1999) find no difference either in debt utilization or in tax expenditures between firms later taken private and a matched sample of firms that remain publicly held. Consequently, they find no evidence that would suggest that firms taken private are unique in their ability to enjoy the tax consequences of the transaction.

2.1.3.Wealth transfer

Since going private transactions are often financed through large increases in debt, the financing could have an ancillary effect of wealth transfer between bondholders and stockholders. This wealth transfer could explain (at least in part) the wealth effect in going private transactions. Lehn and Poulsen (1988) find that the effect of a going private restructuring on the value of debt securities is not significant. Marais, Schipper and Smith (1989) also find an insignificant price effect on nonconvertible debt. Asquith and Wizman (1990), however, report losses to bondholders of firms that are taken private.

2.1.4. Undervaluation and information asymmetry

The undervaluation or information asymmetry explanation for the positive stock price effect observed in going private transactions stems from differences between insiders (“informed

shareholders”) and outsiders (“uninformed shareholders”) in their expectations of future earnings and the true value of the firm. By tendering a premium-price takeover bid, the buyout group, who are typically either incumbent management or buyout specialists, reveal their private information.

Halpern, Kieschnick, and Rotenberg (1999) show that targets of going-private transactions are underperformers in earnings and stock price performance. Due to the underperformance, it is plausible that expectations for these companies have been revised downwards, perhaps overly so. Overdone pessimism could result in underpricing. Insiders, who have a better understanding of future prospects, can capitalize on temporary underpricing, by taking the firm private. At a later date, when the true prospects for the firm are better apparent to investors, the firm can be taken public again to the profit of the group that has not succumbed to the pessimism. DeGeorge and Zeckhauser (1993) show that after being taken private, firms outperform their counterparts both in terms of accounting returns and stock price performance.

Insider trading prior to going-private announcements can provide an indirect test of the information hypothesis. Harlowe and Howe (1993) and Kaestner and Liu (1996) find that insiders of firms taken private engage in significant abnormal buying prior to the going-private announcement. Kaestner and Liu also show that the insider buying is not related to either potential tax savings or free cash flow of the target firm. It could, however, be in anticipation of a premium-price transaction. This study provides a more direct test of the information hypothesis by testing earnings forecast revisions associated with a going-private announcement, since earnings forecasts are a more direct measure of prospects of the firm to be taken private.

2.2.Industry-Wide Information Effects

2.2.1. Favorable Private Information about Future Earnings Prospects of Rivals

Foster (1981) describes the information transfer from an announcing firm to other firms within an industry. Similarly, Szewczyk (1992) demonstrates how announcement of a stock offering can lead to price reactions for similar firms. Likewise, Asness and Smirlock (1991) describe how REIT bankruptcies affect valuation of all firms in the industry. In all of these cases, the announcing firm generates information that is not only firm-specific but also industry-wide.

Industry-wide revision of expectations could transpire in response to a going-private announcement. If a going-private bid reveals private information about earnings prospects of a target firm, this favorable information could transfer to other firms within the same industry. The conjecture of industry-wide information effects is supported by evidence that multiple going-private transactions within the same industry are commonly observed, to the extent that industries could be considered subject to “buyout waves” (Ambrose and Winters, 1992).

Just as earnings forecasts can provide a direct test of the information effect for target firms, it can also provide a direct test of intra-industry information transfer for rival firms. This intra-industry information transfer effect predicts a positive revision in earnings forecasts for rival firms. It also predicts a positive relation between the positive stock price reaction shown by Slovin Shushka and Bendeck (1991) for rival firms and their earnings forecast revisions.

2.2.2. Industry-Wide Reduction in Agency Problems of Free Cash Flow

A takeover aimed at reducing the agency problems of free cash flow for one firm within the industry could provide information about industry-wide agency problems and their potential for attenuation. The ultimate effect on stock prices is not clear, however. If investors were previously unaware of agency problems within the target firm and the industry, then the discovery of such agency problems could lead to a negative stock price reaction and industry-wide downward revision in earnings forecasts.

If investors view a takeover bid in the industry as an indication of the potential for reducing known industry-wide agency problems, then the shareholder wealth effect for rivals could be positive. The positive price response could impound the future benefits of reduced agency problems either through other takeovers within the industry or pre-emptive reduction in agency costs in an effort to thwart future takeovers. In either case, the agency cost reduction might not be immediate. Even though far off in the future, the prospect of industry-wide reduction in agency costs could result in stock price improvements.

2.2.3. Increased Probability of Takeover for Rivals

An increased probability of future control bids within the industry could affect stock prices industry-wide solely due to the premium price at which going-private transactions are accomplished. For example, in the case of a twenty percent takeover premium, a ten percent increase in the probability of takeover for rival firms would increase the expected value of takeover premium by two percent of stock price and lead to a two percent price reaction for rival firms. Such a price increase for rivals could be observed even if the target’s assets are liquidated or put to use in another industry.

If the positive stock price reaction for rival firms shown by Slovin, Shushka, and Bendeck (1991) is due solely to increased probability of takeover bids industry-wide, there should no evidence of significant upwards earnings forecast revisions for rival firms. Likewise, there should be little association between the stock price reaction and earnings forecast revisions for rivals. A significant stock price reaction in the absence of significant upwards earnings forecast revisions for current-year earnings would be consistent with the hypothesis that the price reaction is due to increased probability of takeover for rivals or the hypothesis that the price reaction is due to industry-wide reduction in agency problem of free cash flow.