Earnings Quality and Ownership Structure: The Role of Private Equity Sponsors

by Sharon P. Katz

Overview — Although 99 percent of the companies operating in the United States are private, according to the American Institute of Certified Public Accountants, their accounting practices remain largely unknown due mainly to the lack of publicly available financial statements. In this study, HBS professor Sharon P. Katz used a unique database of firms with privately held equity and publicly held debt to examine how two different ownership structures-private equity sponsorship and non-private equity sponsorship-affect firms' financial reporting practices, financial performance, and stock returns in the years preceding and following the initial public offering (IPO). Key concepts include:

  • Despite their economic importance and the management expertise they bring, little is known about the role private equity (PE) sponsors play in their portfolio companies' accounting practices.
  • The presence of and monitoring by PE sponsors restrains upward earnings management and induces a higher frequency of timely loss recognition, both pre- and post-IPO.
  • Majority ownership by a PE sponsor is associated with better stock price performance relative to management-owned firms.
  • Larger PE sponsor size is positively associated with better long-term financial and stock price performance when a firm goes public.

Author Abstract

This study explores how firms' ownership structures affect their earnings quality and long-term performance. Focusing on a unique sample of private firms for which there is financial data available in the years before and after their initial public offering (IPO), I differentiate between those that have private equity sponsorship (PE-backed firms) and those that do not (non-PE-backed firms). The findings indicate that PE-backed firms generally have higher earnings quality than those that do not have PE sponsorship, engage less in earnings management, and report more conservatively both before and after the IPO. Further, PE-backed firms that are majority-owned by PE sponsors exhibit superior long-term stock price performance after they go public. These results stem from the professional ownership, tighter monitoring, and reputational considerations exhibited by PE sponsors. Keywords: conservatism, earnings management, private and public firms, private equity sponsors. 54 pages.

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