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«Marc Deloof (submitting author) University of Antwerp Department of Accounting and Finance Prinsstraat 13 2000 Antwerp, Belgium Tel: +32-3-220 41 69 ...»

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Private Equity Investments and Disclosure Policy

Christof Beuselinck

Ghent University

Department of Accounting and Corporate Finance

Kuiperskaai 55E

9000 Ghent, BELGIUM

Tel: +32-9-264 35 15 Fax: +32-9-264 35 77

E-mail: Christof.Beuselinck@ugent.be

Marc Deloof (submitting author)

University of Antwerp

Department of Accounting and Finance

Prinsstraat 13

2000 Antwerp, Belgium

Tel: +32-3-220 41 69 Fax: +32-3-220 40 64

E-mail: Marc.Deloof@ua.ac.be

Sophie Manigart

Ghent University

Department of Accounting and Corporate Finance Kuiperskaai 55E 9000 Ghent, BELGIUM Tel: +32-9-264 35 08 Fax: +32-9-264 35 77 E-mail: Sophie.Manigart@ugent.be Private Equity Investments and Disclosure Policy Abstract We investigate whether a firm’s disclosure policy is affected by the changing corporate setting and intensified corporate governance associated with private equity (PE) investments.

First, we argue that a firm discloses more information to the outside world when raising PE finance. The information asymmetry problem that typically arises between a better-informed entrepreneur and outside PE investors gives rise to the lemons problem. In an attempt to resolve this problem, the best entrepreneurs signal their superior quality, and increased disclosure might be a valuable instrument to do so. Various studies have shown that financial figures are key determinants in screening and selecting portfolio companies, especially in Continental Europe. High quality entrepreneurs will showcase their financial reporting openness and professionalism to outsiders by increasing their disclosure levels. We therefore expect to find increased disclosure of financial information in the year before firms get PE.

Second, we argue that portfolio firms’ disclosure policies are affected by PE investors’ governance. This argument originates from the well-illustrated phenomenon that PE investors are close monitors of their portfolio firms. These monitoring efforts are particularly driven by the agency problem between PE investors and entrepreneurs-managers. As a response to this agency problem, PE investors are intensively involved in their portfolio firms’ day-to-day activities and contract a substantial number of controls like cash flow and control rights contingent upon observed performance measures. This strong PE investor involvement results in a substantial change in governance and positively affects the professionalism the firm is operating with. We hypothesize that this intensified governance and professionalization is noticeable in the way financial reporting is conducted and, as such, is manifested in a higher disclosure of financial information to outsiders.

For a unique large hand-collected sample of Belgian unquoted firms receiving PE financing, we observe a significant switch to increased financial disclosure in the pre-investment year, consistent with the hypothesis that entrepreneurs attempt to reduce information asymmetries inherent to the PE application by increasing their disclosure levels. Further, we document that from the PE investment year onwards, the governance and professionalization impact of PE investors affects their portfolio firms’ financial disclosure positively. Finally, differentiating on investor type (government versus non-government related) reveals no overall effect on disclosure, both in the pre- as in the post-investment years. Results are robust to various sensitivity checks.

JEL classification: G30, M10, M41 Keywords : Disclosure, private equity, unlisted firms, monitoring, corporate governance.

1. Introduction Since decades, corporate decisions to disclose information to outsiders have been of interest for both analytical and empirical accounting researchers. This issue is of major importance as economic theory suggests that a firm’s disclosure policy is negatively related to its cost of capital since disclosure reduces information asymmetries. Analytical studies have modeled the discretionary disclosure of information in various settings resulting in full disclosure (Grosman 1981, Milgrom 1981) and partial disclosure equilibria (Bhattacharya and Ritter (1983), Verecchia (1983), Diamond and Verecchia (1991), Gigler (1994)). Empirical work on corporate disclosure is rooted in the 1960s and typically examines the effect of increased levels of disclosure on a firm's ability to reduce agency costs. However, results of these studies are mixed. Other studies focus explicitly on the interaction between a firm’s corporate governance structure and its disclosure policy. Again, results are mixed: authors find both positive and negative relations between the intensity of a firm’s corporate governance structure and its disclosure policy.

The current study is situated in the latter stream of research, in that we study the impact of changes in ownership structure and corporate governance on a firm’s disclosure policy.

More specifically, we examine disclosure policies of a large hand-collected sample of Belgian unlisted firms receiving private equity (PE) financing from professional equity investment companies, both in the period before and after the PE investment.1 The motivation for using this dataset stems from the unique Belgian institutional and legal framework which requires all national companies (both listed and unlisted) to file yearly financial statements to the National Bank of Belgium. This offers a richness of financial statement information and provides the opportunity to study the effect of a change in ownership and governance structure resulting from the PE investment on a firm’s disclosure policy, even when firms are not subject to stock exchange reporting requirements. Further, this dataset is unique in that it contains (changes in) firm-specific disclosure observations around a clearly identified PE financing event and thus allows to study corporate disclosure policies as a response to information-asymmetries and agency problems inherent to the PE offering. As such, this research takes into account that disclosure decisions are non-random events and responds to the worry of researchers that disclosure is often treated independently from a firm’s changing environment or economics (Healy and Palepu (2001)).





A study like this is interesting for several reasons. Studies on unlisted firms is appealing in its own right, due to the predominance of private companies in the economy and the fact that only marginal attention has been paid to these kind of firms in empirical studies.2 Moreover, the PE setting is particularly interesting since it is characterized by various information asymmetries and agency problems which inherently affect the business process and organization. Therefore, the use of financial statement information is important in a PE context, even for unlisted firms (Hand (2005)). We acknowledge the importance of financial statement information and study the relation between the (nearby) governance of a PE investor and a firm’s disclosure policy. Hereby, the current study not only complements accounting research on determinants of disclosure but also entrepreneurial finance research which often treats the corporate reporting environment as exogenous.

We argue that a firm discloses more information to the outside world when raising PE finance and derive this argument from basic economic theory. The information asymmetry problem that typically arises between a better-informed entrepreneur and outside PE investors gives rise to the lemons problem, which causes good and bad projects to be valued at an average level (Akerlof (1970)). In an attempt to resolve this problem, the best entrepreneurs signal their superior quality and increased disclosure might be a valuable instrument to do so.

Various studies have shown that financial figures are key determinants in screening and selecting portfolio companies, especially in Continental Europe (MacMillan, Zemann and Subbanarasimha (1987); Fried and Hisrich (1994); Wright and Robbie (1998); Manigart et al.

(2000)). Moreover, survey evidence shows that more than 70% of professional investors labels accounting disclosure as the most important item which impacts their investment decision (McKinsey (2002)). Consequently, we argue that high quality entrepreneurs showcase their financial reporting openness and professionalism to outsiders by increasing their disclosure levels. We therefore expect and also find evidence of increased disclosure of financial information in the year before firms get PE.

Second, we argue that portfolio firms’ disclosure policies are affected by PE investors’ governance. This argument originates from the well-illustrated phenomenon that PE investors are close monitors of their portfolio firms (Gompers (1995), Sapienza, Manigart and Vermeir (1996), Kaplan and Strömberg (2002)). These monitoring efforts are particularly driven by the agency problem, as described in Jensen and Meckling (1976), where the interests of principals (here: PE investors) and agents (here: entrepreneurs-managers) are not perfectly aligned. As a response to the agency problems, PE investors are intensively involved in their portfolio firms’ day-to-day activities and contract a substantial number of controls like cash flow and control rights contingent upon observed performance measures (Gompers (1995), Robbie and Wright (1998), Gompers and Lerner (2001), Kaplan and Strömberg (2002)). This strong PE investor involvement results in a substantial change in governance and positively affects the professionalism the firm is operating with. We argue and show that this intensified governance and professionalization is noticeable in the way financial reporting is conducted and, as such, is manifested in a higher disclosure of financial information to outsiders.

To document these propositions empirically, we study disclosure policies of a large sample of unlisted Belgian PE backed firms from (at most) 3 years before until (at most) 5 years after they received PE for the first time in their history, and compare these with a matched sample of independent firms that never received PE. Since the firms under analysis are unlisted and press releases or extended annual reports are rare for these kind of firms, we gauge a firm’s disclosure behavior by looking at its willingness to report complete (i.e. more detailed) financial statements when abbreviated (i.e. shorter in length, providing less detail) statements are sufficient to comply with legal requirements. Complete financial statements require more intensive preparation and financial expertise and contain more competitive information. Hence, complete financial statement disclosers incur substantially higher proprietary costs than firms which only report abbreviated financial statements. In the pre-PE financing period one would only expect firms to switch to a complete financial statement reporting if the increase in proprietary costs resulting from the increased disclosure is offset by the decrease in information asymmetry. After the PE investment it is likely that the financial expertise, the intensified monitoring and professionalism of the PE investor will be dominant, leading to expectations of a higher disclosure policy when professional PE investors become involved.

Through panel data analyses, we find that PE portfolio firms partly resolve the information asymmetry gap by disclosing significantly more financial statement information than they are legally obliged to, especially in the pre-PE financing year. These differences remain significant when we control for firm-specific characteristics and potential endogeneity problems. From the PE investment year onwards, PE backed firms are even more likely to disclose complete financial statements compared to both the matched sample and the preinvestment firm-years. This finding suggests a clear governance and professionalization impact of PE investors on their portfolio firms’ disclosure behavior. Further, we condition for differences in investor type by splitting our sample in government PE backed and nongovernment PE backed firms. We expect that the lower monitoring and governance impact which is often associated with government-related PE investors will yield lower disclosure levels for their portfolio firms. Results, however, do not support this view although government PE backed firms switch earlier to a high disclosure strategy. This suggests that the well-documented difference in governance and professionalization between government and non-government PE investors has no sizeable effects on the way financial disclosure of their portfolio firms is enforced.

The current study has several contributions. First, this study distinguishes itself from the traditional disclosure literature which studies governance structures in relation to a firm’s disclosure behavior. Prior studies typically associate proxies for a firm’s governance structure with aggregate measures of disclosure tendencies (Raffournier (1995), Ho and Wong (2001), Eng and Mak (2003)). However, these studies face the problem of being short of good proxies for a firm’s governance structure which often results into mixed results. The firms analyzed in the current study are unique in that they contain an indisputable change in governance system resulting from the PE involvement. This provides an exclusive setting to study the impact of intensified scrutiny and governance pressure on a firm’s disclosure behavior. Second, prior studies typically investigate disclosure tendencies of publicly listed companies, primarily driven by data unavailability of unlisted firms. However, recent evidence shows that financial statement information matters for unlisted firms, especially in a PE context, and that this issue is surprisingly neglected in the literature (Hand (2005)). The current study acknowledges this shortcoming and enhances the understanding of the use of disclosure for unlisted firms in response to increased scrutiny and governance by PE investors. Third, most studies analyze disclosure behavior cross-sectionally and typically neglect intertemporal dependencies.

However, disclosure decisions are non-random events and cannot be treated independently from a firm’s changing environment or economics (Healy and Palepu (2001)). The current study overcomes this disregard and exploits the characteristics of a longitudinal dataset to analyze the disclosure evolution in a panel data context.



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