Investors Understanding of the ‘Financial and Operational Engineering’ Before Management Buyouts and Post-MBO Performance

Abstract

During the year prior to management buyout (MBOs) announcements, target managers seem to lower earnings through opportunistic ‘financial and operational engineering’ activities, i.e., abnormally low discretionary accruals, abnormally high discretionary expenses (mainly R&D and advertising expenses), and realizing losses from asset sales. The latter two are real activities and are associated with lower pre-MBO abnormal stock returns, mainly for firms with higher insider ownership, less institutional monitoring, and greater information asymmetry, whereas discretionary accruals are not. The real activities also seem to improve post-MBO operating performance. None of these earnings-reducing activities affects deal completion likelihood, announcement period abnormal returns, or offer premiums for MBOs. Managers do not seem to influence earnings in other years around the MBOs. Our results suggest that these ‘financial and operational engineering’ activities permit target managers to acquire targets “on the cheap” and to earn higher post-MBO investment returns through wealth transfers from pre-MBO shareholders to post-MBO owners instead of value creation.