Abstract
During the late 1990s, China introduced the gaizhi process for privatizing state-owned firms. Under gaizhi, insiders could acquire their firms at a price that was based on recent profitability. This gave the managers of firms an incentive to reduce short run profits. We compared the performance of firms acquired by their managers to performance at matched control firms. Insider controlled firms experienced a significant decrease in profitability immediately prior to privatization and a return to pre-gaizhi profits soon thereafter. The short term reduction in profits was accompanied by a decrease in labor productivity, an increase in overdue accounts receivable, and an increase in R&D investment. We do not observe a similar pattern among firms acquired by outsiders. These findings suggest that insiders intentionally suppressed the performance of their firms so as to acquire them at less than fair value.
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