Wealth transfer through private placements: Evidence from China

• Author: Jing Lin,Steven X. Zheng,Mingshan Zhou
• Date: 01 May 2020
• Published date: 01 May 2020
• DOI: http://doi.org/10.1111/fire.12215

DOI: 10.1111/fire.12215

ORIGINAL ARTICLE

Wealth transfer through private placements:

Evidence from China

Jing Lin1Steven X. Zheng2Mingshan Zhou3

1School of Management and Economics,

University of Electronic Science and Technology

of China, Chengdu, China

2Asper School of Business, University of

Manitoba, Winnipeg, Manitoba, Canada

3School of Finance, Southwestern Universityof

Finance and Economics, Chengdu, China

Correspondence

StevenX. Zheng, Asper School of Business,

Universityof Manitoba, 181 Freedman Cres-

cent,Winnipeg, MB, Canada R3T 5V4.

Email:Steven.Zheng@umanitoba.ca

Fundinginformation

NationalNatural Science Foundation of China,

Grant/AwardNumber: 71873022; Bank of

MontrealProfessorship in Finance.

Abstract

We examine private issuance of public equity (PIPE) in China, and

our results suggest that PIPE investorsbenefit from the price manip-

ulation before and after issuance. These investors tend to cash out

after lockup expirationand make large profits. We also find evidence

that the tradingof PIPE investors after lockup expiration is informed.

Testsabout the abnormal returns in the 3 years after lockup expira-

tion suggest that at least part of the benefits PIPE investors receive

come from wealth transfer from outside investors. Overall, PIPE

issuers in China seem to use an opaque mechanism to compensate

PIPE investors.

KEYWORDS

earnings management, informed trading, price manipulation, private

placement

JEL CLASSIFICATIONS

G14, G23, G32, G34

1INTRODUCTION

Hertzel, Lemmon, Linck, and Rees (2002) and Krishnamurthy, Spindt, Subramaniam, and Woidtke (2005) show that

firms conducting private issuance of public equity (PIPE) in the U.S. market experiencesignificant stock price run-up

before issuance. Also using U.S. data, Chen, Cheng, Cheng, and Chih (2010) produce results suggesting that issuers

overstate their earnings before PIPEs, implying that at least part of the price run-up is the result of price manipu-

lation. Usually, investors receive a substantial placement discount relative to marketprice in PIPEs,1and the litera-

ture suggests that placement discount is compensation for PIPE participation. However,Chen et al. (2010) show that

PIPE investors do not ask for a fair discount. Theypresent additional evidence to support a hypothesis that some PIPE

investors mayhave been exploited by issuers. In this paper, we explore this issue using data from China.

PIPE regulations in China put a 10% ceiling on the discount of PIPE placement price relativeto the benchmark price.

This reduces the usefulness of price discount (relative to benchmark price) as a transparentcompensation method for

1See,for example, Wruck (1989), Hertzel and Smith (1993), and Hertzel et al. (2002).

Financial Review.2020;55:199–219. wileyonlinelibrary.com/journal/fire c

2019 The Eastern Finance Association 199

200 LIN ET AL.

PIPE participation and PIPE issuers may need to provide other means of compensation to PIPE investors. As in other

emerging markets, the information environment in China is opaque. This makes it easier for PIPE issuers to manipu-

late stock price and for investors to trade based on inside information. In addition, there is a close relation between

controlling shareholder/management and certain investors for some firms in China (e.g., in 2014, the China Secu-

rities Regulation Commission [CSRC] announced investigations involving collusions between controlling sharehold-

ers/management and certain investors for 18 listed firms2), so it is possible that PIPE issuers may try to use opaque

methods to compensate PIPE investors at the cost of uninformed investors.

Reports in Chinese financial media about PIPEs in the ChiNextmarket provide additional hints about this possibility.

Before 2017, ChiNext PIPEs were not subject to lockup restrictions if the shares were issued at or above the market

price. It has been reported that some ChiNext companies first issue PIPE shares at or above the market price, then

announce very positive events to prop up stock price so that PIPE investors can flip their shares for a quick profit.3

Inspiredby this type of maneuver and the evidence that Chinese listed firms pay more dividends after PIPEs (Zhao et al.,

2015), we conjecture that PIPE investors and issuers may be working together to expropriate uninformed investors.

We call this conjecture the collusion hypothesis.

The PIPE process in China is very structured with regulations about the announcement date, benchmark period,

pricing date, issue date, and lockup period. This allows us to examine the earnings management (EM), price manipula-

tion, abnormal return (AR), and PIPE investors’ unrealized profit in different clearly specified periods. Using a sam-

ple of 1,302 PIPEs in China between 2007 and 2015, we find that PIPE issuers in China also conduct aggressive

positive EM in the quarter around the PIPE pricing date. The EM activity is associated with positive AR before the

PIPE pricing date. This benefits PIPE issuers because we find a positive relation between the placement price and the

AR before the PIPE pricing date. However, unlike in Chen et al. (2010), the placement discount in Chinese PIPEs is

also positively related to the AR before the PIPE pricing date, implying that PIPE investors are aware that at least

part of the price increase is the result of manipulation and they get deeper discount as compensation if the stock

price increase is higher. Actually,PIPE investors seem to benefit from the price manipulation because their average

unrealized profit before the lockup period starts is more than 45%, and this unrealized profit is positively related

to the AR before the PIPE pricing date. Additional tests show that the pattern is not driven by the PIPE announce-

ment effect. This result is not consistent with the investor exploitation hypothesisbut is consistent with the collusion

hypothesis.

The high unrealized profit at issuance only exists on paper because PIPE investorshave to wait until lockup expira-

tion to sell PIPE stocks to realize the profit. If the prices of PIPE stocks collapse during the lockup period, then PIPE

investorscan still be exploited. Therefore, we examine the price management activity and AR during the lockup period.

We find that issuers continue to do positive EM. They do more EM if PIPE investors’ unrealized profit at issuance is

low. Issuers also increase stock dividends during the lockup period, and the increase is higher for PIPE stocks with

lower unrealized profit at issuance. It seems that PIPE issuers try to use price manipulation to compensate/appease

those PIPE investors with low unrealized profit at issuance. As a result, the AR during the lockup period is negatively

related to PIPE investors’unrealized profit at issuance. These results are consistent with the idea that PIPE issuers a nd

investors work together.

After lockup expiration,PIPE investors have to sell the shares to realize the profit. We examine the returns of PIPE

stocks in the 3 years after lockup expiration.We do find negative AR, but the average magnitude is only around 2% or

3% per year, giving investors enough time torealize their profit. For example, in the year after lockup expiration, on

average, mutual funds that participate in PIPEs sellmore than 99% of the shares they bought in PIPEs. In addition, for

PIPEswith low unrealized profit at lockup expiration, the trading of participating mutual funds is informed. In additional

tests, we rule out alternative explanations based on investment skills, geographic location alumni relation, and prior

information. The results suggest that PIPE issuers offer more compensation to the funds with lower profit in the form

2http://finance.ifeng.com/a/20141223/13376152_0.shtml

3https://www.yicai.com/news/5255186.html