The High Agency Costs of Overvalued Equity in an Emerging Market: Evidence from the Growth Enterprise Market (GEM) in China

Abstract

Restriction on the access to the public equity market and non-market based selection of public listing create overvaluation and distort managerial incentives in the public listed companies in the Chinese stock market. Using the sample of newly listed firms in the Growth Enterprise Market (GEM), this paper documents evidence on the high agency costs of overvalued equity. We show that newly listed firms experience exodus of top executives shortly after public listing, and the executives time their resignations in order to “cash out” their stock holdings. Firms with greater overvaluation and lower profitability are more likely to experience executive resignation. Consistent with Jensen (2005), we find that managerial actions resulting from systemic equity overvaluation can be destructive: market reactions to executive resignation are negative and firms that experience executive exodus perform poorly. The results suggest that high valuation of public companies resulting from tight control of public equity market entry helps to create wealth for the corporate insiders rather than to create successful enterprises.