Perspectives in Corporate Finance:Study of Contracts and Institutions

Kose John, NYUFMA Doctoral Consortium

October 2005

Introduction

• Corporate Governance• An active research area in Finance,

Economics, Accounting and Law• 1976: Jensen and Meckling, Agency

Theory: How different from Principal-Agent paradigm?

• 1997: Corporate Governance: How different from Agency Theory?

• Focus on institutions (legal/financial) and other noncontractual mechanisms.

• Appropriate (as incomplete contracting is the source of agency problems)

Introduction

Third Consortium 1987, 1994 Different Perspectives of 1987 and 1994 Looking back Looking ahead Design of Institutions Gaps in the literature in four areas

1987: Corporate Finance

• 1988 M&M Thirty Year perspective• Post M&M corporate Finance• Relaxing the assumptions, still in the

backdrop of a well-functioning capital market

• Personal tax equilibria• Asymmetric Information models• Agency theory

1994: Looking Back

• Jensen and Meckling (JFE 1976)• Nexus of contracts view of the firm?• Capital Structure?• Incomplete Contracts• Incentives

• Capital Structure vs Security Design

1994: Looking Back

• Corporate Finance as a study of contracts and institutions

• Incomplete contracts• Corporate Charter• Voting rules

1994: Looking Back

• Junk Bonds and Bankruptcies• Debt Renegotiation• Bankruptcy Design

• Privatization• Design of Mechanisms• Corporate Governance

1994: Looking Back

• S&L crisis• Incentives and regulation• FDIC Reform

1994: Looking Ahead

• Perspectives of contract theory• Complete, Long-term contingent contracts• Incomplete contracting• Role of renegotiation

• Additional constraint "Renegotiation-Proof”• Limits commitment power of contracts• Delays the revelation of private information• Dynamic contracting with renegotiation

1994: Looking Ahead

• Concrete Example: Optimality of resetting of options

• Acharya, John, and Sunderam (JFE, July 2000)• Continuation optimality is a constraint on the

feasible set of contracts• Limited menu • Resetting may be optimal• Also debt renegotiation and bankruptcy

design

Design of Institutions

• Taxes• Organizational forms• Bankruptcy• Corporate Charter• Syndicated finance• Corporate Governance• Banks and regulation• Privatization

Executive Compensation

• Lots of papers• Central issues remain not understood• Problems with pay-performance sensitivity

measures• Risk-aversion and incentive provision• Incentive effects of options

• Theoretical• Empirical

Design of Institutions

• Design of Bankruptcy• Comparitive bankruptcy regimes• Comparative Corporate Governance• Better Data• Needs more theoretical Empirical Work

• Acharya, John, and Sunderam

Corporate Governance

• Differences among corporate governance systems

• The weights on the different governance mechanisms: Ownership, Bank monitoring, Takeovers, Outside shareholder monitoring

• How are these mechanisms optimally combined?• Design of the optimal governance structure

determined by scale of investment and firm growth

• Function of the degree of development of markets and institutions

Literature-Empirical

La Porta et al. (1997, 1998, 1999, 2002)• Legal Protection is an important determinant• Better legal protection is associated with

- Lower concentration of ownership and control

- More valuable stock markets- Higher number of listed firms and

evaluation

Literature-Empirical (cont’d)

• Gompers, Ishi and Merrick (2001)--US firms in the top decile of a “governance index” (related to takeover defenses and shareholder rights) earned significantly higher abnormal returns over those in the lowest decile.

• Crèmers and Nair (JF, 2005)• Crèmers, Nair and Wei (2003)• Crèmers, Nair and John (2005)

Literature-Empirical (cont’d)

• John, Mehran, and Qian (2005)• John, Litov and Yeung (2005)• Litov (2005)

Literature-Empirical (cont’d)

• Hartzell, Gillan and Starks (2003)• Hartzell, and Starks (JF, 2003)• Brick and Chidambaran (2004)• Raheja (JFQA, 2005)• Survey: Morck, Wolfenzon and Yeung (JEL,

2005)

Theory

Not much theory Hirshleifer and Thakor (JCF, 1991) Shleifer and Wolfenzon (2001) Chidambaran and John (1991) Alamazan and Suarez (2001) Maug (JCF, 1997)

Design Problem

Entrepreneur

The firmManager controls investmentand enjoys private benefits

The Governance

Structure

Managerial Alignment

Takeovers

Bank Monitoring

Large Shareholder Monitoring

Two Step Decision

• Step 1:• How do the different mechanisms interact• How are the different mechanisms combined• Natural configurations of mechanisms emerge

• Step 2: • Which of these three configurations does the

entrepreneur choose: Which is optimal? Depends on economy characteristics

Main ResultsMyriad structures possibleResults on the nature and interaction of he mechanisms

imply that four natural groupings arise

Correspond loosely to

•Concentrated Ownership

•Bank Monitoring

•No Takeovers

•No monitoring by large outside shareholder

•Full ownership

•No Bank monitoring

•No takeovers

•No monitoring by large outside shareholder

•Diffused ownership

•Discipline through takeovers, Little use of Bank debt

•If large shareholder is incentive compatible, she monitors

Bank-Based Governance Structures

Market-Based Governance Structures

Family-Based Governance Structures

Optimal systems

Growth and Scale of Investment

• Questions• How is governance systems a function of the

scale of investments?

• Growth of firms and changes in their governance structure

• Growth-induced convergence?

• What governance should emerging economies adopt?

• Intertemporal and cross-sectional variation in ownership structures

Model Setup

• An entrepreneur• A project which can be implemented with

flexible investment scale I• He has initial wealth A with which he invests in

the project• He hires a manager to run the firm. The

manager raises (I-A) as external financing. Set A = 0.

• The output is with some positive probability and zero otherwise

IIH )(

First Best

• In the absence of any agency problems the solution is • The entrepreneur chooses scale of investment

to maximize firm value

• The optimal investment is and

• firm value is

*IIIHIV g )()(

)1(

1

* )( gI

** )1()( IIV

Agency Costs

• As , the first project is the good project

• The manager gets private benefits B from implementing the bad project. The private benefits are uniformly distributed over where , (L is the quality of enforcing institutions)

.10 gb

The Good Project The Bad Project

-I

H

0

g

)1( g

-I

H

0

b

)1( b

)](,0[ IH)( bg 1)1( L

Governance Mechanims

• There are two governance mechanisms • Managerial Ownership a : Higher is this

fraction the greater incentive the manager has to choose the good project

• Takeovers: A raider emerges with a positive probability and implements the good project

)0,()( aM

MMaxa

Governance Solution

• Proposition 1:• Only one of two governance mechanism is

optimal. Either concentrated ownership with no takeovers (insider systems) or diffuse ownership with takeovers (outsider systems)

• Which is optimal depends on M vs M*(I)• Choose outsider systems when )(1 * IMM

Overall Problem

• Entrepreneur problems• To choose governance structure (i.e ownership

a) to minimize agency costs• To choose investment scale I

• Solve the problem is two stages• For any given investment level: Choose

governance structure• Choose the investment level

Agency Costs

• Figure 1: Agency Costs under the Two Governance Systems

• Insider system: Convex, Starts at zero value, increasing in I

• Outsider system: Concave, increasing in I

Empirical Implications

• Implication 1: An increase in the quality of institutions reduces inside ownership. This decrease is larger for economies with less developed markets in comparison to economies with well developed markets

• Implication 2: In any given economy with degree of development of markets above a threshold, technologies that are implemented at smaller investment scale will have higher concentration of insider ownership, and larger firms, a lower concentration of insider ownership.

,M

Empirical Implications...

• Implication 3: Changes in governance may follow changes in productivity of technology. Increases in productivity will be accompanied by decreases in concentration of inside ownership, and decreases in productivity will be accompanied by increases in concentration of ownership.

• Implication 4: The cross-sectional and inter-temporal differences in ownership structures would be higher in economies with well developed markets compared to economies without.

Themes

• Optimal choice of governance structures and investment levels in different economies

• Cross-sectional and intertemporal variation in a given economy

• Markets not developed—insider systems• Some development of markets: Small scale,

insider systems. Large scale, outsider systems.

• Growth implies convergence toward outsider systems

• Also explains Reversals