Topics in Financial Economics Term 2

1. Topics in Financial Economics Term 2 Lecture 8: Corporate governance Takeovers Governing the governors Cheap talk Slack

2. Corporate governance and control • This discussion draws on Schelifer and Vishny and on Ch 10 of the Gale Notes (see module page) • Fundamental questions • Why do investors ever get paid back? • How do investors ensure that managers choose good projects? • How are managers controlled? • Most economies have working answers to these questions, but much room remains for improvement • Ethical investing • Accountancy ‘surprises’ (Enron, Parmalat) • Wide disagreement about soundness of corporate governance • Parallel/complimentary mechanisms: markets for corporate control, markets for managers, regulation, etc. • Competitive models (US/UK, Germany, Japan) • Need to extend models for development, privatisation, etc. • Why doesn’t end-market competition solve the problem?

3. Governance as an agency problem • Owners as principals; managers as agents (what about Debt-holders?): separation of ownership from control • Lock-in: once invested, capital is specific and (partially) ‘sunk’ so owners must trust managers • Moral hazard • Adverse selection • Owners may need assurance • Limits on managerial actions • Ex post verification/audit • External enforcement and other legal protections • Another approach: concentrated ownership • Accumulate significant residual discretion (e.g. voting rights) • Big cash flow claims • Need fewer externally enforced rights than small claimiants • Vulnerable to hold-up

4. Governance as a contract • Between the main parties, we can view the firm as a (network of) contract(s) • Offer, acceptance, consideration • Specified terms, liquidated damages and breach • Reliance on outside enforcement • This contract cannot and should not be complete • Cannot: at negotiation time, the parties cannot know everything and what they know they may disagree about • Should not: contracting costs, inefficient compliance, loss of flexibility (signposts and triggers) • Cannot give all rights to equity holders • They don’t and won’t know enough (that’s why they use managers) • Produces moral hazard for managers • Instead, delegate limited discretion to managers • Contracts limited by need to be interpretable, enforceable • Free-riding among shareholders (like political voter participation)

5. Extent of management latitude • Expropriation of investors’ money • Ponzi schemes and speculative bubbles • Transfer pricing (non-market sale of output to favoured ‘clients’ also good for dealing with regulators, tax authorities) • Below-market sales of assets • 18th, 19th century US/UK/De/Fr, Ru law was more directed against managerial theft than underperformance or monopolisation. • Current laws also pay attention to this: fat cat – payment for failure is a way of drawing down assets without violating debt conventions on payouts • Results include ‘slack,’ perks, overexpansion, pet projects, over-tenure. • Conventions regarding these things has important spillovers for the ‘market for managers’ and implied benchmarking • This reduces willingness to invest, leading to internal or external pre-commitment devices (including requirement for managers to have a financial stake in the firm)

6. After investment: hold-up • One example: asset substitution (manager takes on projects from which he gains, even if NPV is negative) • Coase theorem should rule this out: if a project is not Pareto-optimal, costless and perfectly-informed bargaining would rule it out, but • Bargaining is not costless • Information ism imperfect or even incomplete • Bargains do not usually cover individual actions • Does not usually fail because risk owners (shareholders) free ride, since only a few sit on the Board. • Main reason is that such bargains are unconscionable (though not for greenmailers) – “duty of loyalty” • Best response by shareholders is also to credibly refuse such bargains (like corruption: individual bargains c=good, collective incentive effect bad) – possibly efficient ex ante; probably not ex post

7. Suppose we use ‘smart contracts?’ • High-powered incentives: many contingencies, long-term relationship, compensation highly sensitive to results. • Relies on verifiable indicator of performance and/or commitment to suitable unverifiable ‘trigger’ indicator • In general, optimal form depends on risk aversion, importance of decisions, manager’s ability to ‘buy’ revenue flow up front. • Much debate about sensitivity of pay to performance in practice, extent of ‘self-dealing’ • Regulators distrust such contracts

8. The role of markets • Stylised view: if a publicly-traded firm is badly managed and if Board, proxy battles, contract incentives, dismissal threats, etc. are ineffective, the firm will ‘suffer’ a hostile takeover • Simple model: • Manager chooses action a; firm value is V(a) • Current manager does not maximise value (V(a) < V(a*)) • Raider can buy firm and split V(a*)-V(a) with shareholders • Hold-out problem: • Shareholder participation needed to increase value • They will ‘hold out’ for maximum share of gain • Raider gets nothing; won’t come in.

9. Model is too simple, but let’s try it… • ‘Raider’ offers pr per share and pays fixed cost C > 0 • Shareholders (all same size) can separately choose to accept r reject the offer • If at least 0 < g% < 100% accept, raider gains control and can force choice of a* - otherwise, incumbent management remains in place and continues with a. • This is a multi-stage game, so we analyse it backwards. • In last stage, raider has g% of shares; if g >g the value of the firm is V(a*); otherwise it is V(a) • At second stage, shareholders who tender their shares get pr. If they do not and the bid fails they get V(a); otherwise they will get V(a*) – so they will tender if p > V(a’) (a’ = a, a*) • At first stage, raider picks a price that equals the shareholders’ reservation price (pr> V(a*) • Raider’s profit is then (V(a*) - pr)g – C < 0 • … so raid cannot succeed!

10. Really? • Well, the raider may profit by diluting shareholder control – if the minority shareholders can be made to part with f% of their property rights by self-dealing, etc. the price offered can be lower: pr> (1-f)V(a*) and a successful tender only requires fV(a*) > C • The raider can offer a lower price if he can precommit to excluding those who do not tender, or offering a lower price closer to some ‘deadline’ • The raider may also precommit to making his offer to only a limited set (of size g, for instance) of shareholders. • If the shares are not infinitely divisible the results can be very different – some stockholders must be pivotal and therefore cannot free ride, and it is possible to get successful takeovers without exclusion.

11. The size issue • In a game with a finite number of stockholders, the results can be very different (esp. possibility of successful raids) • Bagnoli and Lippman (1987) have a model where even in the limit of the finite game (as shareholders become infinitesimal) the non-atomic result (no profitable takeovers) is not reached. • The result can go through if ownership is dispersed relative to value increase – otherwise, shareholders will either want to be paid up front (bidding up the tender price to the point where the raider drops out) or will try to get the maximised post-takeover value by going along for the ride (not tendering). • Thus in the general case, don’t need exclusion to get successful takeovers. • Stockholders do better without exclusion, so investors should prefer firms that are valuable relative to dispersion – i.e. firms that are not too widely held. • This fits the evidence: in US/UK where takeovers are culturally acceptable, control is exercised by large shareholders. This both provides good governance and facilitates the market for control.

12. A simple model • Shareholders I = {1,…,n}; I owns proportion qi of firm and tenders fraction ti<qi to the raider. • As above, raid succeeds if Sti>g. • Tender price is pr; shareholder getsRaid succeeds Raid fails .(qi – ti)V(a*) + tipr(qi – ti)V(a) + tipr • If pr lies strictly between V(a) and v(a*), each shareholder will want to minimise his tendering s.t. raid succeeding (if the raid is expected to succeed) and to maximise his tendering if the raid is expected to fail. • There are many equilibria – we look at sub game perfect equilibria: raider offers price pr< V(a) and shareholders tender just enough to make the raid succeed. If the raider offered < V(a) ti = 0 and the raid fails. • This depends critically on the fact that g is common knowledge. • One more piece of evidence: incumbent shareholders usually gain more from successful takeovers than raiders do – possibility of greenmail. • Takeover protection (one share, one vote, poison pills, etc.) offer protection to share owners and to existing managers. Need to balance these two interests to find optimum.

13. A more careful approach: delegation • Standard agency view assumes that manager’s, shareholders’ interests are opposed and that they must control him • This complements the traditional view of managers as the servants of shareholders • Most real situations lie somewhere between – suppose the manager (a local council, say) has interests partially aligned with those of investors (citizens) • Manager has a tendency to over invest their (our) money but also has superior information about efficient level of investment. • Our contract should trade off the costs of overinvestment against the advantages of superior information

14. OK, tell me how to structure the council tax • Random state w, uniformly distributed on [0,M] • Value of town = V(t,w) = (w-t/2)t (t is tax/investment) • Manager’s preferences: U(t,w) = V(t,w+b), b>0 is the manager’s bias. • First best achieved by a Pigovian charge, whereby the manager pays us for the utility he derives from spending our money cP = -bt. Assume we cannot impose this charge. • Problem is that the outcome depends on the unobservable state. We have different solutions depending on whether the townsfolk (investors) can precommit to a particular payment scheme for the managers (analogous to the audit commitment).

15. Cheap talk • Manager reports a state m = f(w) in [0,M] • Townsfolk (investors, principal) choose a council tax t(m) – a nonnegative real number. • Townsfolk's ex post belief as to the true state is a distribution mwon [0,M] • Solution concept: perfect Bayesian equilibrium (PBE): both players choose best replies; beliefs follow Bayes’ rule where possible. In other words: • Townsfolk’s choice maximises expected value of V under beliefs mm, where m is the message sent by manager: t(m) = t maximises (w-t/2)tmm(w)dw • Manager’s choice maximises his expected payoff: f(w) = m maximises (w+b-t(m)/2)t(m) • for almost all m mm is a uniform distribution on f-1(m). • The manager effectively gets to choose t from the range of g. Because his utility is concave, the set f-1(m) is convex.

16. More cheap talk • If t < t’ are tax rates in the range of f that are chosen in equilibrium, then t+b < t’. This is effectively the same as the argument that led us to constant repayment in the optimal contract example – just the IC condition. It implies that there are only a finite number of possible messages and thus of tax rates. • More precisely, the manager’s strategy defines a finite set of intervals {(wi, wi+1): i = 0,..K}, where w0 = 0 and wK = M; all w in (wi, wi+1) give rise the the same message mi and the same tax rate ti. • If {[wi, ti+1]: i = 0,..K} has strictly increasing wi and if • ti = (wi, wi+1)/2 • (wi+1 + b) = (ti + ti+1)/2 Then there is a PBE (t,f,m) such that (wi, wi+1)  f-1(mi) and f(mi) = ti for all I and conversely. • The point is that we can get optimality, but only at isolated points – the size of the bias determines the ‘lumpiness’ of the contract and thus the expected utility loss.

17. Expensive talk - precommitment • Use a revelation game: manager reports state m and townsfolk choose t(m). • We impose incentive compatibility and maximise the townsfolk's’ payoff (w-t(w)/2)t(w)mm(w)dws.t. IC – we can assume here that the manager reports truthfully. • As above, the manager effectively chooses a tax from the range of t. We assume that t([0,M}) is closed. In fact, if t* is optimal and incentive compatible, t*([0,M]) is an interval. • There is a value w* < M such that for all w, t*(w) = min{w *, w +b} • In other words, the optimal mechanism is capping! • Back in the corporate world, this puts an upper limit on the manager’s power to invest – the limit is generous if M is big (big profit opportunities, big uncertainty) or b is small (little diversion between principal, agent motives). • There is some informational advantage in separating management from control, despite the incentive costs.

18. After investment: hold-up • One example: asset substitution (manager takes on projects from which he gains, even if NPV is negative) • Coase theorem should rule this out: if a project is not Pareto-optimal, costless and perfectly-informed bargaining would rule it out, but • Bargaining is not costless • Information ism imperfect or even incomplete • Bargains do not usually cover individual actions • Does not usually fail because risk owners (shareholders) free ride, since only a few sit on the Board. • Main reason is that such bargains are unconscionable (though not for greenmailers) – “duty of loyalty” • Best response by shareholders is also to credibly refuse such bargains (like corruption: individual bargains c=good, collective incentive effect bad) – possibly efficient ex ante; probably not ex post

19. Suppose we use ‘smart contracts?’ • High-powered incentives: many contingencies, long-term relationship, compensation highly sensitive to results. • Relies on verifiable indicator of performance and/or commitment to suitable unverifiable ‘trigger’ indicator • In general, optimal form depends on risk aversion, importance of decisions, manager’s ability to ‘buy’ revenue flow up front. • Much debate about sensitivity of pay to performance in practice, extent of ‘self-dealing’ • Regulators distrust such contracts

20. Self-dealing • A major issue: who negotiates the contract? • Are boards of directors as motivated as large investors? • Do managers use inside information when negotiating contract terms? • Can managers manipulate accounting information to increase pay? • Options: often taken up shortly before (after) good (bad) news. • Hence legal/regulatory suspicion • Rule of law based on non-interference with ‘business judgement’ except for self-dealing and compensation • This keeps down responsiveness of pay to performance • Can’t conclude that managers don’t care about performance, or that incentives solve agency problem

21. Around the agency: the role of markets • Main point: governance is part of the technology of the firm – good technologies should drive out bad. • The ‘equity premium puzzle’ (higher returns to less-leveraged firms) and general success of publicly held companies suggest that agency problems are not too severe (though we’ve looked at other parts of the explanation, like the incentive effects of debt) • Competition certainly disciplines management, and competition among firms and among systems of governance is an important factor. • We’ll look at the competition between two types of firm, differing in managerial objectives and subject to moral hazard (Gale notes, sec. 10.3.1)

22. The Hart (1983) model of ‘slack’ • Many small firms: • n are entrepreneurial (profit maximising) • 1- n are managerial (managers are utility maximising) • Identical cost functions C(w,q,L): • w = price of input, distribution on [wmin, wmax] according to F. • q = amount of output • L = managerial effort • Effort and price are substitutes (can lower cost be either low input cost or more/better effort): C=C(F(w,L),q) • F(w,L) is increasing in w and decreasing in L • w is unobserved except by managers: • F is iid across firms ex ante • ex post the distribution of prices across firms is a scale replica of F. • Manager decides on q and L, given w; investors see only realised profit – leads to shirking when w is low.

23. Managerial choices • Utility is separable in income (I) and effort (L):U = H(U(I)-V(L)) • Manager is very risk averse: U is steep below target I* and flat above it. • Reservation utility U- • Acceptable contracts guarantee manager income at least I* and utility at least U- - defines maximum effort level L*. • To get this level of utility, the manager must get a fixed payment and exert a fixed level of effort. • If investors could observe L they could contract to pay I* in exchange for L* (first-best) • Second-best: know F(w) and output price p and profit. • P(p,F) = maximum profit at p, F. • If manager follows first-best (L = L*), profits are distributed on [P(p,F(wmin,L)) , P(p,F(wmax,L)) ] according to F.

24. More on acceptable contract • Manager’s salary at least I* (otherwise, effort l* would put him below U-) • Second best is to offer I* as long as profits are at least P(p,F(wmax,L*)) and 0 otherwise • This contract • Requires top effort L* is w = wmax • Lets them save effort by choosing L = L(w) s.t.P(p,F(w,L)) = P(p,F(wmax,L*)) otherwise • Lower output, higher price than first-best • Assumes independent draw of w, many small firms: no aggregate uncertainty, no additional private information. • If input prices were perfectly correlated, then output price is also stochastic and correlated with input price. • If investors can’t observe p, profits of other firms, they should still pick a target w* and insist on maximum effort at that price, accepting slack at other prices.

25. How much slack? • [Note similarity to ‘capping’ inefficiency: isolated points of first-best (w = w*) and distortion/rents elsewhere] • Amount of slack measured by amount by which input price could be increased while keeping same profit if slack was eliminated. • Average in independent, correlated cases: Xind, Xcor. • With contracts as above, Xind> Xcor • manager in independent case facing input price < wmax only needs to beat P(p,F(wmax,L*)) • manager in correlated case also faces a lower output price, since all other firms have low input prices, and must work harder to compensate.

26. More slack… • Xind = slack in monopolistic firm with same incentive problem; no real impact of competition here • In correlated case, disciplinary impact of competition shown by fact that increase in n (proportion of entrepreneurial firms) reduces slack. • This result is reversed if manager’s marginal utility of income is positive. • Tensions between shareholders’ and customers’ interests. • Could also benchmark on profits earned by entrepreneurial firms (Holmstrom (1982)) • Further discipline by bankruptcy threat (as with leverage, but not ‘relative fitness’ drives evolution of firms: • Manager works hard to avoid personal cost of bankruptcy • Investors can provide incentives at lower cost – stronger incentives. • But increased competition makes industry ‘leaner’ and reduces benefits of cost reduction: not worth paying for performance.

27. Limits to the analysis • Uncomfortable evidence that some firms do nicely without external governance mechanisms • Focus on cost minimisation is too narrow • Effort is supplied readily; ability, risk shifting, private benefits may be harder. • Innovation is particularly tricky (effort vs. process improvement) • Externalities within, between firms • Where do entrepreneurial firms come from? Model could produce a ‘race to the bottom’ if there are no such firms (formerly public sector?) – analogous to individual vs. species fitness in evolution • Imperfect competition may have different effects: colluding not to work too hard may be easier to enforce, harder to detect and prevent than colluding to fix prices

28. Empirical evidence • Mostly impressionistic: • E. Europe performance fell after competition was suppressed • Porter (1990) on the beneficial impact of domestic competition on international competitiveness • Deregulation usually followed by increased productivity • Exercise of ‘market for corporate control’ power has more ambiguous effects • Impact of takeovers on productivity: • UK: foreign firms pay equivalent employees 3.4% more than domestic firms, though this is wholly attributable to their higher levels of productivity (Conyon et. al 1999) • ‘Breach of trust’ hypothesis (Auerbach), not confirmed in UK data • US data: Merged firms show significant improvements in asset productivity relative to their industries, higher operating cash flow returns (Healy, et al 1992) • Mexico: manufacturing plants where MNCs acquire majority ownership (“control”) become more productive (Pérez-González 2003)

29. Competition and performance in detail • Geroski, Blundell et al find inverse relation between market power and innovation • Caves, Green/Mayes find threshold decrease in technical efficiency with concentration • Some evidence from management literature that competition improves decision making efficiency • Nickell et al found positive link between competition and productivity growth, evidence that competition can substitute for other forms of governance • Implications for large/small firms, financial structure decisions, regulation • But many other factors linking competition to performance

30. Competing for investment capital • Assume competition and free entry – ex post profits reduced to 0, so natural selection forces profit maximisation s.t. incentive constraints – though only for firms that survive • In equilibrium, share holders require payment of opportunity return (outside option) plus information rents. Even monopolies must compete for inputs (including capital) so inefficient firms face survival pressures – esp. with nondecreasing returns to scale • As a result, competitive discipline most effective in industries with ‘tipping’ (winner-takes-all) due to complementarity, learning effects, rapid technological progress, etc.

31. Example • Company needs a manager and initial investment I0 today to produce 2I0 tomorrow. • This revenue can be paid out to investors or reinvested (at a low rate of return) • Manager can earn private benefits (continued employment) from reinvestment strategy • Debt (D) finance limits manager’s ability to reinvest revenues • Assuming market return = reinvestment return = 0 • Investors get min{D, 2I0} and want to set D = 2I0 (all debt) • If capital structures are of different types q in [0, 2I0] and r is opportunity cost of capital, r is set by ‘best option’ (200%) • Only ‘optimal firm’ (q = 2I0) will be able to raise capital.

32. Other remarks • Profitability as a magnet for hostile attention (Harris, et al 2003, Lichetberg et al (1989) US mfg data) • MBO establishments less productive than comparable plants before transfer of ownership; substantial increased productivity afterwards • LBOs plants had significantly higher rates of total-factor productivity (TFP) growth than others in same industry. Productivity impact of LBOs much larger than productivity impact of ownership changes in general, but MBO’s strongest of all LBOs • Labour and capital employed decline (relative to industry average) after buyout, but at slower rate than before • After LBO ratio of nonproduction to production labour cost declines sharply, production worker wage rates increase • Plants involved in management buyouts (but not in other LBOs) are less likely to subsequently close than other plants • Accepted view (Jensen et. al JFE 1983) • Corporate takeovers generate positive gains • Target firm shareholders benefit • Bidding firm shareholders do not lose • Gains from takeovers do not come from creation of market power • Are things different now?