“Concentrating on Governance” (with Matthew Rhodes-Kropf), Journal of Finance, October 2011, 66(5), pp. 1649-1685
This paper develops a novel trade-off view of corporate governance. Using a model that integrates agency costs and bargaining benefits of management-friendly provisions, we identify the economic determinants of the resulting trade-offs for shareholder value. Consistent with the theory, our empirical analysis shows that provisions that allow managers to delay takeovers have significant bargaining effects and a positive relation with shareholder value in concentrated industries. By contrast, non-delay provisions have an unambiguously negative relation with value, particularly in concentrated industries. Our analysis suggests that there are governance trade-offs for shareholders and industry concentration is an important determinant of their severity.
“Managerial Entrenchment Waves” (with Kose John)
This paper documents a novel agency cost that arises because managers of potential takeover targets forego merger opportunities in industry merger waves. We present comprehensive evidence that the entrenchment effect of classified board varies dynamically over time by industry. While the effect is strongly economically significant in years when industries are undergoing a synergistic merger wave, it is muted in years when synergistic industry M&A activity subsides. In wave industry-years, firms without classified board are more than three times as likely to receive a takeover bid compared to firms with classified board. This difference is even larger for less anticipated waves and for firms that also have a high level of takeover protection based on the GIM index of Gompers, Ishii, and Metrick (2003). By contrast, the difference in takeover odds is an order of magnitude smaller and not statistically significant in non-wave industry-years. These results are driven by economic, technological, and regulatory shocks that create economic opportunities to merge in the industry. Overall, our evidence broadens the classical agency view and suggests that the agency cost of classified boards varies significantly over time.
“The Leader-Bias Hypothesis: Corporate Control Dynamics in Industry Equilibrium”
This paper argues that corporate control imperfections have significant consequences for industry structure. In a dynamic oligopoly model with empire-building (Jensen, 1986) managers and endogenously chosen corporate control, one important benefit of managerial discretion is that aggressive product market strategies deter the expansion of rivals. While tight control by shareholders brings about efficiency gains, it also hampers managers’ ability to capture larger market shares. This trade-off implies that the choice of lax control is favored by shareholders of leading firms whose profits are more vulnerable to the expansion of undeterred rivals. The resulting dynamic industry equilibrium suggests a theory of predation based on imperfections in corporate control. Persistent monopolization, the theory predicts and simulations verify, leads to lower turnover, higher concentration, and significantly (up to 30%) lower consumer welfare than in otherwise identical industries with perfect corporate control. Improving corporate governance through public policy measures, such as the Sarbanes-Oxley Act, is potentially pro-competitive. Consistent with the leader-bias hypothesis, industry leaders empirically tend to have weaker shareholder rights than laggards, based on a panel of publicly traded U.S. firms.
“Optimal CEO Incentives and Industry Dynamics” (with Antonio Falato)
This paper develops a competitive equilibrium model of CEO compensation and industry dynamics. CEOs make product pricing and product improvement decisions subject to shareholders’ compensation choices and idiosyncratic shocks to product quality. The choice of high-powered incentives optimally trades-off the benefits from expected product improvements and the associated agency costs. In market equilibrium, the interaction between CEO pay and product market decisions affects the stationary distribution of firms. We characterize a dynamic feedback effect of industry structure on CEO incentives. As a result of this effect, we predict an inverse relation between the magnitude of the performance-based component of CEO pay and, (i) across industries, the degree of heterogeneity of industry structure; (ii) within industries, firm position with respect to its peers. We empirically estimate pay-performance sensitivity for a large sample of U.S. CEOs and other top executives over the 1993 to 2004 period and find strong support for our theory. Our results offer a novel product market rationale for the increased reliance of CEO pay on bonuses and stock options over the 1990s.
“Agency Costs of Idiosyncratic Volatility, Corporate Governance, and Investment” (with Kose John)
This paper identifies a fundamental conflict of interest between managers and shareholders in risk-taking decisions and explores its implications for corporate investment and firm value. In particular, we develop and test the hypothesis that firm-specific uncertainty drives a wedge between the risk preferences of shareholders and those of relatively under-diversified managers. Consistent with this hypothesis, we find that, when faced with increases in idiosyncratic risk due to technology shocks, entrenched managers respond to by making more conservative investment decisions, which include relatively less investment in R&D, more investment in PPE, and more diversifying acquisitions. In addition, we document significant value losses for shareholders from these conservative managerial decisions. Overall, our analysis suggests that agency problems can explain winners and losers from technological progress, thus highlighting firm-specific risk as an important and previously overlooked source of agency costs.
“Relative Governance” (with Kose John)
Using data on antitakeover provisions and headquarters location for a large sample of U.S. public corporations, this paper documents robust evidence of complementarity between firm-level and local corporate governance. In particular, we find that: 1) good governance begets good governance - i.e., firms are less likely to adopt antitakeover provisions in areas with good governance; 2) good firm-level governance increases firm value only if local governance is good. This result holds across a variety of measures of firm value, which include the returns to a buy-and-hold portfolio that longs good and shorts bad governance firms; the short term own and peer announcement returns of the passage of state business combination laws, poison pill adoption, and board declassification; Tobin's Q, operating performance, the value of cash holdings, and acquirer returns. A contribution of the paper is to develop a novel triple-difference estimator that addresses causality by exploiting exogenous variation in local governance generated by the passage of state business combination laws. Our results suggest that in order to understand the governance-performance relationship the literature needs to go beyond the standard single-firm assumption.
“Optimal Board Dynamics: Theory and Evidence” (with Antonio Falato)
This paper develops and tests new cross-sectional predictions on the equilibrium determinants of boards of directors. In particular, we study how shareholders design the structure of boards optimally -- i.e., how much they decide to monitor the CEO -- in order to exploit the competitive effect of managerial effort. Monitoring is costly since outside directors lack firm-specific information and expertise. Competition among firms is dynamic, in that laggards must first catch-up with the leading edge firms in the industry before battling for leadership in the future. In market equilibrium, the interaction between board structure and product market decisions affects the stationary distribution of firms. Our analysis identifies a dynamic feedback effect of industry structure on boards. As a result of this effect, we predict an inverse relation between board independence and, (i) across industries, the degree of symmetry of industry structure; (ii) within industry, firm position with respect to its peers. Moreover, we predict that board independence increases firm value only if industry structure is asymmetric. We find strong empirical support for these predictions in a large sample of U.S. firms over the 1996 to 2005 period. Our structural framework implies that the 2002 governance rules following the Sarbanes Oxley Act, which mandated changes in board independence, were costly for shareholders in industries with intense dynamic competition.
Work in Progress
“Cash and Intangible Capital” (with Antonio Falato and Jae Sim)
“Corporate Governance in a Knowledge Economy”
“Distracted Directors” (with Antonio Falato and Ugur Lel)
“Hedge Funds and Innovation” (with Alon Brav)
“Governing Misvalued Firms” (with Matthew Rhodes-Kropf)
“Preemptive Entrenchment: Theory and Evidence”
“CEO Successions and Firm Performance in the US Financial Industry" (with Antonio Falato)