Governance, Risk and Expected Returns:
Research Frontiers in Corporate Finance
Kose John
New York University
20h Annual Conference on Pacific Basin Finance,
Economics, Accounting and Management
September 8, 2012
Introduction
• Corporate Governance and CEO compensation
• Research areas in Finance, Economics,
Management, Accounting and Law
• Appropriate for PFEAM September 2012
• Many central issues remain for future research
• Opportunities in theoretical and empirical work
• Surveys:
• Bolton, Becht and Roell (2003)
• Aggarwal (2008)
Recent Surveys
• P. Bolton, M. Becht and A. Roell, “Corporate
Governance and Control”, the Handbook of the
Economics of Finance, edited by George
Constantinides, Milton Harris and René Stulz, NorthHolland, 2003.
• Rajesh K. Aggarwal, “ Executive Compensation and
Incentives,” In: Eckbo,B.E. (Ed.), Handbook of
Corporate Finance: Empirical Corporate Finance, Vol. 2.
In: Handbooks in Finance Series. Elsevier/NorthHolland, Amsterdam, 2008.
Overview
• Very interesting interaction between risk and
corporate governance
• Very interesting interaction between risk and
executive compensation
• Interface of Corporate Finance and Asset Pricing
• Research Issues in these areas and some
existing work
• Open Research Questions
• Central Questions remain yet unanswered
• Relation to Global Financial Crisis
Relationship between
Governance and Risk
• Governance and Risk are closely related
• Holmstrom—Risk-neutral agent case
• Risk complicates design of executive compensation
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Partial ownership agency problems
Risk complicates governance problems
Example:
Even more so in a dynamic environment
Even more so in a competitive environment
• Relative Governance
Governance and Risk
Compensation and Risk
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Governance and Systematic Risk
Governance and Unsystematic Risk
Governance and Bondholders
Governance and Dividends
Tail Risk and Fake Alphas
Deferred Compensation and Claw-Back
Provisions
Corporate governance
• Basic theory is missing.
• Going beyond the agency theory: some central
issues.
• Incomplete contracts: how institutional
mechanisms (legal, financial, banks, markets)
evolve to improve governance and make up for
the gap in contracting?
Corporate governance (cont’d)
• Why takeovers, monitored debt, board of directors,
large institutional block holders arise as governance
mechanisms?
• John and Kedia (2009), John and Kedia(2010)
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How do these interact with each other?
Stakeholder governance?
Debt holder governance?
Optimal bankruptcy systems? How do they interact
with corporate governance mechanisms?
Corporate governance (cont’d)
• How does competition affect corporate
governance?
• What role do financial markets play? Corporate
governance and the ability to transfer large stakes
of ownership.
• Market economies vs. bank-centered economies?
• Financial policy and corporate governance: debt
and governance, dividends and governance?
• Economy-wide governance vs. firm-specific
governance?
Overview Of Some
Theoretical Research
• Design of Governance
• How is the optimal governance system structured in
different economies
• Growth and Governance
• How does the optimal governance change as firms grow
and economies grow
• Governance and regulation
• Positive and negative externalities
• Limited liability organizational forms and bailouts
• Institutional umbrella and noninvasive regulation
Executive Compensation and
Risk
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Large number of articles
Explosive Growth in options and articles
Wedge
Tying the undiversified CEO in an illiquid fashion
Restricted stocks, options
Not characterized the benefits of incentive
compensation (theoretically or empirically)
• Central trade-off
Central Issues
• What is the optimal structure of a well-designed
compensation package?
• Optimal blend of restricted stocks and options?
• Theoretical and empirical work?
Central issues (cont’d)
• The correct pay-for-performance metric?
• Does it measure the strength of managerial
incentives?
• Appropriate for non-linear compensation
structures?
• Appropriate for large firms and small firms?
Central issues (cont’d)
• Level of CEO compensation?
• Too large, or too small?
• The right institutional structure and process to
determine CEO compensation?
Dynamic issues
 Usual incentive compensation
 Manager augments the firm cash flow with a portfolio of
holdings designed to add the return distribution
10% with prob. 0.9999 and -10,000 % with prob.
0.0001
 This can be constructed with derivatives in a selffinancing portfolio
 Sequence of years with good performance and hence
bonuses. Disaster state in the 20th year.
Dynamic Issues (cont’d)
• With such institutional convexities:
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Optimal intertemporal compensation structure?
Deferred compensation?
Claw-back provisions?
Long-term vesting?
• Incentive structures in compensation and
disclosure. High-powered incentives also provide
incentives to exaggerate performance. Earnings
smoothing.Competition?
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 contro
- More valuable stock markets
- Higher number of listed firms and evaluation
Literature-Empirical
• Gompers, Ishi and Merrick (2003)
• 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.
• There are a large number of articles building on GIM.
Still the effect of governance on excess returns and
value remains unclear.
• Firms that increase governance do not show that
increases in performance follow.
Literature-Empirical
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Governance and risk-taking by managers.
Governance and systematic priced risk.
Relative governance.
Optimal level of governance is endogenous.
Governance simultaneously chosen with
financial policy variables, and incentive features
in CEO compensation.
Relationship between Financial
Crisis and Governance
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Governance failures and financial crisis?
Two objective functions?
Banks holding on to toxic assets and not lending
Dark side of complete markets
Fake alphas and systemic risk
Deferred compensation and Claw backs
• Competition?
• Dynamically optimal compensation structures
• Transparency of derivative trading
• Centralized Clearing
Literature Empirical (cont’d)
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Cremers, Nair and John (RFS, 2009)
John, Litov and Yeung (JF, 2008)
John and Litov (NYU WP, 2009)
John and Kadyrzhanova (NYU WP, 2009)
John and Knyazeva (NYU WP, 2009)
John, Knyazeva and Knyazeva (JFE, 2011)
John and Kadyrzhanova (NYU WP, 2012)
Francis, John, Hasan and Waisman (JFE, 2010)
Literature Empirical (cont’d)
• Survey: Morck, Wolfenzon and Yeung (JEL,
2005)
• Xiaoji Lin (JFE February 2012)
• Aslan and Kumar (RFS July 2012)
Takeovers and
the Cross-Section of Returns
John, Cremers, and Nair
RFS 2009
The impact of takeovers on
valuation
Takeover activity: idiosyncratic or (partly)
systematic?
Bruner (2004); Rhodes-Kropf & Viswanathan (2005)
Time-varying, takeover waves
Related to equity market conditions
Potential effect significant
Mitchell and Stafford (2003)
Median bid premium 1980-1998: 35%
Lots of M&A: 3,467 completed deals in 1980-1998
Takeover impact
on expected returns
Takeover likelihood
Proxy for the exposure to (unobserved) state variables
determining the cash flows & price of risk
More sensitive to cash flow shocks:
higher required rate of return
Why? You receive cash (takeover premium) when you
least need it (when the market is doing great).
Quintet of empirical results
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Abnormal returns related to takeover vulnerability, ‘Takeover’
factor
Using estimates of takeover likelihood, construct a takeover
spread portfolio
Relative to Fama-French-Carhart four-factor model, 11.7%
annualized abnormal return
Takeover factor predicts real takeover activity
Explains differences in cross-section of equity returns Crosssectional pricing of BM/size-sorted portfolios
Relation to to governance portfolios: Decrease significantly
once we add the Takeover factor to the asset-pricing model
Corporate Governance and
Managerial Risk-Taking: Theory and
Evidence
Kose John, Lubomir Litov,
Bernard Yeung
Journal of Finance 2008
What is this paper about?
Large existing literature
Better investor protection  lower cost of
capital, more informed and developed
capital markets, better capital allocations
 faster growth
Offer an additional angle
Better investor protection  managers
undertake more value enhancing risky
investment  faster growth
A model + empirical evidence
Governance and Risk
Provide an agency-based rationale for the
linkage between investor protection, risktaking and growth.
Corporate managers are sub-optimally
conservative in the presence of large
perks.Better governance mechanisms lower
perks, leading to more value-enhancing risky
investments.
Corporate accountability and risk-taking.
Risk-taking and growth. Not caused by
income-smoothing
Merger Waves and Relative Governance
Kose John, NYU Stern
Dalida Kadyrzhanova, University of Maryland
Motivation
Classical agency view
Contestable market for corporate control disciplines
managers (Manne (1965), Scharfstein (1988))
Resilient puzzle: weak or no relation between ATPs and
outcomes in the market for corporate control
Takeover Premiums (Comment & Schwert (1995))
Takeover Likelihood (Bates, Becher, & Lemmon
(2008))
“Overall, the evidence is inconsistent with the conventional
wisdom that board classification is an antitakeover device that
facilitates managerial entrenchment” (BBL (2008))
Main Results
• Relative Governance in a peer group of firms
matter
• During merger waves the protection from ATMs
make a significant difference.
Agency Costs of Idiosyncratic Volatility,
Corporate Governance, and Investment
Kose John, NYU Stern
Dalida Kadyrzhanova, University of
Maryland
Motivation
Identifies new fundamental conflict of interest due to
firm-specific uncertainty ‘Dark side’ of IT shocks
Agency problem may arise since managers are
exposed to total risk, while shareholders aren’t
Managers are under-diversified due to the specificity
of their human capital, equity incentives, etc.Welldiversified shareholders only care about systematic
risk
Key insight: Agency problem is likely to be more
severe when the wedge between total risk and priced
risk (IVOL) is high Amihud & Lev (1981)
Main Hypotheses
Behavioral hypothesis:
Managers of high IVOL firms will want to turn
down too many risky projects & accept too
many safe projects
IVOL hypothesis:
Agency costs of idiosyncratic volatility are
higher for firms with ATPs, whose managers
are more entrenched. First-order effect is on
capital budgeting decisions (corporate
investment, R&D)
Empirical Evidence
Robust evidence of agency costs of IVOL: for high IVOL firms,
entrenchment (ATPs) leads to excess managerial
conservatism, i.e.
1. lower R&D & higher Capex expenditures
2. higher likelihood of diversifying acquisitions
3. lower firm value (Tobin’s Q)
New GMM approach to deal with omitted variables and
reverse causality
To address reverse causality, additional evidence from
“natural experiment”
Governance shocks (passage of state BC laws)
IVOL shocks (industry IT intensity shocks)
Concluding Thoughts
• Governance and Risk are closely related
• Top-Management compensation and Risk are
closely related
• Opportunities abound to make central research
contributions
• Governance, Compensation and Systematic Risk
• Corporate Finance and Asset Pricing
• Dynamic Issues
• Effect of Competition
Conclusions
• Need more theory
• Need more careful empirical work
• Perhaps more structural models of governance
and CEO compensation
• More calibration in corporate finance to sort out
first order and second order effects in
governance
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Governance, Risk and Expected Returns