Οικονομικό Πανεπιστήμιο Αθηνών
Τμήμα Οικονομικής Επιστήμης
Άνοιξη 2012
Χρηματοοικονομικές αγορές και εταιρική διακυβέρνηση
Lecture 9: Monitoring (Chapter 8)
Recall:
The Anglo-Saxon (AS) model of corporate governance emphasize a well-developed stock
market with strong investor protection, substantial disclosure requirements, shareholder
activism (i.e. pension funds) and takeovers. In this model public debt market (commercial
paper, bonds) may flourish
The AS model is criticized for encouraging short-termism and preventing long-term trust
relationships between management and stakeholders from developing. [Managers do not
invest enough because the prospect of cashing in on stock options or a takeover or being
fired make them too concerned with short-term performance. Also, financial markets are
too short term oriented in that analysts look for firms that will perform well in the short
term but not necessarily in the long term]
The Germany Japan (GJ) model encourages long-term trust relationships between
management and investors. Many firms stay private and the stock market is thin. Banks
are very important. Ownership is quite concentrated. The system is favoring established
managers.
Monitoring: There is a way of reducing informational asymmetries between firms and
investors.
Active and passive monitoring
According to the type of information that investors should gather in an efficient
governance structure. We have:
Active monitoring:
Prospective or value enhancing information: Information collected by equity holders like
a venture capitalist or a large shareholder before managerial decisions. It refers to
information regarding the optimal action that the firm should take. It improves the firm’s
decision making. It helps decisions like: investments, advertising, pricing, replacement of
management etc. It is associated with either formal or real control.
Passive monitoring
Retrospective or speculative information: Information on past managerial performance. Is
collected by equity holders who do not interfere with the firm’s management but want to
know how the stock price is affected by the announcement of good or bad news.
Although passive it can serve the purpose of rewarding or punishing the management for
its past behavior.
Entry into corporate governance
Active monitoring can be undertaken by incumbents (such as a venture capitalist or a
board of directors) or by entrants such as a raider or a proxy fight organizer. Entry into
monitoring may be desirable for reasons that are similar to the entry into any
conventional market (monopoly with/without the fear of entry).
Entry into the monitoring market is important as: Incumbent monitors may collude with
management and not perform their monitoring function.
Entry into corporate monitoring may be costly for the firm. There is luck of trust and
coordination problems between managers and new monitors.
Who is a good monitor?
Junior claimants have greater incentives to monitor as their claim is more sensitive than a
senior claim to managerial moral hazard.
Sometimes banks are better monitors.
It is efficient to have different monitors collecting different pieces of information: A large
equityholder has good incentives to monitor value enhancements. A short-term debt
holder has good incentives to monitor risk taking etc.
Performance measurement and the value of speculative information
The existence of early signals of performance reduces the agency cost and thereby
increases the pledgeable income, facilitating financing.
Let a (basic research activity) firm. The research activity will last 3 to 4 years and the
final profit is a poor indicator of the prospects created (the value of assets in place) by the
initial activity. Also, the final product is realized after a long period of time.
How could the entrepreneur be rewarded for his performance during this period?
It is important to measure his performance early: The manager may need the money long
before the final profit is realized. Also, we can have better incentive schemes if we can
obtain some indication of the manager’s effort early in time.
In this framework, the design of managerial compensation requires obtaining
performance measures that do not rely solely on accounting and income recognition.
The set- up:
An entrepreneur has a project that requires a fixed investment I. He has cash A < I. He
must borrow I – A from investors. The project is subject to moral hazard. The project
succeeds with prob. pH if the entrepreneur works. The project succeeds with prob. pL if
the entrepreneur does not work hard. The project yields income R in the case of success
and yields no income in the case of failure. The entrepreneur may mismanage the project.
In such case he gets private benefit B.
After the entrepreneur’s choice of effort but before the project succeeds or fails
information can be acquired about the final outcome.
There are two possible signals. H, L. The positive probability of signal j conditional on
effort i is denoted sij. Let vj the probability of success given signal j. We also have: vH >
pH (the high signal enhances the confidence in success) and vL < pL.
Effort i  {H.L} > signal sij. > signal j > vj > outcome
The ex ante probability of success given a high and a low effort to be equal to pH and pL
respectively it must be the case that:
pH = sHH vH + sHL vL.
(1)
and the ex ante probability of success given a low effort:
pL = sLH vH + sLL vL.
(2)
Free performance monitoring
The signal can be obtained for free and the entrepreneur’s incentive scheme can be
directly contingent on this signal.
The entrepreneur receives reward Rb in a case of a high signal (regardless of success or
failure), and zero in the case of a low signal.
The reward for a good signal should be sufficient to induce the entrepreneur to choose the
high effort. A high effort increases the probability of a high signal from sLH to sHH. but
does not enable the entrepreneur to enjoy a private benefit B. We require:
(sHH – sLH) Rb≥B.
As Rb≥B/( sHH – sLH), the expected value of the entrepreneur’s share can not be lower than
sHH Rb=( sHH*B)/( sHH – sLH).
Thus, the necessary and sufficient condition for funding is: The project’s NPV net of the
entrepreneur’s share exceeds the investor’s contribution to the initial investment:
pH R - ( sHH*B)/( sHH – sLH) ≥ I - A
Recall, when no signal is available we have:
pH R - (pH *B)/( pH- pL)  I – A
We have: (by siH + siL = 1 for i  {H.L}) the following
(pH )/( pH- pL) > ( sHH)/( sHH – sLH)
The existence of the signal increases pledgeable (secured) income and thus facilitates
funding (the minimum A the entrepreneur needs to have is smaller).
In general: Early signals provide information about future performance, and thus about
the moral hazard activity.
Designated monitor
Costly monitoring (c) for the party that collects the signals. The information collected is
private. Thus, there is a moral hazard issue in the collection of information. The monitor
must be given an incentive scheme that induces him to (a) collect the information and (b)
to reveal truthfully this information.
The entrepreneur offers to the monitor a stock option contract with strike price equal to
the stock price at the date at which the options are granted. The monitor has the right to
purchase s’ shares at the ex ante par value pH R per share [recall, sHH is the prob. the
signal is high]. The number of options is given by
s’ * sHH(vH R - pH R) = c
(3)
Why does the above consist a NE?
The entrepreneur is paid according to: sHH Rb*=( sHH*B)/( sHH – sLH), that is he receives
Rb* if the monitor exercises his option and receives zero if he does not (which conveys
bad news about the value of the firm). The entrepreneur works if he expects monitor to
collect the information.
Suppose the entrepreneur is expected to choose the high effort. If the monitor does not
purchase the signal, he does not know the signal. He can buy the stock option: Not
knowing the signal, he still values shares at their ex ante par value pH R which is also the
strike price. The monitor makes no profit.
If the monitor purchases the signal, then with probability sHH the signal is high and the
shares are worth vH R to the monitor. Thus, he has capital gain equal to (vH R - pH R ) per
share. When the value is low, the monitor values shares at vL R < pH R and does not
exercise the options. (Exp. Benefit from collecting the information is equal to its cost:
See equation 3). That is, the monitor dos not receive a rent.