Governance, Risk and Expected Returns: Research Frontiers in Corporate Finance

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Governance, Risk and Expected ReturnsResearch
Frontiers in Corporate Finance

• Kose John
• New York University
• 20h Annual Conference on Pacific Basin Finance,
  Economics, Accounting and Management
• September 8, 2012

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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)

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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,
  North-Holland, 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/North-Holland, Amsterdam, 2008.

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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

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Relationship between Governance and Risk

• Governance and Risk are closely related
• HolmstromRisk-neutral agent case
• Risk complicates design of executive compensation
• 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

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Governance and RiskCompensation and Risk

• 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

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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?

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Corporate governance (contd)

• Why takeovers, monitored debt, board of
  directors, large institutional block holders
  arise as governance mechanisms?
• John and Kedia (2009), John and Kedia(2010)
• How do these interact with each other?
• Stakeholder governance?
• Debt holder governance?
• Optimal bankruptcy systems? How do they interact
  with corporate governance mechanisms?

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Corporate governance (contd)

• 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?

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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

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Executive Compensation and Risk

• 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

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Central Issues

• What is the optimal structure of a well-designed
  compensation package?
• Optimal blend of restricted stocks and options?
• Theoretical and empirical work?

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Central issues (contd)

• 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?

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Central issues (contd)

• Level of CEO compensation?
• Too large, or too small?
• The right institutional structure and process to
  determine CEO compensation?

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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
  self-financing portfolio
• Sequence of years with good performance and hence
  bonuses. Disaster state in the 20th year.

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Dynamic Issues (contd)

• With such institutional convexities
• 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?

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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

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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.

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Literature-Empirical

• 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.

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Relationship between Financial Crisis and
Governance

• 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

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Literature Empirical (contd)

• 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)

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Literature Empirical (contd)

• Survey Morck, Wolfenzon and Yeung (JEL, 2005)
• Xiaoji Lin (JFE February 2012)
• Aslan and Kumar (RFS July 2012)

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Takeovers and the Cross-Section of Returns

• John, Cremers, and Nair
• RFS 2009

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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 MA 3,467 completed deals in 1980-1998

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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).

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Quintet of empirical results

• 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 Cross-sectional pricing of BM/size-sorted
  portfolios
• Relation to to governance portfolios Decrease
  significantly once we add the Takeover factor to
  the asset-pricing model

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Corporate Governance and Managerial Risk-Taking
Theory and Evidence

• Kose John, Lubomir Litov,
• Bernard Yeung
• Journal of Finance 2008

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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

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Governance and Risk

• Provide an agency-based rationale for the linkage
  between investor protection, risk-taking 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

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Merger Waves and Relative Governance

• Kose John, NYU Stern
• Dalida Kadyrzhanova, University of Maryland

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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))

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Main Results

• Relative Governance in a peer group of firms
  matter
• During merger waves the protection from ATMs make
  a significant difference.

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Agency Costs of Idiosyncratic Volatility,
Corporate Governance, and Investment

• Kose John, NYU SternDalida Kadyrzhanova,
  University of Maryland

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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 arent
• Managers are under-diversified due to the
  specificity of their human capital, equity
  incentives, etc.Well-diversified 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)

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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, RD)

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Empirical Evidence

• Robust evidence of agency costs of IVOL for high
  IVOL firms, entrenchment (ATPs) leads to excess
  managerial conservatism, i.e.
• lower RD higher Capex expenditures
• higher likelihood of diversifying acquisitions
• lower firm value (Tobins 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)

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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

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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