The Moderating Effect of Relative Performance Evaluation on the Risk Incentive Properties of Executives’ Equity Portfolios

We offer evidence that the use of relative performance evaluation (RPE) in CEOs’ incentive contracts influences the effect of risk‐taking incentives on both the magnitude and composition of firm risk. We find that, when the incentive design lacks RPE features, the incentive portfolio vega motivates CEOs to increase total risk through the systematic component because it can be hedged. In contrast, when the incentive design includes RPE features, CEOs prefer idiosyncratic risk because RPE filters out the systematic component of firm performance. We also document that the use of RPE reinforces the incentive portfolio vega's effect on the total risk.     

Capital Structure Swaps and Shareholder Wealth

We show how capital structure swaps can increase the wealth of a firm's long‐term shareholders when a firm's debt or equity is misvalued. We review the conventional rule that a firm should issue equity and use the proceeds to retire outstanding debt (an equity‐for‐debt swap) when equity is overvalued, or repurchase equity with proceeds of new debt (a debt‐for‐equity swap) when equity is undervalued. We also analyse the more complex case where a firm's debt and equity are both undervalued, showing the optimal swap may be to issue undervalued equity, contrary to the conventional rule.     

Contracting for information under imperfect commitment

We study optimal contracting under imperfect commitment in a model with an uninformed principal and an informed agent. The principal can commit to pay the agent for his advice but retains decision‐making authority. Under an optimal contract, the principal should (i) never induce the agent to fully reveal what he knows—even though this is feasible—and (ii) never pay the agent for imprecise information. We compare optimal contracts under imperfect commitment to those under full commitment as well as to delegation schemes. We find that gains from contracting are greatest when the divergence in the preferences of the principal and the agent is moderate.     

Financing Decisions along a Firm’s Life‐cycle: Debt as a Commitment Device

We analyse the life‐cycle patterns of a firm’s financing decisions and their interaction with future growth and development decisions. We derive different financing sequences which we link to existing empirical research as well as derive new testable hypotheses regarding differences in firms’ financing decisions to project, firm, market and country characteristics. We provide a rationale for the importance of (external) start‐up debt financing as observed in recent empirical studies. Furthermore, we argue that equity financing at both development stages is more likely for closely‐held firms and in countries in which entrepreneurs face high stigmatisation costs.     

Transparency,Liquidity, and Valuation: International Evidence on When Transparency Matters Most

We examine the relation between firm‐level transparency, stock market liquidity, and valuation across countries, focusing on whether the relation varies with a firm's characteristics and economic environment. We document lower transaction costs and greater liquidity (as measured by lower bid‐ask spreads and fewer zero‐return days) for firms with greater transparency (as measured by less evidence of earnings management, better accounting standards, higher quality auditors, more analyst following, and more accurate analyst forecasts). The relation between transparency and liquidity is more pronounced in periods of high volatility, when investor protection, disclosure requirements, and media penetration are poor, and when ownership is more concentrated, suggesting that firm‐level transparency matters more when overall investor uncertainty is greater. Increased liquidity is associated with lower implied cost of capital and with higher valuation as measured by Tobin's Q. Finally, a mediation analysis suggests that liquidity is a significant channel through which transparency affects firm valuation and equity cost of capital.     

Managerial Incentives,Fraud, and Monitoring

In response to equity compensation contracts that encourage managers to commit fraud as well as provide productive effort, owners may choose to monitor the manager to limit the fraud. We examine the firm owners’ incentives to perform both ex ante monitoring, such as internal controls, and ex post monitoring, such as audits, in a model that includes the reputational damages caused when a fraud is discovered. We provide conditions under which the owner prefers either more or less monitoring, and examine the effect of additional monitoring on the optimal equity package and equilibrium level of fraud.     

Testing Agency Theory with Entrepreneur Effort and Wealth

We develop a principal‐agent model in an entrepreneurial setting and test the model's predictions using unique data on entrepreneurial effort and wealth in privately held firms. Accounting for unobserved firm heterogeneity using instrumental‐variables techniques, we find that entrepreneurial ownership shares increase with outside wealth and decrease with firm risk; effort increases with ownership; and effort increases firm performance. The magnitude of the effects in the cross‐section of firms suggests that agency costs may help explain why entrepreneurs concentrate large fractions of their wealth in firm equity.     

Information Revelation, Lock-In, and Bank Loan Commitments

This paper considers the extent to which loan commitments mitigate the problems of information monopolies that arise when the firm contracts with a private lender. Loan commitments in conjunction with short-term debt often provide the firm with superior investment incentives by influencing both the states in which bargaining occurs as well as the outcomes from bargaining. Commitment contracts are particularly valuable when there is a high likelihood that information about the firm will be publicly revealed ex post. We also identify circumstances under which the firm foregoes commitment financing, relying on short-term debt instead. Journal of Economic Literature Classification Numbers G21, G32, D82.     

Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model

We derive the optimal dynamic contract in a continuous‐time principal‐agent setting, and implement it with a capital structure (credit line, long‐term debt, and equity) over which the agent controls the payout policy. While the project's volatility and liquidation cost have little impact on the firm's total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise.     

Managerial hedging,equity ownership,and firm value

Suppose risk‐averse managers can hedge the aggregate component of their exposure to firm's cash‐flow risk by trading in financial markets but cannot hedge their firm‐specific exposure. This gives them incentives to pass up firm‐specific projects in favor of standard projects that contain greater aggregate risk. Such forms of moral hazard give rise to excessive aggregate risk in stock markets. In this context, optimal managerial contracts induce a relationship between managerial ownership and (i) aggregate risk in the firm's cash flows, as well as (ii) firm value. We show that this can help explain the shape of the empirically documented relationship between ownership and firm performance.     

Standard promotion practices versus up‐or‐out contracts

This article develops a theory concerning the choice between standard promotion practices and up‐or‐out contracts. Our theory is based on asymmetric learning and promotion incentives. We find that firms employ up‐or‐out contracts when firm‐specific human capital is low and standard promotion practices when it is high. We also find that, if commitment to a wage floor is feasible and effort provision is important, up‐or‐out is employed when low‐ and high‐level jobs are similar. These results are consistent with many of the settings in which up‐or‐out is typically observed, such as law firms and academia.     

Optimal capital structures for private firms

This article shows how to construct an optimal capital structure for a private firm. Since the agents who supply the firm’s capital are risk averse, they diversify by holding both debt and equity. This can mitigate, or even eliminate, the classical risk shifting problem. There is a wealth effect since the optimal capital structure, which can involve multiple types of debt, depends on the amount of wealth that each agent contributes to the firm. However, it is shown that the agents’ equity holdings do not depend on the contributed amounts of wealth. Thus the model can produce a wedge between ownership rights and equity cashflow rights. These features are illustrated in a firm with three agents.     

Efficiency out of disorder: Contested ownership in incomplete contracts

In many situations, irreconcilable disagreements between players lead to costly ownership disputes over assets—for example, in case of joint ownership. This article studies the role of such disputes in a situation where two players have to make a transaction‐specific investment and when contracts are incomplete. I show that potentially contested ownership may mitigate the inefficiency of investments due to the incompleteness of contracts generating an exchange surplus that comes closer to the first‐best surplus as compared to any other ex ante distribution of ownership typically discussed in the literature following the influential work by Grossman, Hart, and Moore. If the contest is an all‐pay auction, each player makes a transaction‐specific investment as if he or she owns the asset. This article can explain why shared ownership—as for example in equity joint ventures, family firms, start‐up partnerships, and so on—is an important part of today's corporate landscape.     

Optimal job design in the presence of implicit contracts

We characterize the optimal job design in a multitasking environment when the firms use implicit contracts (i.e., bonus payments). Two natural forms of job design are compared: (i) individual assignment, where each agent is assigned to a particular job and (ii) team assignment, where a group of agents share responsibility for a job and are jointly accountable for its outcome. Team assignment mitigates the multitasking problem but may weaken the implicit contracts. The optimal job design follows a cutoff rule where only the firms with high reputation concerns opt for team assignment. However, the cutoff rule need not hold if the firm can combine implicit incentives with explicit pay‐per‐performance contracts.     

Myopic loss aversion,reference point,and money illusion

We use the portfolio selection model presented in He and Zhou [Manage. Sci., 2011, 57, 315–331] and the NYSE equity and US treasury bond returns for the period 1926–1990 to revisit Benartzi and Thaler’s myopic loss aversion theory. Through an extensive empirical study, we find that in addition to the agent’s loss aversion and evaluation period, his reference point also has a significant effect on optimal asset allocation. We demonstrate that the agent’s optimal allocation to equities is consistent with market observation when he has reasonable values of degree of loss aversion, evaluation period and reference point. We also find that the optimal allocation to equities is sensitive to these parameters. We then examine the implications of money illusion for asset allocation. Finally, we extend the model to a dynamic setting.     

Yesterday's Heroes: Compensation and Risk at Financial Firms

Many believe that compensation, misaligned from shareholders’ value due to managerial entrenchment, caused financial firms to take risks before the financial crisis of 2008. We argue that, even in a classical principal‐agent setting without entrenchment and with exogenous firm risk, riskier firms may offer higher total pay as compensation for the extra risk in equity stakes borne by risk‐averse managers. Using long lags of stock price risk to capture exogenous firm risk, we confirm our conjecture and show that riskier firms are also more productive and more likely to be held by institutional investors, who are most able to influence compensation.     

Institutional Investment Horizons and the Cost of Equity Capital

We examine the influence of institutional investors’ investment horizons on a firm's cost of equity. We argue that the cost of equity will decrease in the presence of institutional investors with longer‐term investment horizons due to improved monitoring and information quality. Our empirical results demonstrate that the cost of equity declines in the presence of institutional investors with long‐term investment horizons, all else remaining equal. Our results indicate also that the monitoring role of long‐term institutional investors is more pronounced for firms with higher agency problems (poorly governed firms). Overall, our evidence suggests that when considering the influence of institutional investors, it is critical to account for institutional heterogeneity, which leads to new directions for future research.     

Passive Institutional Ownership,R2 Trends,and Price Informativeness

A distinctive trend in the capital markets over the past two decades is the rise in equity ownership of passive financial institutions. We propose that this rise has a negative effect on price informativeness. By not trading around firm‐specific news, passive investors reduce the firm‐specific component of total volatility and increase stock correlations. Consistent with this hypothesis, we find that the growth in passive institutional ownership is robustly associated with the growth in market model R²s of individual stocks since the early 1990s. Additionally, we find a negative relation between passive ownership and earnings predictability, an informativeness proxy.     

Accounting rules,equity valuation,and growth options

In a model with irreversible capacity investments, we show that financial statements prepared under replacement cost accounting provide investors with sufficient information for equity valuation purposes. Under alternative accounting rules, including historical cost and value in use accounting, investors will generally not be able to value precisely a firm’s growth options and therefore its equity. For these accounting rules, we describe the range of valuations that is consistent with the firm’s financial statements. We further show that replacement cost accounting preserves all value-relevant information if the firm’s investments are reversible. However, the directional relation between the value of the firm’s equity and the replacement cost of its assets is different from that in the setting with irreversible investments.     

A theory of delegated search for the best alternative

Searching for the best worker, a reliable supply alternative, or the most profitable investment is frequently delegated to an agent. This article develops a theory of delegated search. We show that the principal’s ability to delegate depends on the agent’s luck, her initial resources, and the contract that governs her search. With moral hazard, the optimal contract is characterized by performance deadlines with bonuses for early completion. If performance cannot be specified, the optimal search is implemented by an option‐to‐buy contract for the principal. If performance is partially specified, the optimal contract is a standard pay‐for‐performance arrangement.