Rewarding risk-taking or skill? The case of private equity fund managers

We examine whether typical private equity fund compensation contracts reward excessive risk-taking rather than managerial skill. Our analysis is based on a novel model of investment value, cash flows, and fee dynamics of private equity funds. Given the embedded option-like fee components, our results demonstrate that fund managers indeed have an incentive for excessive risk-taking when only fee income from the current fund is considered. However, when managers also consider potential compensation from follow-on funds, their risk-taking incentives depend on their individual skill levels, and skilled managers will have an incentive to reduce fund risk. We also show that managers must generate substantial abnormal returns in order to compensate investors for the given fee components.     

Universal Banking, Asset Management, and Stock Underwriting

This paper examines institutions that underwrite IPOs and have asset management divisions from 1993 through 1998. We provide evidence that these firms use asset management funds as vehicles to help them earn more equity underwriting business. We also show that asset managers affiliated with IPO underwriters use their superior information about their own institution's IPOs to earn annualised market adjusted returns 7.6% above asset managers of firms who did not underwrite the IPO. Superior future returns by asset managers who trade affiliated IPOs are dependent on the information environment for the IPO and the underwriter reputation rank.     

Are Golden Parachutes an Optimal Contracting Response or Evidence of Managerial Entrenchment?: Evidence from Successful Takeovers

Two models that attempt to explain the adoption of golden parachutes are examined. The first model views golden parachutes as an optimal contracting response to a takeover, the other perceives them as an outgrowth of severe managerial entrenchment that results in contracts for the benefit of managers. Using a sample of 169 successful acquisitions of NYSE targets from 1981 through 1989, I document that targets that have adopted golden parachutes experience significantly higher excess returns around the announcement of a takeover than targets without these contracts. I find similar increased excess returns for the bidder/target portfolios. In addition, bidder excess return is independent of the existence of golden parachutes in targets. Additional results suggest that golden parachutes do not reduce managerial resistance to takeovers. The results are consistent with the managerial entrenchment hypothesis and inconsistent with the optimal contracting hypothesis. Sensitivity tests confirm these results.     

State contingent banking and asset price bubbles: The case of Islamic banking industry

This paper examines how state contingent banking can help neutralize challenges like debt overhang and lack of optimal risk takings, problems associated with conventional banking that can eventually manifest in the creation of asset price bubbles and a financial crisis. Our analysis also contributes to the literature on Islamic banking which considers state contingent contracts as ideal from a religious perspective. We develop a model of banking with state contingent contracts on the liability and asset sides. Our model shows that in state contingent banking, the returns for the depositors, bank and the borrowers are more aligned with the real economy, which reduces the incentive for excessive borrowing, lending and investing. Our model also shows that with the state contingent banking on the liability side, during periods of heightened macroeconomic risk, depositors' payoff would be more volatile reducing the liquidity influx from the real economy to the banking sector. This neutralizes the pressure on state contingent banks to excessively lend on the asset side. Our model further demonstrates that state contingent contracts on the asset side can help avoid too much (or too little) lending by reducing the managerial discretion in charging low (or high) interest rates. With returns linked to the prices of the underlying assets, state contingent contracts may prevent lack of optimal risk taking.     

CEO Ownership,Stock Market Performance,and Managerial Discretion

We examine the relationship between CEO ownership and stock market performance. A strategy based on public information about managerial ownership delivers annual abnormal returns of 4% to 10%. The effect is strongest among firms with weak external governance, weak product market competition, and large managerial discretion, suggesting that CEO ownership can reverse the negative impact of weak governance. Furthermore, owner‐CEOs are value increasing: they reduce empire building and run their firms more efficiently. Overall, our findings indicate that the market does not correctly price the incentive effects of managerial ownership, suggesting interesting feedback effects between corporate finance and asset pricing.     

Corporate tax avoidance and high-powered incentives

This paper analyzes the links between corporate tax avoidance and the growth of high-powered incentives for managers. A simple model demonstrates the role of feedback effects between tax sheltering and managerial diversion in determining how high-powered incentives influence tax sheltering decisions. A novel measure of corporate tax avoidance (the component of the book-tax gap not attributable to accounting accruals) allows for an investigation of the link between tax avoidance and incentive compensation. Increases in incentive compensation tend to reduce the level of tax sheltering, in a manner consistent with a complementary relationship between diversion and sheltering. In addition, this negative effect is driven primarily by firms with relatively weak governance arrangements, confirming a central prediction of the model. These results can help explain the growing cross-sectional variation among firms in their levels of tax avoidance, the undersheltering puzzle, and why large book-tax gaps are associated with subsequent negative abnormal returns.     

Leading Indicator Variables, Performance Measurement, and Long-Term Versus Short-Term Contracts

In this article we develop a multiperiod agency model to study the role of leading indicator variables in managerial performance measures. In addition to the familiar moral hazard problem, the principal faces the task of motivating a manager to undertake “soft” investments. These investments are not directly contractible, but the principal can instead rely on leading indicator variables that provide a noisy forecast of the investment returns to be received in future periods. Our analysis relates the role of leading indicator variables to the duration of the manager's incentive contract. With short‐term contracts, leading indicator variables are essential in mitigating a holdup problem resulting from the fact that investments are sunk at the end of the first period. With long‐term contracts, leading indicator variables will be valuable if the manager's compensation schemes are not stationary over time. The leading indicator variables then become an instrument for matching the future investment return with the current investment expenditure. We identify conditions under which the optimal long‐term contract induces larger investments and less reliance on the leading indicator variables as compared with short‐term contracts. Under certain conditions, though, the principal does better with a sequence of one‐period contracts than with a long‐term contract.     

Business groups and the incorporation of firm-specific shocks into stock prices

Firm-specific information has a damped effect on business group-affiliated firms’ stock prices. Such firms’ idiosyncratic stock returns are less responsive to idiosyncratic commodity price shocks than are the idiosyncratic returns of otherwise similar unaffiliated firms in the same country and commodity-sensitive industry. Using global commodity shocks means we assess responses to common idiosyncratic shocks of the same magnitude, frequency, and observability. Further identification follows from difference-in-difference tests exploiting successful and matched exogenously failed control block transactions. We conclude that business group firms’ stock prices provide less firm-specific information to capital providers and managers.     

Real option component of cash holdings,business cycle,and stock returns

Corporate managers tend to preserve cash with an expectation of a worse economy while spend cash to exercise growth opportunities with a favorable economic condition. Using three empirical proxies (book-to-market ratio, idiosyncratic volatility and return on asset) in the literature, we extract a real option component of corporate cash holdings, serving both functions of precautionary saving and exercising growth options. Our empirical results show this component, in aggregate, increases when the real GDP declines and decreases when GDP inflates. Also, stocks with returns declining more to a shock to the aggregate real option component of cash holdings earn higher future returns. Moreover, stock returns of firms with higher cash holdings positively comove with the shock to the aggregate real option component, suggesting investors prefer to hold firms with higher cash holdings when the economy is deteriorating.     

Accrual versus cash-basis accounting methods: An agency-theoretic comparison

In an agency setting with moral hazard, this paper analytically demonstrates that accrual accounting is superior to cash-basis accounting (subject to costs). The main reason is that accrual accounting information more fully reflects the overall effects of managerial actions or efforts on future cash flows than cash flow realizations in any given period. As a result, accrual accounting information is more efficient than cash-basis accounting information for both motivating managers to expend efforts and sharing risks under moral hazard.     

Volatilities and Momentum Returns in Real Estate Investment Trusts

We examine the relation of time-varying idiosyncratic risk and momentum returns in REITs using a GARCH-in-mean model and incorporate liquidity risk in the asset pricing model. This is important because illiquidity may be more severe for REITs due to the nature of their underlying assets. We find that momentum returns display asymmetric volatility, i.e., momentum returns are higher when volatility is higher. Additionally, we find evidence that REITs with lowest past returns (losers) have higher idiosyncratic risks than those with highest past returns (winners) and that investors require a lower risk premium for holding losers’ idiosyncratic risks. Therefore, although losers have higher levels of idiosyncratic risks, their low risk premia cause low returns, which contribute to momentum. Lastly, we find a positive relation between REITs’ momentum return and turnover.     

Mergers increase default risk

We examine the impact of mergers on default risk. Despite the potential for asset diversification, we find that, on average, a merger increases the default risk of the acquiring firm. This result cannot solely be explained by the tendency for generally safe acquirers to purchase riskier targets or by the tendency of acquiring firms to increase leverage post-merger. Our evidence suggests that managerial motivations may play an important role. In particular, we find larger merger-related increases in risk at firms where CEOs have large option-based compensation, where recent stock performance is poor, and where idiosyncratic equity volatility is high. These results suggest that the increased default risk may arise from aggressive managerial actions affecting risk enough to outweigh the strong risk-reducing asset diversification expected from a typical merger.     

Hedge fund seeding with fees-for-guarantee swaps

This paper introduces a new instrument in the context of hedge fund seeding, which we call fees-for-guarantee swap, with the aim of alleviating the early-stage funds (ESF) managers' financial constraint caused by severe asymmetric information between investors and managers. The swap plays a role in enhancing the ESFs manager's credibility by swapping part of her fees for an insurance on the behalf of seeding investors, whom would be fully refunded once the fund defaults. We set up a dynamic continuous-time framework within which closed-form prices for seed capital, guarantee costs and other claims have been derived. Our numerical findings indicate that incentive compensations, managerial ownership and hedge funds liquidation risks not only inhibit ESFs managers' risk-shifting incentive but align interests among ESFs manager, seeder and insurer as well.     

Corporate Governance and Asset Sales: The Effect of Internal and External Control Mechanisms

We investigate firms that sell assets to determine whether corporate governance mechanisms are effective at controlling agency problems. Our evidence shows that these firms have lower managerial ownership and are more likely to make unrelated acquisitions, suggesting weak internal controls. Analysis of insider trading activity shows that, on average, net buying increases before the asset sale and shareholders benefit more when this occurs. Results suggest that how managers reach a given level of ownership provides more information about incentive alignment than just the level of ownership. Our results also highlight the dynamic nature of corporate restructuring as firms acquire and then sell assets.     

Corporate social responsibility as a common risk factor

This article challenges factor models widely used to explain stock returns. For European firms involved in corporate social responsibility (CSR) actions, we find a risk premium associated with extra-financial ratings priced by the market (that is, environmental, social, and governance [ESG] ratings). This premium is calculated as the excess return of low-rated firms compared to high-rated firms. To describe rated firms' returns, we propose a parsimonious two-factor model that includes both the market factor and this premium. Unlike the CAPM, three-, or five-factor models, our model is validated by the Gibbons, Ross and Shanken (1989) test. Our results lead to many managerial implications related to portfolio management, asset pricing, and corporate financial and investing decisions.     

Why Do Managers Diversify Their Firms? Agency Reconsidered

We develop a contracting model between shareholders and managers in which managers diversify their firms for two reasons: to reduce idiosyncratic risk and to capture private benefits. We test the comparative static predictions of our model. In contrast to previous work, we find that diversification is positively related to managerial incentives. Further, the link between firm performance and managerial incentives is weaker for firms that experience changes in diversification than it is for firms that do not. Our findings suggest that managers diversify their firms in response to changes in private benefits rather than to reduce their exposure to risk.     

An Equilibrium Model of Asset Pricing and Moral Hazard

This article develops an integrated model of asset pricing andmoral hazard. It is demonstrated that the expected dollar returnof a stock is independent of managerial incentives and idiosyncraticrisk, but the equilibrium price of the stock depends on them.Thus, the expected rate of return is affected by managerialincentives and idiosyncratic risk. It is shown, however, thatmanagerial incentives and idiosyncratic risk affect the expectedrate of return through their influence on systematic risk ratherthan serve as independent risk factors. It is also shown thatthe risk aversion of the principal in the model leads to lessemphasis on relative performance evaluation than in a modelwith a risk-neutral principal.     

Optimal Contracts Under Adverse Selection and Moral Hazard: A Continuous-Time Approach

This article presents a continuous-time agency model in thepresence of adverse selection and moral hazard with a risk-averseagent and a risk-neutral principal. Under the model setup, weshow that the optimal controls are constant over time, and thusthe optimal menu consists of contracts that are linear in thefinal outcome. We also show that when a moral hazard problemadds to an adverse selection problem, the monotonicity conditionwell known in the pure adverse selection literature needs tobe modified to ensure the incentive compatibility for informationrevelation. The model is applied to a few managerial compensationproblems involving managerial project selection and capitalbudgeting decisions. We argue that in the third-best world,the relationship between the volatility of the outcome and thesensitivity of the contract depends on interactions betweenthe managerial cost and the firm’s production functions.Contrary to conventional wisdom, sometimes the higher the volatility,the higher the sensitivity of the contract. The firm receivinggood news sometimes chooses safer projects or invests less thanit does with bad news. We also examine the effects of the observabilityof the volatility on corporate investment decisions.     

Executive stock-based compensation and firms’ cash payout: the role of shareholders’ tax-related payout preferences

We hypothesize that the structure of executive stock-based compensation helps to align managers’ payout choices with shareholders’ tax-related payout preferences. Specifically, stock options, which are not dividend-protected, can deter self-interested executives from using dividends as a form of payout. In contrast, restricted stock, which is dividend-protected, is more likely to induce the use of dividends. Relatedly, shareholders’ preferences for dividends, which are taxed as ordinary income, can depend on the income tax consequences of dividends relative to those of long-term capital gains. To test our hypothesis, we investigate whether the exogenous changes in shareholders’ tax-related payout preferences following the 2003 dividend tax rate reduction result in predictable shifts in executive stock-based compensation and in managers’ payout choices. Consistent with our prediction, we find a positive relation between the increased use of dividends in firms’ payouts and the increased (decreased) use of restricted stock (stock options) in executive compensation, particularly for firms with a greater percentage ownership by individual investors and with lower costs associated with modifying the structure of their compensation plans. Our investigation of the role of shareholders’ tax-related payout preferences in the design of executive stock-based compensation extends the prior literature that has largely focused on the role of incentive contracts in inducing managerial effort, risk taking, and retention.