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Abstract:
Our model of the initial public offering process links the three main empirical IPO anomalies underpricing, hot issue markets, and long-run underperformance and traces them to a common source of inefficiency. We relate hot IPO markets (such as the 1999/2000 market for Internet IPOs) to the presence of a class of investors who are irrational in the sense of having exuberant expectations regarding future performance. Underpricing and long-run underperformance emerge as underwriters attempt to maximize profits from the sale of equity, at the expense of these exuberant investors. Underpricing serves to compensate regular IPO investors for their role in restricting the supply of available shares and maintaining prices. The model is shown to be consistent with many aspects of the IPO process. It also generates a number of new empirical predictions.

Abstract:
Our model of the initial public offering process links the three main empirical IPO anomalies underpricing, hot issue markets, and long-run under performance and traces them to a common source of inefficiency. We relate hot IPO markets (such as the 1999/2000market for Internet IPOs) to the presence of a class of investors who are irrational inthe sense of having exuberant expectations regarding future performance. Underpricingand long-run under performance emerge as underwriters attempt to maximize profits fromthe sale of equity, at the expense of these exuberant investors. Underpricing serves tocompensate regular IPO investors for their role in restricting the supply of available shares and maintaining prices. The model is shown to be consistent with many aspects of the IPO process. It also generates a number of new empirical predictions.

Abstract:
We model an IPO company's optimal response to the presence of sentiment investors and short sale constraints. Given regulatory constraints on price discrimination, the optimal mechanism involves the issuer allocating stock to 'regular' institutional investors for subsequent resale to sentiment investors, at prices the regulars maintain by restricting supply. Because the hot market can end prematurely, carrying IPO stock in inventory is risky, so to break even in expectation regulars require the stock to be underpriced - even in the absence of asymmetric information. However, the offer price still exceeds fundamental value, as it capitalizes the regulars' expected gain from trading with the sentiment investors. This resolves the apparent paradox that issuers, while shrewdly timing their IPOs to take advantage of optimistic valuations, appear not to price their stock very aggressively. The model generates a number of new and refutable empirical predictions regarding the extent of long-run underperformance, offer size, flipping, and lock-ups.

Initial public offerings, hot issue markets, behavioural finance, long-run performance

Abstract:
We model an IPO company's optimal response to the presence of sentiment investors and short sale constraints. Given regulatory constraints on price discrimination, the optimal mechanism involves the issuer allocating stock to 'regular' institutional investors for subsequent resale to sentiment investors, at prices the regulars maintain by restricting supply. Because the hot market can end prematurely, carrying IPO stock in inventory is risky, so to break even in expectation regulars require the stock to be underpriced - even in the absence of asymmetric information. However, the offer price still exceeds fundamental value, as it capitalizes the regulars' expected gain from trading with the sentiment investors. This resolves the apparent paradox that issuers, while shrewdly timing their IPOs to take advantage of optimistic valuations, appear not to price their stock very aggressively. The model generates a number of new and refutable empirical predictions regarding the extent of long-run underperformance, offer size, flipping, and lock-ups.

Initial public offerings, hot issue markets, behavioural finance, long-run performance

Abstract:
The paper develops an equilibrium model in which both the structure of mutual funds and the liquidity premium on a traded security are determined endogenously. The setting is one in which investors, subject to liquidity shocks, choose whether to invest directly in the security, invest via mutual funds or stay with cash. Mutual funds, by pooling across investors, emerge as an efficient way for investors with greater liquidation costs to invest -- by diversifying uncorrelated liquidity shocks, minimizing the impact of systematic shocks by optimal asset allocation and by enabling investors to commit to ex-post transfers across investors with different liquidity realizations. Alternative fund structures may be optimal depending on fund efficiency and other model parameters. In the equilibrium in which some investors hold the security directly and others hold mutual fund shares or cash, it is shown that mutual funds emerge as the marginal investors in the security, thereby determining its price and liquidity premium. In the presence of mutual funds, the liquidity premium is shown to be relatively insensitive to increases in the supply of the security, unlike the situation when mutual funds are absent. It is shown that improvements in fund efficiency will tend to result in fund structures with lower penalties for early withdrawal, a reduction in the security liquidity premium and an increase in the size of the fund industry. An interesting feature is that relatively small improvements in fund efficiency can result in large changes in the size of the mutual fund industry, accompanied by changes in fund structure -- which, we argue, is consistent with recent experience. The model is used to generate empirical predictions and to discuss policy and welfare implications.

Abstract:
Recent literature has been largely negative in its assessment of corporate diversification. Diversified firms have been regarded as destructive of firm value, prone to agency problems and divisional rent-seeking. The empirical finding that multi-division firms tend to trade at a 'discount,' or negative 'excess value' relative to their single-segment counterparts, is claimed in support of this view. Our paper offers a different, more positive, perspective. We develop a simple, industry-based model to argue that conglomeration (and discounts) may, in fact, reflect an endogenous, value-enhancing response of firms to industry conditions and agency problems prevalent in all firms, not just conglomerates. With managers reluctant to reduce assets under their control, conglomeration emerges as a way to optimally induce managers to shift resources away from an industry, in response to unfavorable conditions. The model also provides a framework, with testable implications, to analyze patterns of conglomeration and excess values across different environments. The degree of conglomeration in an industry is predicted to have an inverse relation to the excess values of conglomerates in the industry and to the investment opportunities anticipated for single-segment firms. Using a panel data set of fifty of the largest US industries, over 1978-1997, we find significant empirical support for the model's predictions.

Abstract:
This paper provides a model that explains the structure of mutual funds. Specifically, the paper explains why funds structure as open- or closed-end funds, and why some open-end funds charge loads. In our model fund managers generate earn excess returns that, on the margin, are increasing in their ability and decreasing in the size of funds under management. Managers capture the rents from their ability by optimally setting the management fee and attracting funds from investors. Investors have stochastic liquidity needs that impose a cost on open-end funds and reduce managers' expected profits by causing the funds available for investment to deviate from an optimal level. While managers of open-end funds can charge loads to discourage investors with high anticipated liquidity needs, they need to pay a premium in the form of higher expected returns to attract the relatively scarce investors with low liquidity needs. Fund managers whose ability is known with more precision can avoid paying investors the premium by forming closed-end funds which provide investors liquidity without exposing the fund to liquidity shocks. Managers whose ability is more uncertain will prefer to form open-end funds, however, since an open-end fund will tend to be closer to an optimal size as investors respond to new information about managerial ability by increasing or decreasing the funds under management. The model provides several empirical implications: 1) Among open-end funds, load funds are more profitable to operate than no-load funds. 2) Investors in open-end load fund earn higher returns than those in no-load open-end funds. 3) The higher the uncertainty in investor liquidity needs in the economy, the higher is the rate of return required by investors in open-end load funds. 4) Minimum loads charged by open-end funds are positively related to investors' rate of return from such funds and uncertainty in liquidity needs in the economy. 5) Closed-end fund managers are likely to be those with a well established reputation.

Abstract:
This paper develops a theory of organization based on the benefits and costs of internal capital markets. A central assumption is that the transaction cost of raising external funds is greater than the cost of internal funds. The benefit of internal resource allocation is that it gives the firm a real option to avoid external capital markets (and the associated deadweight transaction costs) in more states of the world than single-business firms. The cost is the internal resource flexibility exacerbates an over investment agency problem. The optimal focus is determined by trading off the benefit of the option against the cost of over investment. In this context, we show how the relative efficiency of integration and separation depends ultimately on assignment of control rights over cash flow. Testable implications are derived for the level of divisional investment, the sensitivity of divisional investment to cash flow, and the diversification discount.

Abstract:
We analyze cross-sectional and time-series patterns in the relationship between firms that are frequent issuers of new securities and their underwriters over the 1970-1996 period. In particular, we focus on the relation between fees charged for underwriting services and the closeness of the firm's relationship with its primary underwriter. We find that firms that are more loyal to their primary investment bank tend to pay higher fees when issuing securities. The loyalty premium is smaller for public utilities than it is for other industrial firms. Fees are also somewhat lower when a firm switches from its primary bank to another underwriter. We propose and investigate alternative hypotheses for the loyalty premium. We can reject, for instance, the hypothesis that it is underwriter market power in particular industry segments that accounts for higher loyalty and fees. There is, however, evidence that the concentration of firms in an industry segment is negatively related to underwriting fees. We find that it is firms that are of smaller size, issue securities less often and have lower credit ratings, that tend to be more loyal and to pay higher fees. This is supportive of the notion that the loyalty premium may partly reflect compensation for a relatively higher level of underwriter advice and service regularly sought by the less experienced and unsophisticated issuers. We also find a decrease in firm loyalty over the sample period, with the larger, and presumably more prestigious, underwriters tending to have more loyal clients. Average fees have also declined over this period, at least in part due to the introduction of shelf registration.

Abstract:
It is well known that historically a larger number of firms issue common stock and the proportion of external financing accounted for by equity is substantially higher in expansionary phases of the business cycle. We show that this phenomenon is consistent with firms selling seasoned equity when they face lower adverse selection costs, which occurs in period with more promising investment opportunities and with less uncertainty about assets in place. Thus, firm announcements of equity issues are predicted to convey less adverse information about equity values in such periods. Empirically, we find evidence that generally supports these predictions. Consistent with historical patterns, firms in recent times have tended to increase equity more frequently in expansionary periods. While business cycle variables are significant explanatory variables, interest rate variables are generally insignificant. The adverse selection effects as measured by the average negative price reaction to seasoned common stock offering announcements is significantly lower in expansionary periods and in periods with a relatively larger volume of equity financing. These offer announcement effects are less negative for smaller stock offerings and for issuers with less uncertainty about assets in place.

Seasoned equity offering, SEOs, common stock offers, business cycles, adverse selection, aggregate stock issuance activity

Abstract:
We examine the extent to which a fund's cash flows are affected by the stellar performance of other funds in its family - and consequences of such spillovers. We show that star performance results in greater cash inflow to the fund and to other funds in its family. Moreover, families with higher variation in investment strategies across funds are shown to be more likely to generate star performance. We argue that spillovers may induce lower ability families to pursue star creating strategies. Consistent with our conjecture, families with high variation in investment strategies across funds significantly underperform low variation families.

Mutual Funds, Performance Evaluation, Cash Flow, Fund Complex, Fund Family, Investment

Abstract:
This paper presents a rationale for divestiture consistent with one of the frequently cited reasons by divesting firms, namely, that the firm is undervalued and splitting the firm into its component businesses will make it easier for the market to value the components accurately. The rationale is based on two basic premises. One, the market can observe the aggregate cash flows of the firm but not divisional cash flows; two, the cost of financing a project by divesting a division is greater than the cost of external equity financing which, in turn, is costlier than internal capital. In this setup, we show that the firm may be misvalued if the informativeness of divisional cash flows regarding the respective divisions' future prospects are different. If an undervalued firm needs external capital, it may resort to costly divestiture while an overvalued firm will use less costly external equity, resulting in correct valuation of the divisions. Among the empirical implications the model yields are: 1) The stock price reaction to a divestiture announcement is positive and is greater for focus-increasing divestitures; 2) Firms that divest invest more than their conglomerate counterparts; 3) Firms that divest are likely to divest the poorly performing divisions.

Abstract:
We hypothesize that public firms that create novel innovations rely more on arm's length financing (equity and public debt) than on relationship based bank financing. A primary reason is that banks, unable to evaluate novel technologies, will tend to discourage investing in innovative projects and be more prone to shut down ones that are ongoing. Using a large panel of US companies from 1974-2000, we find that consistent with our predictions, firms that rely more on arm's length financing have a larger number of patents and these patents are more significant in terms of influencing subsequent patents. We confirm our findings by showing a significant increase in innovative activity of firms following a large infusion of arm's length financing and no such pattern after a similar infusion of bank loans. Creating novel innovations leads to a significantly higher firm value and suggests that firms would rationally take into account the potential impact of innovative activity when making their financing choices. Finally, we use an IV approach to ameliorate endogeneity concerns and demonstrate that our findings are driven primarily by innovative firms choosing their financing arrangements.

Technological, Innovation, Finance, Growth, Patent, Citations, Arm's Length, Capital Structure

Abstract:
In the 1990s, a large majority of funds with front-end loads introduced additional share classes, which allowed investors to pay annual fees and/or back-end charges instead of a front-end load. The transition to a multiple-class structure provides a natural experiment with regard to investor clienteles and fund performance. We examine (a) whether the new fee structures increase fund cash flows by attracting investors with different investment horizons and sensitivities to performance; (b) whether changes in the volatility and level of fund flows induced by new investor clienteles affect fund performance - despite little change in fund management and investment objectives. Our finding is that the multiple-class funds, after controlling for performance and fund attributes, attract significantly more new money than the single-class funds. Consistent with the clientele hypothesis, investors in the new classes tend to have a shorter investment horizon and a greater sensitivity to fund performance than investors in the front-end load class. The downside to introducing the new classes, however, is a significant drop in fund performance, which erodes the cash flow benefit of the new classes. Furthermore, the performance drop is shown to be increasing in the relative size of the new classes and in the volatility of their fund flows.

Abstract:
Close to 50% of municipal bonds are pre-packaged with insurance at the time of issue. We offer a tax-based rationale for the emergence of third-party insurance of tax-exempt bonds. We argue that insurance adds value as it allows a third party to become, in a probabilistic sense, an issuer of tax-exempt securities. Insurance, however, reduces value by eliminating the possibility of a capital tax loss. While the net benefit from insurance increases with bond maturity, the benefit may not increase monotonically with default risk. We also provide empirical evidence supportive of the model's predictions.

Tax-exempt bonds, Insurance, Tax-arbitrage

Abstract:
Close to 50% of municipal bonds are pre-packaged with insurance at the time of issue. We offer a tax-based rationale for the emergence of third-party insurance of tax-exempt bonds. We argue that insurance adds value as it allows a third party to become, in a probabilistic sense, an issuer of tax-exempt securities. Insurance, however, reduces value by eliminating the possibility of a capital tax loss. While the net benefit from insurance increases with bond maturity, the benefit may not increase monotonically with default risk. We also provide empirical evidence supportive of the model's predictions.

Abstract:
In the 1990s, many load funds introduced additional share classes that give investors the choice of paying back-end loads and/or annual fees instead of front-end loads. The transition to a multiple-class structure provides a well-controlled setting for research with regard to investor clienteles and fund performance. We examine (a) whether the new fee structures increase the level and volatility of fund cash flows by attracting new investor clienteles; (b) whether changes induced in fund flow characteristics by the new investor clienteles affect fund performance - despite little change in fund management and investment objectives. We find that investors in the new classes tend to have a shorter investment horizon and greater sensitivity to past fund performance than investors in the front-end load class. Introducing the new classes attracts significantly more new money in the first one to two years, controlling for performance and other fund attributes. The downside, however, is that about two years after introducing the new classes, funds experience a significant drop in performance, which is expected to substantially erode the cash flow growth induced by the new classes. The results in the paper have significant implications for empirical studies of mutual funds using the data in the 1990s.

mutual fund, share class, performance, flow, expense

Abstract:
In this paper we offer a novel, internal capital market explanation for dividend payments by business group firms by relating the dividends to insiders' direct investment in other firms in the group. We analyze a simple model in which business groups operate a type of internal capital market and channel resources to profitable investments across the group. Dividend payout and its reinvestment by group insiders provides a transparent means of transferring cash across group firms, in contrast to intra-group investments. The trade-off from the insiders' perspective is that while the dividend channel reduces private benefits it is also associated with lower auditing and monitoring costs than the more opaque intra-group channel. The model generates a number of testable predictions: (i) group firm dividends are predicted to be correlated with investments by other firms in the group and the correlation is expected to be stronger when the investments are smaller and more profitable and when the legal regime is more protective of shareholder rights and (ii) insider holding in a group firm is predicted to be positively related to dividend distributions by other member firms. We find strong support for our predictions in firm level data from 23 countries within Asia and Europe.

Business Groups, Dividends, Insider Holding

Abstract:
This paper investigates the resource allocation decision in conglomerates under moral hazard. We consider a firm where the input factors are unknown managerial ability that is common to all divisions, capital allocated to each division, and intangible resources that the manager allocates to each division. While capital allocation across divisions is fully observable, the allocation of intangible resources is only partially observable. The divisions differ in how informative of their cash flows are about managerial ability. The manager maximizes perceived ability. In this set up, we show that divisions with more informative cash flows about the manager's ability receive more than the first-best allocation of both capital and intangible resources. This allocation inefficiency results in conglomerates being valued less than a portfolio of single-segment firms. The paper shows that the diversification discount increases with the variance of informativeness, and the correlation, between the divisions. The discount decreases as the observability of the intangible resource allocation improves. The model also highlights a cost of segment reporting, namely, that it creates avenues for managers to distort their perceived ability at the expense of shareholders.

Abstract:
What is the role of lead arranger reputation in the loan syndication market? We answer this question by examining the impact of borrower bankruptcy - which we use to identify loss of reputation - on a lead arranger's ability to syndicate future loans. Consistent with a reduced syndication ability, there is a drop in the lead arranger's aggregate level of activity in the loan syndication market. The lead arranger shifts lending to less risky borrowers and is more likely to include security and restrictive covenants in its loans. Controlling for loan amount and borrower fixed effects, the lead arranger syndicates loans less often and finances a larger percentage of the loans that it does syndicate. Other lenders are in general less willing to participate in the lead arranger's syndicates, but this effect is weaker in case of lenders that have done several deals with the lead arranger in the past. The negative consequences of borrower bankruptcy are stronger for small lead arrangers and are weaker in years when several other lead arrangers also suffer borrower bankruptcy. Overall, our findings support the notion of borrower bankruptcy damaging the lead arranger's reputation, and highlight the importance of lead arranger reputation in the loan syndication market. Our findings cannot be fully explained by alternate hypotheses that only emphasize pecuniary losses incurred by the lead arranger or poor investment prospects in the lead arranger's area of specialization.

Reputation, Syndicated loans, Lead arranger, Bankruptcy

Abstract:
We argue that powerful CEOs induce their boards to shift the weight on performance measures towards the better performing measures, thereby rigging the incentive part of their pay. The intuition is developed in a simple model in which some powerful CEOs exploit superior information and lack of transparency in compensation contracts to extract rents. The model delivers an explicit structural form for the rigging of CEO incentive pay along with testable implications that rigging is expected to (1) increase with CEO power; (2) increase with CEO human capital intensity and uncertainty about a firm's future prospects; and (3) negatively impact firm performance. Using measures of CEO power and board independence on a large panel of firms in the U.S., we find support for these predictions. Rigging accounts for 10%-30% of the sensitivity of compensation to performance measures and is increasing in CEO human capital and volatility of a firm's future prospects. Moreover, the portion of incentive pay that is predicted by power is associated with negative subsequent future stock performance of the order of 1% and operating performance of 5% per year. Overall, the results provide evidence against the agency substitution theory and support instead the entrenchment skimming theory.

CEO Power, Incentive Contracts, CEO Compensation, Board of Directors, Governance, Rent Extraction

Abstract:
We examine underwriting fees for repeat issuers of new securities to determine the relation between loyalty to an underwriting bank and the fees charged. For a sample of offers over the 1975-2001 period, we find that loyalty is associated with lower fees for common stock offers, consistent with valuable relationship capital being built through loyalty. For debt offers, however, we find the opposite pattern, consistent with relationship capital not being as valuable. For both offer types, firms that graduate to higher-quality banks face lower fees. Firms that are more likely to be switching banks to improve analyst coverage face higher fees for common stock offers, but not for debt offers.

Underwriting, Relationship capital, Firm loyalty, Seasoned offers

Abstract:
We examine underwriting fees for repeat issuers of new securities to determine the relation between loyalty to an underwriting bank and the fees charged. For a sample of offers over the 1975-2001 period, we find that loyalty is associated with lower fees for common stock offers, consistent with valuable relationship capital being built through loyalty. For debt offers, however, we document the opposite pattern, consistent with relationship capital not being as valuable. For both offer types, firms that graduate to higher quality banks face lower fees. Firms that are more likely to be switching banks to improve analyst coverage face high fees for common stock offers, but not for debt offers.

Abstract:
We develop a model of trading by an informed fund manager compensated on the basis of her fund's Net Asset Value (NAV) and show that she has an incentive to pump her portfolio by buying securities already held by her fund. Such portfolio pumping leads to excessive trading and diminished long-term fund performance. Portfolio pumping also introduces an upward bias in measured NAVs and contributes to the closed-end fund discount. Despite such costs, it may be optimal to base fund manager compensation on NAV in order to incentivize her to trade more aggressively.

mutual fund, managerial incentives, trading

Abstract:
This paper investigates the resource allocation decisions in conglomerates when managers are motivated by career concerns. The output of a conglomerate division is determined by the unknown ability of corporate management, the capital employed in the division, and intangible resources that the management allocates to the division. While capital allocation across divisions is fully observable and contractible, the allocation of intangible resources is not. The divisions differ in how informative their cash flows are about managerial ability. Corporate management, influenced by career concerns, seeks to maximize perceived ability. In this set up, we show that it is in the interest of management to overallocate intangible resources to the more informative divisions in order to increase the market's perception of its ability. Anticipating this bias, it is in the firm's owners' interest to also overallocate capital to the more informative divisions. To the extent that industries with lower cash flow informativeness have higher q-ratios, this inefficiency results in a form of corporate socialism. Value loss due to the allocational inefficiency increases with the difference in informativeness and the correlation between the divisional cash flows. The model highlights a cost of segment reporting and tracking stocks, namely, that they create avenues for managers to distort their perceived ability at the expense of investors.

Conglomeration, capital misallocation, career concerns, resource allocation, inefficient capital allocation

Abstract:
We investigate the importance of reputation-based implicit contracts in firm financing in the context of Indian Business Groups. The group structure enables us to cleanly analyze the negative spillovers on other firms, triggered by a member firm defaulting on its debt obligations. We hypothesize that business group insiders will support financially distressed member firms in order to maintain the group's reputation. The default by a group firm will damage a group's reputation - making it more difficult for the remaining firms to raise capital, thereby affecting their performance and survival. We show this to be the case for our sample: Groups use intra-group loans to support member firms in financial distress and, as a result, firms belonging to groups with unimpaired reputation are less likely to become bankrupt, relative to stand alone firms. The first bankruptcy in a group is followed by a significant drop in the amount of external finance raised, a discontinuous drop in investments and profits, and an increase in the bankruptcy probability of other healthy firms in the group. Consistent with loss of reputation being the reason for these spillovers, we find that negative consequences are more severe for firms in the group with closer managerial links to the bankrupt firm and for firms which depend more on external finance.

Reputation, business groups, spillovers

Abstract:
To estimate the grant-date expense of their employee stock options (ESOs), as required under the new accounting rules (FAS 123R), companies have typically had to choose among various theoretical valuation models because there is no secondary market for ESOs. Different models, all permissible under FAS 123R, produce widely different values, raising questions about the efficacy of the new rules. We study an alternative market-based scheme, recently proposed by Zions Bancorporation, in which options are valued by means of an online auction of securities (ESOARS) that track the aggregate payments made to the reference ESOs. Zions has conducted two ESOARS auctions, under somewhat different rules (in June 2006 and May 2007). We investigate whether the auctions represent an effective, arms-length approach to the pricing of ESOs - as indicated by bidders' demand elasticity and a comparison of the auction prices to various model-based estimates. Despite legitimate concerns about size and seller incentives, we find that the auction mechanism appears quite resilient in terms of delivering fair values of ESOs. In particular, the 2007 auction - with rules that, for instance, reduce incentives to delay bidding ('snipe') - produced a value similar to those generated by models that explicitly consider the historical pattern of employees' early exercise decisions (e.g., Bajaj et. al. (2006)). Policy and other implications of our findings are discussed as well.

auctions, employee stock options, financial reporting

Abstract:
Recent literature has been largely negative in its assessment of value effects of corporate diversification. Does value maximization nevertheless play an important role in the conglomeration process? Drawing upon value maximization theories, we identify industry conditions that make a conglomerate structure more likely and relatively more valuable. We argue that existing value maximization theories of conglomeration predict a negative relation between two industry factors (growth opportunities and industry concentration) and the degree of conglomeration in an industry. We find empirical support for this prediction using a panel of 50 industries across 20 years. The role of value-maximization in conglomeration decisions is further supported by the evidence that conglomerates are more valuable relative to single segment firms when industry conditions predict high levels of conglomeration. Although our evidence does not rule out the existence of agency-motivated conglomeration, we conclude that value-maximization also plays an important role.

Conglomeration, Excess value, Diversification, Internal capital market, Focus

Abstract:
We show that closed-end fund managers can reduce their fund discount by adopting a target distribution policy that commits the fund to distribute at least 10% of its net assets each year. In some cases it is evident that the distribution policy is adopted in response to takeover threats and pressure from investors. We develop a simple model to show that the target distribution policy, by reducing the fund's growth rate of total net assets (TNA), lowers its anticipated exposure to non-fundamental risk (e.g., sentiment risk) - and, thereby, the fund discount. Interestingly, the discount can decrease without any change in the sensitivity of a fund to non-fundamental risk. Empirical evidence confirms that there is a positive and significant relationship between the average TNA growth rate and the level of discount, and that the commitment to a high payout ratio is essential for the target policy to be effective. Moreover, funds with the target policy tend to have higher sensitivity to non-fundamental shocks, suggesting that it is funds with larger potential discounts that have a greater incentive to adopt the target distribution policy.

closed-end fund, payout policy, limited arbitrage, non-fundamental risk

Abstract:
The adoption of a Managed Distribution Policy (MDP) by closed-end funds appears effective in dramatically reducing, even eliminating, fund discounts. We investigate various explanations: the signaling explanation offered in the literature - that the MDP serves as a positive signal of future fund performance - and alternatives based on agency costs (two versions) and investor dividend preferences. Our results indicate that signaling is, at best, only part of the explanation and that the evidence is generally more consistent with a (prospective) version of agency costs and the dividend preference hypothesis. For funds adopting aggressive payout targets of 10% (median target) and above, discounts tend to disappear or even be replaced by premia - though there is no discernible improvement in NAV performance. Further, inconsistent with signaling, it is often pressure from institutions/large shareholders that leads to the adoption of aggressive payout policies. We find that institutions, as a whole, tend to build up their fund holdings prior to the adoption of an aggressive MDP - and liquidate their positions once the price rises. Some evidence that we uncover, in terms of rights offerings and correlation between MDP discounts and measures of investor dividend preference, is generally more supportive of the dividend preference than the agency cost hypothesis.

Payout Policy, Closed-End Discount, Signaling, Agency Costs, Dividend Preferences

Abstract:
We study the offer choice between rights and firm commitments for a sample of industrial firms issuing equity in the 1930's and 1940's. Unlike existing studies, our sample is drawn from a time period when rights were as common an offer method for industrial firms as were firm commitments. This sample allows us to perform out-of-sample tests of existing theories of offer choice. Our analysis indicates that firms choosing rights were larger, healthier firms with lower leverage and higher cash flow liquidity. Firms electing the firm commitment method experienced significantly negative size-adjusted returns during the 12 months following the offer, consistent with recent evidence for SEO's. In striking contrast, firms issuing equity through rights were not subject to negative post-offer returns, suggesting that firm commitments were timed to exploit overvaluation while rights offers were not. Finally, we investigate a number of long term factors that could have contributed to the decision to migrate from rights issues to firm commitment.

Rights offers, Firm commitments, Equity issuance, Offer choice

Abstract:
The adoption of a Managed Distribution Policy (MDP) by closed-end funds appears effective in dramatically reducing, even eliminating, fund discounts. We investigate various explanations: the signaling explanation offered in the literature - that the MDP serves as a positive signal of future fund performance - and alternatives based on agency problems and investor naiveté. Our results indicate that signaling and agency are, at best, only part of the explanation. The evidence is more supportive of a naive investor hypothesis: the possibility that fund prices may be driven by naive investors that mistake payout - which can include return of capital - for performance. For funds adopting aggressive payout targets of 10% or larger, discounts tend to disappear or even be replaced by premia - though there is no discernible improvement in NAV performance. More moderate MDP funds experience a small reduction in discount and, under some specifications, an improvement in NAV performance. Consistent with investor naiveté, aggressive MDP funds experience higher prices even when the payout involves a return of capital rather than profits. Institutions/large shareholders exert significant pressure for the adoption of aggressive payout policies. We find that institutions tend to build up their fund holdings prior to influencing the adoption of an aggressive MDP - and liquidate their positions, presumably selling to naive retail investors, once the price rises. While aggressive payout tends to deplete assets, funds that begin trading at a premium are able to replenish their capital, at least in part, through new rights offerings.

Closed-End Fund Discount, Payout Policy, Behavioral Bias

Abstract:
It is widely believed that contrary to standard asset allocation theory, employees irrationally hold concentrated investments in company stock in their 401(k) plans thus bearing firm-specific risk that could otherwise have been diversified away [See for example, Benartzi (2001)]. However, in measuring any such lack of diversification costs, a unique tax benefit associated with such investments (available to those who choose the Net Unrealized Appreciation [NUA] strategy) has been hitherto ignored. We analyze an employee's optimal allocation of retirement assets among alternative investments, including company stock, in the presence of the NUA tax benefit. The employee has a standard power utility function and seeks to maximize expected utility from her after-tax wealth upon retirement. Based on simulations, we find that, even when company stock is stochastically dominated by investments in the market index, the employee will allocate a non-trivial part of her retirement funds to company stock for a wide range of parameter values. Consistent with empirical evidence, the allocation to company stock is greater for employees closer to retirement and when the company's stock has experienced substantial gain in value.

NUA, 401(K), Retirement, Investment in Company Stock

Abstract:
We analyze the risk choices by hedge funds that perform poorly, relative to other funds and in absolute terms -- and test predictions on the extent to which these decisions are related to the fund's incentive contract, investment horizon and dissemination of performance information. We find that "tournament" behavior is more prevalent in the (backfilled) period when funds may be at an incubation stage, before they start voluntarily reporting to a database. Excluding backfilled data, we find that variance shifts depend on absolute rather than relative fund performance. Consistent with theoretical arguments, the propensity for losing funds to increase risk is significantly weaker among those that tie the manager's incentive pay to the fund's high-water mark -- suggesting a possible benefit from such incentive structures -- and among funds that face little immediate risk of closure. Overall, the combination of factors such as reporting performance to a database, high-water mark provisions, and low risk of fund closure appear to make poorly performing funds more conservative with regard to risk-shifting.

hedge funds, tournaments, risk-taking, backfilling, high-water marks

Abstract:
Prior literature argues that stock-for-stock mergers are often financed by overvalued stock. How do a target's institutional owners trade when faced with a stock-financed bid, particularly one from an acquirer more likely to be overvalued? If institutional owners perceive the acquirer's stock as overvalued, arguments in Shleifer and Vishny (2003) imply they should sell their holdings more aggressively in order to reap short-term profits. We find, however, that while institutions are net sellers in stock-for-stock deals they retain significantly more shares when valuation measures suggest a greater potential for acquirer overvaluation. We also find that share retention is increasing in the acquirer's price-to-book ratio regardless of whether the institution prefers growth or value stocks. Institutions with large-cap, growth-stock preferences are particularly enthusiastic about bids from large high price-to-book acquirers, substantially increasing their stakes in such deals.

Abstract:
Prior literature argues that stock-for-stock mergers are often financed by overvalued stock. How do a target's institutional owners trade when faced with a stock-financed bid, particularly one from an acquirer more likely to be overvalued? If institutional owners perceive the acquirer's stock as overvalued, arguments in Shleifer and Vishny (2003) imply they should sell their holdings more aggressively in order to reap short term profits. We find, however, that while institutions are net sellers in stock-for-stock deals they retain significantly more shares when valuation measures a greater potential for acquirer overvaluation. We also find that share retention is increasing in the acquirer's price-to-book ratio regardless of whether the institution prefers growth or value stocks. Institutions with large-cap, growth-stock preferences are particularly enthusiastic about bids from large high price-to-book acquirers, substantially increasing their stakes in such deals.

Mergers and acquisitions, takeovers, institutional trading, overvaluation

Abstract:
Prior literature argues that stock-for-stock mergers are often financed by overvalued stock. How do a target's institutional owners trade when faced with a stock-financed bid, particularly one from an acquirer more likely to be overvalued? If institutional owners perceive the acquirer's stock as overvalued, arguments in Shleifer and Vishny (2003) imply they should sell their holdings more aggressively in order to reap short term profits. We find, however, that while institutions are net sellers in stock-for-stock deals they retain significantly more shares when valuation measures a greater potential for acquirer overvaluation. We also find that share retention is increasing in the acquirer's price-to-book ratio regardless of whether the institution prefers growth or value stocks. Institutions with large-cap, growth-stock preferences are particularly enthusiastic about bids from large high price-to-book acquirers, substantially increasing their stakes in such deals.

Mergers and acquisitions, takeovers, institutional trading, overvaluation

Abstract:
Close to 50 prominent business schools have been named in the 1980s and 1990s, in exchange for sizable financial donations. We view the business school naming market as an interesting example of the type of exhaustible resource market examined in Hotelling (1931). When considering an offer, business schools face a trade-off that involves a possible benefit from waiting (the potential to receive a larger gift) against the cost of delay (the opportunity cost of capital). We find that business schools wait to accept a name until the annualized rate of increase in offered gifts is around 5%. This is in keeping with Hotelling's principle and the existence of a functioning market in business school names. We also find that on average, lower ranked schools receive smaller naming gifts and delay their namings longer.

Business school namings, hotelling

Abstract:
Close to 50 prominent business schools have been "named" in the 1980s and 1990s, in exchange for sizable financial donations. Recognizing that schools are limited in number and have one name to sell, we suggest that the market for business school names can be regarded as an interesting example of the type of exhaustible resource market examined in Hotelling (1931). When considering an offer, business schools face a trade-off that involves a possible benefit from waiting (the potential to receive a larger gift) against the cost of delay (the opportunity cost of capital). Heterogeneity in the prestige of business schools, however, can affect this tradeoff. We propose that lower ranked schools may have the most to gain from waiting, since they may be able to attract higher naming gifts as the supply of schools with similar or higher prestige diminishes. The empirical results suggest that lower ranked schools are indeed named later, and that business schools wait to accept a name until the annualized rate of increase in offered gifts is around 5%.

Abstract:
Our model of the initial public offering process links the three main empirical IPO 'anomalies' - underpricing, hot issue markets, and long-run underperformance - and traces them to a common source of inefficiency. We relate hot IPO markets (such as the 1999/2000 market for Internet IPOs) to the presence of a class of investors who are 'irrational' in the sense of having exuberant expectations regarding future performance. Underpricing and long-run underperformance emerge as underwriters attempt to maximize profits from the sale of equity, at the expense of these exuberant investors. Underpricing serves to compensate regular IPO investors for their role in restricting the supply of available shares and maintaining prices. The model is shown to be consistent with many aspects of the IPO process. It also generates a number of new empirical predictions.

Initial public offerings, hot issue markets, behavioural finance, long-run performance

Abstract:
Empirical evidence indicates that venture capital funds, unlike mutual funds, deliver persistent abnormal returns and top performing funds are often reluctant to accept additional funds from investors. Why do VC funds leave money on the table, rather than increasing their fees or size? We argue that VC funds are fundamentally different from mutual funds and buyout funds because success is contingent on attracting high quality entrepreneurs/firms. However, attracting good investment prospects may depend on whether the fund manager is perceived as having the ability to add value. We show that when there is asymmetric information about fund attributes or fee structure, the fund's performance can be an indicator of managerial quality, giving managers the incentive to manipulate fund returns. In particular, by charging lower fees and/or constraining fund size a manager tries to improve firms' beliefs about his ability to add value. In equilibrium firms are not fooled. Regardless, the manager leaves money on the table because otherwise his probability of matching with good investment opportunities decreases. We consider various forms of information asymmetry and discuss implications for equilibrium fees, fund size and net returns to investors. We discuss how managers' incentive to manipulate firms beliefs depends on time series and cross sectional properties of the VC fund attributes. For example, our theory can explain why we have stronger performance and persistence of returns in venture capital compared to buyout firms.

venture capital, private equity, persistence in alphas, signal

Abstract:
Do reputation concerns of a lead arranger help alleviate agency problems with participant lenders in the loan syndication market? We investigate this question by measuring how defaults by a lead arranger's borrowers affect its subsequent lending activity. Defaults appear to diminish a lead arranger's ability to syndicate loans: fewer loans are syndicated and lead arrangers retain a larger fraction of loans they do syndicate. This is consistent with a loss of lead arranger reputation, and contrary to defaults affecting subsequent lending only via a reduction in lead arranger capital. The effects are stronger when lead arrangers are small and when the defaults are less expected; e.g., when few other lead arrangers experience defaults, when the loans are low-yield loans and when defaults occur soon after loan origination. Lenders continuing to participate in the lead arranger's syndicates tend to be small, less diversified and to have a strong prior relationship with the lead arranger. Overall, there is a significant decline in the lead arranger's lending activity following defaults, suggestive of an erosion in capital in addition to a loss of reputation. Our results support the disciplining role of reputation concerns in the loan syndication market, and also highlight the limitations of a reputation-based disciplining mechanism.

Reputation, Loan syndication, Defaults

Abstract:
We investigate whether the timing of equity sales to exploit market overvaluation may account for the reported poor post-offer stock performance of firms issuing equity. We posit that rights offers, targeted to a firm's current shareholders, are less likely to be timed to exploit overvaluation. Our study compares firm commitment and rights offerings during 1933-1949 when rights offers were common. We find that abnormal returns for firms electing the firm commitment method were significantly negative over the year following the offer, while those for firms using rights were not. This suggests that firm commitments were timed, while rights offers were not.

Abstract:
We investigate whether the timing of equity sales to exploit market overvaluation may account for the reported poor post-offer stock performance of firms issuing equity. We posit that rights offers, targeted to a firm's current shareholders, are less likely to be timed to exploit overvaluation. Our study compares firm commitment and rights offerings during 1933-1949 when rights offers were common. We find that abnormal returns for firms electing the firm commitment method were significantly negative over the year following the offer, while those for firms using rights were not. This suggests that firm commitments were timed, while rights offers were not.

rights offers, firm commitments, seasoned equity offer, managerial timing

Abstract:
We investigate the functioning of internal capital markets in Indian Business Groups. We document that intra-group loans are an important means of transferring cash across group firms and that such transfers are typically used to support the financially weaker firms. Groups significantly increase the extent of loans when member firms are hit with a negative earnings shock. Consistent with a support motive, loans tend to be made on favorable terms - typically at zero interest - and loan inflows significantly reduce the bankruptcy probability. Loans are not, in general, used to fund investment opportunities or to tunnel resources. Evidence suggests that an important reason for support may be to avoid group firm default and consequent negative spillovers to the group. The first bankruptcy in a group is followed by a significant drop in the amount of external finance raised, a discontinuous drop in investments and profits, and an increase in the bankruptcy probability of other healthy firms in the group. Moreover, consistent with spillovers on account of negative information, we find that consequences are more severe for firms with closer managerial links to the bankrupt firm.

Reputation, business groups, spillovers

Abstract:
Existing literature argues that disparity in investment opportunities within diversified firms can erode firm value. We investigate this 'diversity cost' hypothesis in the context of spinoffs by using post-spinoff data to (1) 'reconstruct' the diversified firm after the spinoff and assess the aggregate improvement in value (relative to focused firms) and (2) relate any value improvements to changes in diversity. We find that improvements in aggregate value depend significantly on changes in both a direct measure of diversity and measures based on industry proxies. We conclude that diversification discounts at least partially reflect a value loss due to the diversified nature of the firm itself, rather than selection bias or measurement error.

Abstract:
The takeover boom of the 1980s was accompanied by a series of innovations in debt contracts, including the poison put that allowed bonds to be redeemed in the event of a corporate control change. By any measure the poison put was a successful innovation and was included in a large majority of convertible debt offerings, shortly after the first issues with such provisions. In the paper we attempt to understand the factors that contributed to the widespread adoption of this innovation in convertible bonds and the consequences for shareholder wealth. Our findings suggest that by reducing the potential for bondholder-shareholder conflicts, poison puts resulted in significant benefits to issuing firm shareholders, particularly if the firm was under takeover speculation. There were no benefits if the firm had adopted anti-takeover measures prior to the offering. There is weaker evidence of wealth transfer from existing bondholders of the firm shareholders as a consequence of such poison puts.

Abstract:
This paper presents a rationale for divestiture consistent with one of the frequently cited reasons by divesting firms, namely, that the firm is undervalued and splitting the firm into its component businesses will make it easier for the market to value the components accurately. When firms are undervalued due to unobservability of divisional cash flows, they may resort to divestiture to raise capital while overvalued firms will use external equity. Diversification thus might result in costly future divestiture. Firms trade off this expected cost of diversification against the benefit of higher levels of cheaper internal capital in deciding the scope of the firm.

Abstract:
We propose a simple model in which all agents are rational and symmetrically informed. We show that when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability -- in the sense that prices can move rationally, even in the absence of any change in fundamentals. We explore the effects of market composition and market trading rules on the stability of the market. Sufficiently large margin requirements are always associated with stability. Decreasing the margin requirements sufficiently may also ensure stability. A major result of the paper is that price limits might enhance market stability by excluding potentially destabilizing market prices. The tradeoffs involved in choosing an optimal combination of price limits and margin requirements to achieve market stability are analyzed. The possible role of specialists and price continuity rules in enhancing market stability are discussed.

Abstract:
We show that when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability--in the sense that prices can move rationally--even in the absence of any change in fundamentals. We show this with a simple model in which all agents are rational and symmetrically informed. We discuss welfare implications of price stability and explore the effects of market composition and market trading rules on the stability of the market. A major result of this article is that price limits might enhance market stability by excluding potentially destabilizing market prices.

Abstract:
This paper provides a model that explains the structure of mutual funds. Specifically, the paper explains why funds structure as open- or closed-end funds, and why some open-end funds charge loads. In our model fund managers generate earn excess returns that, on the margin, are increasing in their ability and decreasing in the size of funds under management. Managers capture the rents from their ability by optimally setting the management fee and attracting funds from investors. Investors have stochastic liquidity needs that impose a cost on open-end funds and reduce manager's expected profits by causing the funds available for investment to deviate from an optimal level. While managers of open-end funds can charge loads to discourage investors with high anticipated liquidity needs, they need to pay a premium in the form of higher expected returns to attract the relatively scarce investors with low liquidity needs. Fund managers whose ability is known with more precision can avoid paying investors the premium by forming closed-end funds which provide investors liquidity without exposing the fund to liquidity shocks. Managers whose ability is more uncertain will prefer to form open-end funds, however, since an open-end fund will tend to be closer to an optimal size n as investors respond to new information about managerial ability by increasing or decreasing the funds under management. The model provides several empirical implications: 1) Among open-end funds, load funds are more profitable to operate than no-load funds. 2) Investors in open-end load fund earn higher returns than those in no-load open-end funds. 3) The higher the uncertainty in investor liquidity needs in the economy, the higher is the rate of return required by investors in open-end load funds. 4) Minimum loads charged by open-end funds are positively related to investor's rate of return from such funds and uncertainty in liquidity needs in the economy. 5) Closed-end fund managers are likely to be those with a well established reputation.

Abstract:
The paper analyzes financial innovations by investment banking firms in an environment in which client firms find it costly to switch between banks and can delay their utilization of bank services. An underlying assumption is that financial products, unlike many other innovative products, cannot be patented and are rapidly imitated by competitors. The paper shows that the decision to develop a financial innovation can be strongly influenced by the market share of an investment bank: a bank with a larger market share will develop innovations that a smaller bank will not. For innovations that are designed to exploit tax or regulatory loopholes, a more efficient regulatory response is shown to actually increase incentives to develop such products by making it more costly for clients to delay adoption. The paper demonstrates that due to a lack of adequate appropriability without patent protection, it may pay for an innovating bank to introduce a series of smaller innovations rather than introducing a more significant innovation at one go. Finally, the paper explores the role of cooperative sharing arrangements among investment banks in the context of the introduction of innovative financial products. The analysis throws light on why we seem to observe significant innovations activity in an industry that is generally bereft of patent protection.

Abstract:
We argue that in the after-market trading of an IPO, the underwriting syndicate, by standing ready to buy back shares at the offer price ("price stabilization"), compensates uninformed investors ex post for the adverse selection cost they face in bidding for IPOs. This dominates ex ante compensation by underpricing. The reason is thatstabilization exploits ex post information about investor demand whereas underpricing must be based on ex ante information. However, liquidity and syndication costs constrain the use of stabilization which, in equilibrium, generates some underpricing as well. We develop a model that formalizes this intuition and generates several empirical implications.

Abstract:
We argue that in the after-market trading of an IPO, the underwriting syndicate, by standing ready to buy back shares at the offer price (price stabilization), compensates uninformed investors ex post for the adverse selection cost they face in bidding for IPOs. This dominates ex ante compensation by underpricing alone. By forming larger syndicates underwriters can increase their capacity to sustain losses associated with after-market price stabilization. Issuer revenues are maximized by trading off the cost of forming syndicates with larger loss capacity versus the benefits of greater capacity for after-market intervention. We show that larger issues are associated with larger underpricing and with syndicates that have a larger loss capacity. Also, "hot issue" periods with a high volume of IPOs are associated with larger underpricing and syndicates with a smaller loss capacity.