The Lemons Problem in Markets for Strategy

Abstract

Research in corporate governance has predominantly focused on the moral hazard problem and governance mechanisms that mitigate it. In this conceptual paper, we instead focus on adverse selection as an alternative agency problem, emphasizing well-intentioned managers making strategic choices they believe will increase firm value, but facing difficulty informing capital market participants about the value of these choices. We suggest that more valuable strategies are more difficult for market participants to evaluate, and that pressures on managers to adopt easy-to-evaluate strategies can generate this adverse selection or ‘lemons’ problem. We argue that governance mechanisms designed to mitigate moral hazard operate differently here, in some cases exacerbating rather than solving the adverse selection problem. We further propose that firms with unique and complex strategies may migrate to private equity.

Keywords: Adverse selection, capital markets, corporate governance, intermediaries, moral hazard

JEL Classification: G34, G24, L1, L2, M10, M40, N20