Optimal Executive Compensation vs. Managerial Power: A Review of Lucian Bebchuk and Jesse Fried's "Pay without Performance: The Unfulfilled Promise of Executive Compensation"

This essay reviews Bebchuk and Fried's "Pay without Performance: The Unfulfilled Promise of Executive Compensation". Bebchuk and Fried criticize the standard view of executive compensation, in which executives negotiate contracts with shareholders that provide incentives that motivate them to maximize the shareholders' welfare. In contrast, Bebchuk and Fried argue that executive compensation is more consistent with executives who control their own boards, and who maximize their own compensation subject to an "outrage constraint". They provide a host of evidence consistent with this alternative viewpoint. The book can be evaluated from both a positive and a normative perspective. From a positive perspective, much of the evidence they present, especially about the camouflage and risk-taking aspects of executive compensation systems, is fairly persuasive. However, from a normative perspective, the book conveys the idea that policy changes can dramatically improve executive compensation systems and consequently overall corporate performance. It is unclear to me how effective in practice are potential reforms designed to achieve such changes likely to be.

Motivations for Public Equity Offers: An International Perspective

This paper examines the extent to which investment financing and market-timing explanations motivate public equity offers. We consider a sample of 16,958 initial public offerings and 12,373 seasoned equity offerings from 38 countries between 1990 and 2003. We provide estimates of the change in each accounting variable for each dollar raised in an equity offer, and for each dollar of internally generated cash. Our estimates imply that firms invest 18.8 cents in R&D and 7.3 cents in capital expenditures for an incremental dollar raised in an equity offer during the year following the offer, rising to 84.8 cents and 14.3 cents when the change is measured over a four-year period. These findings are consistent with one motive for the equity offer being to raise capital for investment. However, firms also hold onto much of the cash they raised, and this fraction is higher when the firm has a high q. In addition, firms are more likely to issue secondary shares, which are usually sold by insiders, when q is high, enabling insiders to benefit personally from potential overvaluation. These results suggest that market timing as well as investment financing is a motivation for equity offers.

Transparency and Corporate Governance

An objective of many proposed corporate governance reforms is increased transparency. This goal has been relatively uncontroversial, as most observers believe increased transparency to be unambiguously good. We argue that, from a corporate governance perspective, there are likely to be both costs and benefits to increased transparency, leading to an optimum level beyond which increasing transparency lowers profits. This result holds even when there is no direct cost of increasing transparency and no issue of revealing information to regulators or product-market rivals. We show that reforms that seek to increase transparency can reduce firm profits, raise executive compensation, and inefficiently increase the rate of CEO turnover. We further consider the possibility that executives will take actions to distort information. We show that executives could have incentives, due to career concerns, to increase transparency and that increases in penalties for distorting information can be profit reducing.

A Framework for Assessing Corporate Governance Reform

In light of recent corporate scandals, numerous proposals have been introduced for reforming corporate governance. This paper provides a theoretical framework through which to evaluate these reforms. Unlike various ad hoc arguments, this framework recognizes that governance structures arise endogenously in response to the constrained optimization problems faced by the relevant parties. Contract theory provides a set of necessary conditions under which governance reform can be welfare-improving: 1) There is asymmetric information at the time of contracting; or 2) Governance failures impose externalities on third parties; or 3) The state has access to remedies or punishments that are not available to third parties. We provide a series of models that illustrate the importance of these conditions and what can go wrong if they are not met.

Information Disclosure and Corporate Governance

In public-policy discussions about corporate disclosure, more is typically judged better than less. In particular, better disclosure is seen as a way to reduce the agency problems that plague firms. We show that this view is incomplete. In particular, our theoretical analysis shows that increased disclosure is a two-edged sword: More information permits principals to make better decisions; but it can, itself, generate additional agency problems and other costs for shareholders, including increased executive compensation. Consequently, there can exist a point beyond which additional disclosure decreases firm value. We further show that larger firms will tend to adopt stricter disclosure rules than smaller firms, ceteris paribus. Firms with better disclosure will tend, all else equal, to employ more able management. We show that governance reforms that have imposed greater disclosure could, in part, explain recent increases in both CEO compensation and CEO turnover rates.Corporate governance; Corporate disclosure

Boards of directors as an endogenously determined institution: a survey of the economic literature

The authors identify the primary findings of the empirical literature on boards of directors. Typically, these studies have sought to answer one of the following questions: How are the characteristics of the board related to profitability? How do these characteristics affect boards' observable actions? What factors affect board makeup and evolution? Across these studies, a number of regularities have emerged - notably, the fact that board composition does not seem to predict corporate performance, while board size has a negative relationship to performance. The authors note, however, that because there has been little theory to accompany these studies, it is difficult to interpret the empirical results, particularly with respect to possible policy prescriptions.Corporate governance ; Corporate profits

Corporate Demand for Liquidity

This paper proposes a theory of corporate liquidity demand and provides new evidence on corporate cash policies. Firms have access to valuable investment opportunities, but potentially cannot fund them with the use of external finance. Firms that are financially unconstrained can undertake all positive NPV projects regardless of their cash position, so their cash positions are irrelevant. In contrast, firms facing financial constraints have an optimal cash position determined by the value of today's investments relative to the expected value of future investments. The model predicts that constrained firms will save a positive fraction of incremental cash flows, while unconstrained firms will not. We also consider the impact of Jensen (1986) style overinvestment on the model's equilibrium, and derive conditions under which overinvestment affects corporate cash policies. We test the model's implications on a large sample of publicly-traded manufacturing firms over the 1981-2000 period, and find that firms classified as financially constrained save a positive fraction of their cash flows, while firms classified as unconstrained do not. Moreover, constrained firms save a higher fraction of cash inflows during recessions. These results are robust to the use of alternative proxies for financial constraints, and to several changes in the empirical specification. We also find weak evidence consistent with our agency-based model of corporate liquidity.

Corporate Financial and Investment Policies when Future Financing is not Frictionless

Much of corporate finance is concerned with the impact of financing constraints on firms. However, the literature on financing constraints largely ignores the intertemporal implications of those constraints; in particular, how future financing constraints affect current investment decisions. We present a model in which future financing constraints lead firms to have a current preference for investments with shorter payback periods, investments with less risk, and investments that utilize more liquid/pledgeable assets. The model has a host of implications in different areas of corporate finance, including firms' capital budgeting rules, risk-taking behavior, capital structure choices, hedging strategies, and cash management policies. We show how a number of patterns reported in the empirical literature can be reconciled and interpreted in light of the intertemporal optimization problem firms solve when they face costly external financing. For example, contrary to Jensen and Meckling (1976), we show that firms may reduce rather than increase risk when leverage increases exogenously. Furthermore, firms in economies with less developed financial markets will not only take different quantities of investment, but will also take different kinds of investment (safer, short-term projects that are potentially less profitable). We also point out to several predictions that have not been empirically examined. For example, our model predicts that investment safety and liquidity are complementary: constrained firms are specially likely to distort the risk profile of their most liquid investments.

Why are Buyouts Levered: The Financial Structure of Private Equity Funds

This paper presents a model of the financial structure of private equity firms. In the model, the general partner of the firm encounters a sequence of deals over time where the exact quality of each deal cannot be credibly communicated to investors. We show that the optimal financing arrangement is consistent with a number of characteristics of the private equity industry. First, the firm should be financed by a combination of fund capital raised before deals are encountered, and capital that is raised to finance a specific deal. Second, the fund investors' claim on fund cash flow is a combination of debt and levered equity, while the general partner receives a claim similar to the carry contracts received by real-world practitioners. Third, the fund will be set up in a manner similar to that observed in practice, with investments pooled within a fund, decision rights over investments held by the general partner, and limits set in partnership agreements on the size of particular investments. Fourth, the model suggests that incentives will lead to overinvestment in good states of the world and underinvestment in bad states, so that the natural industry cycles will be multiplied. Fifth, investments made in recessions will on average outperform investments made in booms.

World Market for Mergers and Acquisitions

Despite the fact that one-third of worldwide mergers involve firms from different countries, the vast majority of the academic literature on mergers studies domestic mergers. What little has been written about cross-border mergers has focused on public firms, usually from the United States. Yet, the vast majority of cross-border mergers involve private firms that are not from the United States. We provide an analysis of a sample of 56,978 cross-border mergers occurring between 1990 and 2007. We first characterize the patterns of who buys whom: Geography matters, with firms being much more likely to purchase firms in nearby countries than in countries far away. Purchasers are usually but not always from developed countries and they tend to purchase firms in countries with lower accounting standards. A significant factor in determining acquisition patterns is currency movements; firms tend to purchase firms from countries relative to which the currency of the acquirers country has appreciated. In addition, economy-wide factors reflected in the countrys stock market returns lead to acquisitions as well. Both the currency and stock market effect could suggest either misvaluation or wealth explanations. Our evidence is more consistent with the wealth explanation than the misvaluation explanation.Mergers; Currency movements; Market movements; Valuation