Favoritism or Markets in Capital Allocation

1
Favoritism or Markets in Capital Allocation?

• Mariassunta Giannetti
• Stockholm School of Economics, CEPR and ECGI
• Xiaoyun Yu
• Indiana University

2
Background

• Capital allocation is often driven by favoritism
  rather than by markets and information about
  future expected returns
• Financial intermediaries convey funds to their
  cronies (La Porta, Lopez-de-Silanes and Zamarripa
  2003)
• Entrepreneurs reinvest funds in their business
  (Khanna and Yafeh 2006)
• Firms do not to list on exchange but raise
  capital from family and friends (Pagano, Panetta
  and Zingales 1998)

3
Two regimes for capital allocation

• Favoritism
• Financiers do not investigate new investment
  opportunities and fund only entrepreneurs they
  are familiar with
• Inefficiencies may arise if entrepreneurs differ
  in productivity

Entrepreneur Financier Information is freely
available
Risk free technology
Entrepreneur Financier Information is freely
available
4
Two regimes for capital allocation II

• Markets
• Financiers acquire information, identify distant
  investment opportunities, and possibly fund
  distant investment opportunities

Entrepreneur Financier Information is freely
available
Risk free technology
Entrepreneur Financier Information is freely
available
t cost of discovering a distant entrepreneur
5
Research questions

• When does favoritism (or markets) emerge as an
  equilibrium out come?
• When does favoritism lead to an efficient
  allocation of capital?

6
Preview of results

• Favoritism is an equilibrium outcome if saving is
  low and/or if information is unreliable and
  costly
• Financiers incentive to investigate distant
  investment opportunities depend on the quality
  and reliability of information
• Favoritism can achieve an efficient allocation
  when domestic saving is low
• Markets become crucial for achieving an efficient
  allocation of capital as the economys saving
  increases
• Favoritism can still be an equilibrium outcome
• Market remain imperfect in equilibrium
• if it is difficult to identify the highest
  quality entrepreneurs, low productivity
  entrepreneurs are funded

7
Preview of results II

• Why do not markets triumph?
• Entrepreneurs may have no incentive to spur
  institutional changes that leads to a more
  efficient allocation of capital
• They have to pay higher returns to external
  financiers
• Trade-off between rents per unit of capital
  invested and level of investment
• In equilibrium, even high quality entrepreneurs
  may prefer that there are many low quality
  entrepreneurs around

8
Outline

• A brief literature review
• The model
• The agents financiers and entrepreneurs
• The technologies
• The timing of the events
• Results
• Benchmark costless information
• Information asymmetry
• Empirical implications
• Conclusion

9
A quick glance of related literature

• Financial systems and economic development
• Allen and Gale (2000)
• Winner picking effect and allocation of capital
• Stein (1996)

10
The model Financiers

• A continuum I risk neutral financiers
• Endowed with an initial capital k gt 0
• Total capital available in the economy (the pool
  of saving) kI
• A financier either funds an entrepreneur or
  invests in a risk free technology

Entrepreneur Financier Information is freely
available
Entrepreneur Financier Information is freely
available
Risk free technology
t cost of discovering a distant entrepreneur
11
The model Entrepreneurs

• A number of N risk neutral entrepreneurs
• No capital endowment
• Type H and L based on their productivity
• Probability of encountering one type of
  entrepreneur ?H, and ?L.
• Each type has the same mass of close financiers
• Compete a la Bertrand to attract capital from
  financiers by offering a return on capital
  invested
• Equivalent to offer a share of companys future
  cash flows
• They can discriminate across investors depending
  on their alternative investment opportunities
• Empirical evidence on the allocation of IPOs and
  tranching supports this assumption

12
The model The technologies

• Entrepreneurs productivity
• Constant return to scale technology AH, and AL,
  the return per unit of capital invested
• AH gt AL.
• Risk free technology
• Offers a return g(?) per unit capital invested
• ?g(?)/?? lt 0, ??g(?)/?? gt 0
• g(0) gt AH
• .

13
Timing of the events

• Time 0
• Financiers choose whether to acquire information
  on a distant entrepreneur
• Financiers allocate their capital
• Financiers who evaluate only the close
  entrepreneur decide how to allocate their capital
  between the close entrepreneur and risk free
  technology
• Financiers who evaluate both the close and
  distant entrepreneur decide how to allocate their
  capital between the two entrepreneurs and risk
  free technology
• Time 1
• Returns are realized and payoffs are distributed

14
Benchmark case Efficient Markets

• Information is costless ? ? 0
• Evaluating all entrepreneurs is optimal
• Any financier can identify all H-entrepreneurs
• Only H entrepreneurs are funded for a return AH
  if kI gt g-1(AH).
• Financiers are promised return AH.

15
Favoritism

• Suppose financiers do not invest in information
  acquisition
• Financiers decide capital allocation between the
  risk free technology and the close entrepreneur

Efficient
Increasingly inefficient
16
Favoritism II

• In comparison to the benchmark case
• Financiers face lower return per unit of capital
  invested
• Entrepreneurs enjoy a rent per unit of capital
  invested
• All two types of entrepreneurs are (weakly)
  better off with favoritism
• Payoffs of type H entrepreneurs are higher AH
  AL.
• Intuition
• Financiers lack alternative investment
  opportunities and entrepreneurs are able to keep
  a rent

17
Costly information acquisition

• Assume that acquiring information on a distant
  entrepreneur involves a cost ?
• When information acquisition is costly, there are
  three types of equilibria
• Financiers acquire information and fund H
  entrepreneurs only (inefficient markets)
• Financiers acquire information and fund H and L
  entrepreneurs (more inefficient markets)
• Financiers choose not to acquire information and
  fund only the close entrepreneur (favoritism)

18
When do markets thrive?

• Incentives to acquire information are strong
  enough,
• then markets can improve the capital allocation

Good equilibrium Markets emerge only at late
stage of development and the foster economic
performance
Inefficient Markets 2nd Best
Favoritism
Very Inefficient Markets
19
Inefficient markets Implications

• In comparison to the equilibrium of no
  information acquisition, funding only H
  entrepreneurs leads to
• A (more) efficient capital allocation
• Higher returns for financiers
• Lower rents for all entrepreneurs
• Entrepreneurs welfare
• H entrepreneurs face a trade-off between
  attracting more capital and preserving their
  rents (offering lower returns to financiers)

20
When do markets fail?

• If
• markets emerge only at late stage of development
  and fail to significantly improve capital
  allocation

Very Inefficient markets
Favoritism
21
Do entrepreneurs want markets to thrive?

• Do H entrepreneurs favor information acquisition?
• (Tentative) answer depends on kI
• If kI is small, entrepreneurs prefer to enjoy
  high rents as information acquisition does not
  allow to expand investment to a sufficiently
  large extent
• For large kI, entrepreneurs may prefer
  inefficient markets to favoritism
• Entrepreneurs prefer to have a lot of L
  entrepreneurs around
• As information acquisition is less likely to
  emerge as an equilibrium outcome.
• (even more tentative) they enjoy a larger rent
  per unit of capital invested if financiers
  acquire information

22
Empirical implications

• Allocation of capital based on personal
  connections is efficient at early stages of
  development
• It becomes inefficient as the economy becomes
  capital rich
• Lamoreaux (1996), Khanna and Yafeh (2006)
• East Asian economies experience
• Transparency and investor protection spur
  information production and improve capital
  allocation
• Morck, Yeung and Yu (2000)

23
Empirical implications II

• Financiers expected return is higher when
  competition for external funds is strongest
• IPOs during hot markets and undepring (Lowry
  and Schwert 2002, Benveniste, Ljungqvist, Wilhelm
  and Yu 2003)
• Financial liberalizations are followed by an
  improvement in transparency
• Increases in kI make more likely that
  entrepreneurs prefer inefficient markets to
  very inefficient markets

24
Empirical implications III

• Exchanges fail to attract entrepreneurs if
  listing requirements become too demanding
• After the Sarbanes-Oxley Act, an increasing
  number of foreign firms exit the U.S. security
  market by deregistering (Marosi and Massoud 2006)
• Higher disclosure standards by SEC force firms
  off the OTC (Bushee and Leuz 2005)
• London Stock Exchange with lower listing
  stahdards has had success in attracting foreign
  listings (Economist, 2006)
• Consistent with the finding that entrepreneurs
  payoff in the equilibrium with information
  acquisition decreases in ?H

25
Conclusions

• At early stages of development, markets are
  unnecessary for reaching an efficient capital
  allocation
• When the economy accumulates enough capital,
  information acquisition on distant investment
  opportunities becomes crucial for capital
  allocation
• If information is reliable and cheap, financiers
  financial markets thrive
• If information is unreliable and costly,
  favoritism may persist or markets may remain
  very inefficient.
• Entrepreneurs may prefer favoritism and put
  obstacles to changes that foster information
  acquisition.