Corporate Finance II

1
Corporate Finance II

• Financial Contracting
• Corporate Governance
• Corporate Governance and Financial Development

2
Financial Contracting

• In Corporate Finance I we have seen moral hazard
  models that make debt or equity optimal in
  different setups. But all these models were in
  fact theories of the optimal incentive scheme for
  the manager
• However, incentive scheme can be totally
  independent of capital structure. If the manager
  is on the optimal incentive scheme, capital
  structure is irrelevant
• Similar criticism applies to the pecking order
  theory
• If the managers payoff scheme is linked to the
  TOTAL market value of the firm (such that he
  cares about ALL, not only current shareholders),
  he would have no preference for issuing
  information insensitive securities
• Financial contracting literature reconsiders the
  notions of debt, equity and other securities by
  focusing on CONTROL (decision) rights associated
  with securities, rather than cash-flow rights.

3
Key word control

• Incomplete contracts framework (Grossman-Hart-Moor
  e)
• Some eventualities cannot be foreseen or
  described ex-ante
• Who could predict Internet or the fall of USSR in
  1980? People could not write contract on these
  events
• Difficult to determine ex-ante thresholds for
  students grades what to give 5 for depends on
  the difficulty of the exam, degrees of difficulty
  are hard to describe ex-ante.
• In the contract parties agree on certain actions
  under certain circumstances, AND they decide who
  has (residual) control when something not
  described in the contract happens
• Who decides whether a firm should change
  strategy?
• Who decides whether CEO should be fired,
  acquisition be made or the firm must be
  liquidated?
• Who has control matters

4

• Financial securities can be classified according
  to the control rights they bear.
• Equity comes with votes
• Electing directors (who have the right to make
  key decisions)
• Approving certain transactions, charter
  amendments
• Debt has no votes, but under certain
  circumstances debtholders can
• foreclose the firms assets
• Initiate bankruptcy (then creditors also acquire
  some power of owners)

5
Efficiency

• Allocate control so as to maximize ex-ante social
  welfare.
• Note That does not imply ex-post efficient
  decisions. Sometimes (but not always!) in order
  to induce ex-ante efficient investment some
  ex-post inefficiency is needed.
• Ex-post inefficiency creates ex-post incentives
  for renegotiation. If renegotiation is possible,
  it should be taken into account when designing
  the ex-ante optimal contract (renegotiation is
  not necessarily bad).

6
Example

• Setup
• Project yields cash flows V, pivate benefits B
  (for the entrepreneur)
• B is non-contractible.
• Entrepreneur is allocated fraction ? of V.
• The project is set up at t0, all decisions are
  taken and benefits earned at t1
• Values of V and B are determined by the decisions
  taken at t1.
• Entrepreneur max B ?V
• Investor max (1- ?)V ? max V
• Neither objective coincides with the social
  welfare maximization
• Social optimum max B V

7

• Setup (continued)
• The only decision to be made terminate or
  continue
• Continuation B 100, V 0
• Liquidation B 0, V 200
• Assume ? 0.1
• Solution
• Social optimum liquidation (200 gt 100)
• Achieved by allocating control to I
• If E has control 100 0.10 gt 0 0.1200 ?
  continuation
• --------------------------------------------------
  ------------------------
• Assume instead under liquidation V 120
• Social optimum continuation (220 gt 200)
• Achieved by allocating control to E (100
  0.1120 gt 0.1200)
• If I has control, he will choose liquidation.

8

• In principle, ? is endogenous, and the contract
  should define both ? and the allocation of
  control rights.
• Then, in case 1 (V 0 under liquidation) the
  optimum can be achieved even with Es control if
  ? gt 1/2 (incentives are substitute for control).
• In case 2 (V 120 under liquidation) only Es
  control achieves the optimum as B is
  non-contractible.
• ? Looks like Es control can always achieve the
  social optimum. But

9

• But assume, that the investor invested K at t0
  and has to recover it.
• Now we cannot look only at the ex-post optimal
  decision.
• In case 1
• setting ? gt ½ and giving control to E can achieve
  the social optimum only iff K lt 100.
• If K gt 100, then the only optimal solution is Is
  control, since Es control would be inconsistent
  with the investors participation
• In case 2
• If K lt 120, you can always pick ? such that
  (1-?)V gt K. Es control achieves both ex-post
  optimal decision and ex-ante investment.
• Assume K gt 120
• Since B is non-contractible, Es control, though
  yielding the ex-post optimal decision, does not
  satisfy the investors participation constraint
  (even for ? 0) Hence, in this case, investors
  control is ex-ante optimal!

10
Theories

• Optimal allocation of control between insiders
  and outsiders (mainly theories of debt)
• Optimal allocation of control between different
  ouitsiders
• Debtholders and equityholders
• Debtholders with different maturityies
• Several debtholders with the same maturity

11
Corporate Governance

• More general thing than financial contracting
• Definitions
• Shleifer and Vishny the ways in which the
  suppliers of finance to corporations assure
  themselves on getting a return on their
  investment
• Zingales governance system as a complex set of
  conditions that shape the outcome of the ex-post
  bargaining over the quasi rents that are
  generated in the course of a relationship
• Mechanisms of corporate governance
• Executive compensation
• Boards of directors
• Auditors
• Takeovers
• Large shareholders (blockholders)
• Bank monitoring
• Design of corporate charter (more rights to
  shareholders)
• Commitment to dividends
• Securities structure
• ...

12
Notion of pledgeable income

• From the traditional (Shleifer and Vishny)
  perspective the goal of corporate governance
  mechanisms is to minimize pledgeable income (at
  the lowest cost)
• Pledgeable income how much (in expected terms)
  the manager can credibly promise to return to
  investors.
• The greater it is the more confident investors
  are in getting their money back, hence, the more
  willing they are to invest in positive NPV
  projects

13
Basic framework
NPV is positive
Incentive scheme E gets w if success, 0 if
failure.
Incentive compatibility (no private benefit
extraction)
Setting w at we get that
the financing is feasible iff
14
Pledgeable income exceeds the investors outlay

• The basic idea of corporate governance
  increase pledgeable income through the reduction
  of private benefits.
• It should be done in the least costly way
  (optimal combination of the corporate governance
  mechanisms)

15
Our focus

• Takeovers
• Disciplining role (incentives for incumbent
  managers)
• Ex-post efficiency of takeovers
• Efficient takeover VR BR gt XI BI
• Do all efficient takeovers necessarily occur?
• Do inefficient takeovers sometimes occur?
• ? Implications for security-voting structure,
  takeover regulation
• Large shareholders
• Role in takeovers
• Monitoring of management
• Reducing managerial opportunism, but
• Danger of excessive monitoring
• Collusion between monitor and manager
• ? Implications for ownership structure

16
Corporate Governance and Financial Development

• Theories of financial development
• Law and finance
• Endowment (environment, encountered by
  colonizers)
• Ideology and culture
• Political economy (interest groups influence)

17
Corporate Governance and Financial Development

• Law and Finance (LLSV)
• Legal system (both law-on-the-books and
  enforcement) may either mitigate or aggravate
  agency problems
• Better protection of investors limits insiders
  opportunism (self-dealing, private benefit
  extraction, stealing). Hence, outside finance are
  easier (cheaper) to raise.
• Financial arrangements, ownership and control
  structures depend on the quality of the legal
  system (second-best response of firms).

18

• Consequence worse investor (shareholder)
  protection leads to
• Fewer firms obtaining finance
• Smaller size of projects
• Higher ownership and control concentration
• Smaller stock markets
• LLSV claim legal origin has predetermined the
  development of institutions of property rights
  (investor protection, in particular)
• Common law (Anglo-Saxon countries) protects
  minority shareholders better than civil law
  (especially French)

19

• Unresolved issues in the Law and Finance story
• What is there in legal origin that makes civil
  law systems worse?
• Degree of investor protection has varied
  substantially over time (Anglo-Saxon countries
  have not always been better than civil law
  countries)
• Historical puzzles (US, UK, France in early 20th
  century, Italy)

20

• Political economy theories
• Influence of interest groups, rather than legal
  origin, is the determinant of financial
  development
• Does not necessarily contradict law and finance
  story, but simply says that law is endogenous
• Interest groups may favor poor financial
  development, in particular weak investor
  protection.

21
Examples

• Regulation
• Protection of minority shareholders
• Takeover restrictions (US)
• Specific interventions
• Takeover prevention
• Bailouts (or subsidies)
• Nationalization

22
Corporate Governance in transition and developing
economies (Russia in particular)

• Main issues and mechanisms
• Enforcement is the main problem
• Ownership concentration is the main mechanism
• State interference
• Can firms compensate for weak institutions by
  practicing proper corporate governance?
• Yes, but only to a certain extent. Good
  governance pays off, but its effect is weakened
  by poor quality of institutions

23

• Good corporate governance pays off (1999 data)

24
Raise and fall of Yukos(state as the major
player in Russias corporate governance)