Governance, Risk and Expected Returns: Research Frontiers in Corporate Finance

1. Governance, Risk and Expected Returns:Research Frontiers in Corporate Finance Kose John New York University 20h Annual Conference on Pacific Basin Finance, Economics, Accounting and Management September 8, 2012

2. Introduction Corporate Governance and CEO compensation Research areas in Finance, Economics, Management, Accounting and Law Appropriate for PFEAM September 2012 Many central issues remain for future research Opportunities in theoretical and empirical work Surveys: Bolton, Becht and Roell (2003) Aggarwal (2008)

3. Recent Surveys P. Bolton, M. Becht and A. Roell, “Corporate Governance and Control”, the Handbook of the Economics of Finance, edited by George Constantinides, Milton Harris and René Stulz, North-Holland, 2003. Rajesh K. Aggarwal, “ Executive Compensation and Incentives,” In: Eckbo,B.E. (Ed.), Handbook of Corporate Finance: Empirical Corporate Finance, Vol. 2. In: Handbooks in Finance Series. Elsevier/North-Holland, Amsterdam, 2008.

4. Overview • Very interesting interaction between risk and corporate governance • Very interesting interaction between risk and executive compensation • Interface of Corporate Finance and Asset Pricing • Research Issues in these areas and some existing work • Open Research Questions • Central Questions remain yet unanswered • Relation to Global Financial Crisis

5. Relationship between Governance and Risk • Governance and Risk are closely related • Holmstrom—Risk-neutral agent case • Risk complicates design of executive compensation • Partial ownership agency problems • Risk complicates governance problems • Example: • Even more so in a dynamic environment • Even more so in a competitive environment • Relative Governance

6. Governance and RiskCompensation and Risk • Governance and Systematic Risk • Governance and Unsystematic Risk • Governance and Bondholders • Governance and Dividends • Tail Risk and Fake Alphas • Deferred Compensation and Claw-Back Provisions

7. Corporate governance Basic theory is missing. Going beyond the agency theory: some central issues. Incomplete contracts: how institutional mechanisms (legal, financial, banks, markets) evolve to improve governance and make up for the gap in contracting?

8. Corporate governance (cont’d) Why takeovers, monitored debt, board of directors, large institutional block holders arise as governance mechanisms? John and Kedia (2009), John and Kedia(2010) How do these interact with each other? Stakeholder governance? Debt holder governance? Optimal bankruptcy systems? How do they interact with corporate governance mechanisms?

9. Corporate governance (cont’d) How does competition affect corporate governance? What role do financial markets play? Corporate governance and the ability to transfer large stakes of ownership. Market economies vs. bank-centered economies? Financial policy and corporate governance: debt and governance, dividends and governance? Economy-wide governance vs. firm-specific governance?

10. Overview Of Some Theoretical Research Design of Governance How is the optimal governance system structured in different economies Growth and Governance How does the optimal governance change as firms grow and economies grow Governance and regulation Positive and negative externalities Limited liability organizational forms and bailouts Institutional umbrella and noninvasive regulation

11. Executive Compensation and Risk Large number of articles Explosive Growth in options and articles Wedge Tying the undiversified CEO in an illiquid fashion Restricted stocks, options Not characterized the benefits of incentive compensation (theoretically or empirically) Central trade-off

12. Central Issues What is the optimal structure of a well-designed compensation package? Optimal blend of restricted stocks and options? Theoretical and empirical work?

13. Central issues (cont’d) The correct pay-for-performance metric? Does it measure the strength of managerial incentives? Appropriate for non-linear compensation structures? Appropriate for large firms and small firms?

14. Central issues (cont’d) Level of CEO compensation? Too large, or too small? The right institutional structure and process to determine CEO compensation?

15. Dynamic issues Usual incentive compensation Manager augments the firm cash flow with a portfolio of holdings designed to add the return distribution 10% with prob. 0.9999 and -10,000 % with prob. 0.0001 This can be constructed with derivatives in a self-financing portfolio Sequence of years with good performance and hence bonuses. Disaster state in the 20th year.

16. Dynamic Issues (cont’d) With such institutional convexities: Optimal intertemporal compensation structure? Deferred compensation? Claw-back provisions? Long-term vesting? Incentive structures in compensation and disclosure. High-powered incentives also provide incentives to exaggerate performance. Earnings smoothing.Competition?

17. Literature -Empirical • La Porta et al. (1997, 1998, 1999, 2002) • Legal Protection is an important determinant • Better legal protection is associated with • Lower concentration of ownership and contro • More valuable stock markets • Higher number of listed firms and evaluation

18. Literature-Empirical Gompers, Ishi and Merrick (2003) US firms in the top decile of a “governance index” (related to takeover defenses and shareholder rights) earned significantly higher abnormal returns over those in the lowest decile. There are a large number of articles building on GIM. Still the effect of governance on excess returns and value remains unclear. Firms that increase governance do not show that increases in performance follow.

19. Literature-Empirical Governance and risk-taking by managers. Governance and systematic priced risk. Relative governance. Optimal level of governance is endogenous. Governance simultaneously chosen with financial policy variables, and incentive features in CEO compensation.

20. Relationship between Financial Crisis and Governance • Governance failures and financial crisis? • Two objective functions? • Banks holding on to toxic assets and not lending • Dark side of complete markets • Fake alphas and systemic risk • Deferred compensation and Claw backs • Competition? • Dynamically optimal compensation structures • Transparency of derivative trading • Centralized Clearing

21. Literature Empirical (cont’d) • Cremers, Nair and John (RFS, 2009) • John, Litov and Yeung (JF, 2008) • John and Litov (NYU WP, 2009) • John and Kadyrzhanova (NYU WP, 2009) • John and Knyazeva (NYU WP, 2009) • John, Knyazeva and Knyazeva (JFE, 2011) • John and Kadyrzhanova (NYU WP, 2012) • Francis, John, Hasan and Waisman (JFE, 2010)

22. Literature Empirical (cont’d) • Survey: Morck, Wolfenzon and Yeung (JEL, 2005) • Xiaoji Lin (JFE February 2012) • Aslan and Kumar (RFS July 2012)

23. Takeovers and the Cross-Section of Returns John, Cremers, and Nair RFS 2009

24. The impact of takeovers on valuation Takeover activity: idiosyncratic or (partly) systematic? Bruner (2004); Rhodes-Kropf & Viswanathan (2005) Time-varying, takeover waves Related to equity market conditions Potential effect significant Mitchell and Stafford (2003) Median bid premium 1980-1998: 35% Lots of M&A: 3,467 completed deals in 1980-1998

25. Takeover impact on expected returns Takeover likelihood Proxy for the exposure to (unobserved) state variables determining the cash flows & price of risk More sensitive to cash flow shocks: higherrequired rate of return Why? You receive cash (takeover premium) when you least need it (when the market is doing great).

26. Quintet of empirical results • Abnormal returns related to takeover vulnerability, ‘Takeover’ factor • Using estimates of takeover likelihood, construct a takeover spread portfolio • Relative to Fama-French-Carhart four-factor model, 11.7% annualized abnormal return Takeover factor predicts real takeover activity • Explains differences in cross-section of equity returns Cross-sectional pricing of BM/size-sorted portfolios • Relation to to governance portfolios: Decrease significantly once we add the Takeover factor to the asset-pricing model

27. Corporate Governance and Managerial Risk-Taking: Theory and Evidence Kose John, Lubomir Litov, Bernard Yeung Journal of Finance 2008

28. What is this paper about? Large existing literature Better investor protection  lower cost of capital, more informed and developed capital markets, better capital allocations  faster growth Offer an additional angle Better investor protection  managers undertake more value enhancing risky investment  faster growth A model + empirical evidence

29. Governance and Risk Provide an agency-based rationale for the linkage between investor protection, risk-taking and growth. Corporate managers are sub-optimally conservative in the presence of large perks.Better governance mechanisms lower perks, leading to more value-enhancing risky investments. Corporate accountability and risk-taking. Risk-taking and growth. Not caused by income-smoothing

30. Merger Waves and Relative Governance Kose John, NYU Stern Dalida Kadyrzhanova, University of Maryland

31. Motivation Classical agency view Contestable market for corporate control disciplines managers (Manne (1965), Scharfstein (1988)) Resilient puzzle: weak or no relation between ATPs and outcomes in the market for corporate control Takeover Premiums (Comment & Schwert (1995)) Takeover Likelihood (Bates, Becher, & Lemmon (2008)) “Overall, the evidence is inconsistent with the conventional wisdom that board classification is an antitakeover device that facilitates managerial entrenchment” (BBL (2008))

32. Main Results Relative Governance in a peer group of firms matter During merger waves the protection from ATMs make a significant difference.

33. Agency Costs of Idiosyncratic Volatility, Corporate Governance, and Investment Kose John, NYU SternDalida Kadyrzhanova, University of Maryland

34. Motivation Identifies new fundamental conflict of interest due to firm-specific uncertainty‘Dark side’ of IT shocks Agency problem may arise since managers are exposed to total risk, while shareholders aren’t Managers are under-diversified due to the specificity of their human capital, equity incentives, etc.Well-diversified shareholders only care about systematic risk Key insight: Agency problem is likely to be more severe when the wedge between total risk and priced risk (IVOL) is high Amihud & Lev (1981)

35. Main Hypotheses Behavioral hypothesis: Managers of high IVOL firms will want to turn down too many risky projects & accept too many safe projects IVOL hypothesis: Agency costs of idiosyncratic volatility are higher for firms with ATPs, whose managers are more entrenched. First-order effect is on capital budgeting decisions (corporate investment, R&D)

36. Empirical Evidence Robust evidence of agency costs of IVOL: for high IVOL firms, entrenchment (ATPs) leads to excess managerial conservatism, i.e. lower R&D & higher Capex expenditures higher likelihood of diversifying acquisitions lowerfirm value (Tobin’s Q) New GMM approach to deal with omitted variables and reverse causality To address reverse causality, additional evidence from “natural experiment” Governance shocks (passage of state BC laws) IVOL shocks (industry IT intensity shocks)

37. Concluding Thoughts • Governance and Risk are closely related • Top-Management compensation and Risk are closely related • Opportunities abound to make central research contributions • Governance, Compensation and Systematic Risk • Corporate Finance and Asset Pricing • Dynamic Issues • Effect of Competition

38. Conclusions Need more theory Need more careful empirical work Perhaps more structural models of governance and CEO compensation More calibration in corporate finance to sort out first order and second order effects in governance