EXIT AND VOICE IN CORPORATE GOVERNANCE 4th set of transparencies for ToCF

1. EXIT AND VOICE IN CORPORATE GOVERNANCE 4th set of transparencies for ToCF

2. I. INTRODUCTION Basic idea: Agency problem (adverse selection, moral hazard,...) want to reduce asymmetry of information by "hiring monitors".

3. 1 ACTIVE VS PASSIVE MONITORS Two types of information to be collected Prospective / value enhancing Retrospective / value neutral / speculative INTERVENTION (ex ante) MEASUREMENT (ex post) boards of directors venture capitalist bank led corporate governance takeovers shareholders activism speculation (voting with one’s feet) ST debt runs rating agencies IPOs Retrospective info useful only if  enters compensation (stock option,...) determines refinancing affects pr (keeping job)

4. 2 INCUMBENTS VS ENTRANTS/ ENTRY INTO CORPORATE GOVERNANCE "Hired monitors" have their limits: liquidity needs lack of diversification (Huddart 1993, Admati et al 1994) "wrong choice" collusion. takeovers voice Example of "free entry": speculation "exit". 3 CLAIMS HELD BY MONITORS Claim = incentive scheme for monitor Monitor "uninformed investors" "insiders" claims Firm Debt or equity?

5. Depends on what’s being monitored no general answer. E.g.: moral hazard: FOSD (“e” determines mean): equity? SOSD (“e” determine risk): convertible? ST or demandable debt?  collateral (“e” = maintenance) : secured debt. Example of debate: Fama 1985: junior claimants have greater incentives to monitor First-come-first-served rule as an incentive for depositors (Calomiris) Collateral-taking by banks. More likely: want different claimholders to monitor different pieces of information (“advocates”).

6. II. INVESTORS OF PASSAGE PERFORMANCE MEASUREMENT AND THE VALUE OF SPECULATIVE INFORMATION Fixed-investment model Simplifying assumption: intermediate signal is a sufficient statistic Effort signal outcome

7. Notation : pr (signal j | effort i) pr (success | signal j) Assumption: high signal good news about high effort: A) FREELY AVAILABLE, CONTRACTABLE SIGNAL • Holmström 1979 sufficient statistic theorem reward entrepreneur solely on basis of signal (entrepreneur not accountable for variables (s)he does not control) • (ICb) when low signal when high signal

8. PLEDGEABLE INCOME Incentives require leaving at least to the entrepreneur PLEDGEABLE INCOME HAS INCREASED B) COSTLY, NONCONTRACTABLE SIGNAL Private cost c of obtaining speculative information DESIGNATED MONITOR: Option: can buy s shares at ex ante par value Call option has no value if monitor does not acquire information. monitors: doesn’t exercise option if low signal exercises option if high signal.

9. Collusion. Possibility of excessive speculation Suppose that at cost c (or ), hired monitor can learn final noise. Then gets bigger expected reward: Problem: pledgeable income goes back to Notion of “good” and “bad” information acquisition. ANONYMOUS MONITORING Stock market: everyone has call (or put) option, integrity of valuation process. New issue: sale price can no longer be guaranteed to be Grossman-Hart (1980): free rider problem:

10. Someone wants to buy price becomes zero gross profit speculator loses c. Holmström-Tirole (1993): need liquidity for the equity market. All sell (simplified Kyle 1985 model) Liquidity traders: (size s) Noone sells

11. Outcome moral hazard speculator observes signal  contract with entrepreneur  claims issued  s claims held by "liquidity traders"  • NET ORDER • FLOW OBSERVED • SPECULATOR • LIQUIDITY TRADERS • MARKET MAKERS  high signal  liquidity traders sell. Speculator can make money only if

12. Expected gain Monitoring if Remarks: 1 Expected returns on shares for liquidity traders smaller than In fact, equal to Empirical implications. 2 Heterogeneity among equityholders important (no liquidity trading no speculation stock price uninformative). Why don’t "ST" traders sell their shares to "LT" traders?

13. Beginning of an answer: general equilibrium with LT investors in short supply LT investors ST investors equity bonds Equity premium (here sold under par to attract ST investors).

14. III. INVESTOR ACTIVISM 1 BENEFIT OF ACTIVISM: reduces MH (or AS ) and thereby increases pledgeable income. Modeling Two types of bad projects: Monitor Entrepreneur Monitor, by expanding c, eliminates Bad project: thus: B b

15. Assume that monitoring capital is not scarce Entrepreneur receives NPV if funded: Ub=pHR – I - c lower than in the absence of intermediation: avoids intermediated finance if (s)he can. Pledgeable income  investors' total cost: Intermediation facilitates financing if A No funding Intermediated finance (monitoring) Direct finance (no monitoring)

16. 2 COSTS OF MONITORING (besides c) i. Collusion (Dessi 2005). ii. Scarcity of monitors (e.g., credit crunch). iii. Lack of diversification. iv. Lack of liquidity. v. May facilitate soft budget constraint. vi. Overmonitoring • see next (Pagano-Roell 1998), • bad for initiative (Burkart-Gromb-Panunzi 1997).

17. Example of overmonitoring c(x) x= pr (monitor finds Bad project) 0 1 Monitor chooses x

18. Optimum: (1): Implementation: (2) Since then monitor should not hold all external shares. Intuition: 2 externalities negative on entrepreneur positive on other investors (0 if holds all external shares)