EXIT AND VOICE IN CORPORATE

GOVERNANCE

4th set of transparencies for ToCF

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I.

Basic idea: Agency problem (adverse selection, moral hazard,...)

want to reduce asymmetry of information by "hiring monitors".

INTRODUCTION

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1 ACTIVE VS PASSIVE MONITORSTwo 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)

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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.

Example of "free entry": takeovers voicespeculation "exit".

3 CLAIMS HELD BY MONITORS

Claim = incentive scheme for monitor

"insiders"

Monitor

Firm

claims

"uninformed investors"

Debt or equity?

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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.

Fama 1985: junior claimants have greater incentives to monitor

First-come-first-served rule as an incentive for depositors

(Calomiris)

Collateral-taking by banks.

Example of debate:

More likely: want different claimholders to monitor different pieces of information (“advocates”).

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II.

PERFORMANCE MEASUREMENT AND THE VALUE OF SPECULATIVE

INFORMATION

INVESTORS OF PASSAGE

Fixed-investment model

Simplifying assumption: intermediate signal is a sufficient statistic

Effort signal outcome

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Notation :

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)

pr (signal j | effort i)pr (success | signal j)

• (ICb)

when high signalwhen low signal

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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.

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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:

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Someone wants to buy price becomeszero gross profit

speculator loses c.

Holmström-Tirole (1993): need liquidity for the equity market.

Liquidity traders:(size s)

(simplified Kyle 1985 model)

All sell

Noone sells

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Outcome

Speculator can make money only if high signal

liquidity traders sell.

contract with entrepreneur

claims issued s claims held

by "liquidity traders" 

speculator observes signal

NET ORDERFLOW OBSERVED SPECULATOR LIQUIDITY TRADERS MARKET MAKERS

moral hazard

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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?

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Beginning of an answer: general equilibrium with LT investors in short supply

LT investors ST investors

Equity premium (here sold under par to attract ST investors).

equity bonds

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III. INVESTOR ACTIVISM

1 BENEFIT OF ACTIVISM: reduces MH (or AS ) and thereby increases pledgeable income.

Modeling

Monitor, by expanding c, eliminates Bad project:

thus: B b

Monitor

Entrepreneur

Two types of bad projects:

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No funding Intermediatedfinance(monitoring)

Direct finance(no monitoring)

A

Assume that monitoring capital is not scarce

Ub=pHR – I - c lower than in the absence of intermediation:

avoids intermediated finance if (s)he can.

Intermediation facilitates financing if

Entrepreneur receives NPV if funded:

Pledgeable income investors' total cost:

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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).

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Example of overmonitoring

Monitor chooses x

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c(x)

x= pr (monitor finds Bad project)

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Optimum: (1):

Implementation: (2)

monitor should not hold all external shares.

Intuition: 2 externalities

negative on entrepreneur

positive on other investors (0 if holds all external shares)

Since then