Corporate Finance

November 6, 2015
Peter Demarzo of Stanford University and Bruce Carlin of University of California, Los Angeles, Organizers

Boris Vallée, Harvard University, and Christophe Pérignon, HEC Paris

The Political Economy of Financial Innovation: Evidence from Local Governments

Pérignon and Vallée present an empirical investigation of the role of political incentives in the use of innovative financial products. The adoption of structured loans, a high-risk type of borrowing for local governments, is more frequent when incentives for politicians to obtain immediate cash-flows are higher. The researchers also show that using structured loans helps politicians get reelected, mainly by allowing them to offer relatively lower taxes. Conversely, structured loan usage is hard to empirically reconcile with politicians' ex post claim that they do not understand the transactions. The authors' findings are supportive of financial innovation amplifying agency costs within the political system.

Ilya A. Strebulaev, Stanford University and NBER, and Christopher Hennessy, London School of Business and CEPR

Natural Experiment Policy Evaluation: A Critique and Correction (NBER Working Paper No. 20978)

Random assignment is insufficient for measured treatment responses to recover causal effects (comparative statics) in dynamic economies. Strebulaev and Hennessy characterize analytically bias probabilities and magnitudes. If the policy variable is binary there is attenuation bias. With more than two policy states, treatment responses can undershoot, overshoot, or have incorrect signs. Under permanent random assignment, treatment responses overshoot (have incorrect signs) for realized changes opposite in sign to (small relative to) expected changes. Hennessy and Strebulaev derive necessary and sufficient conditions, beyond random assignment, for correct inference of causal effects: martingale policy variable. Infinitesimal transition rates are only sufficient absent fixed costs. Stochastic monotonicity is sufficient for correct sign inference. If these conditions are not met, the researchers show how treatment responses can nevertheless be corrected and mapped to causal effects or extrapolated to forecast responses to future policy changes within or across policy generating processes.

Andrew Hertzberg, Columbia University; Andres Liberman, New York University; and Daniel Paravisini, London School of Economics

Adverse Selection on Maturity: Evidence from On-line Consumer Credit

Hertzberg, Liberman, and Paravisini provide evidence that borrowers who select into long term debt are unobservably more exposed to shocks to their ability to repay. The researchers' estimation compares two groups of observationally equivalent borrowers that took identical 36-month loans, but where only one of the groups is selected on maturity, in the sense that it chose the 36-month loan when a 60-month maturity option was also available. The researchers find that borrowers who self-select into short maturity loans default less, have higher future credit ratings, and, conditional on good standing, prepay more. The authors' findings imply that loan maturity can be used to screen borrowers in consumer credit markets with asymmetric information.

Ulf Axelson, London School of Economics, and Igor Makarov, London School of Economics

Informational Black Holes in Auctions

Ulf Axelson, London School of Economics, and Igor Makarov, London School of Economics,
Informational Black Holes in Financial Markets

A central role for financial markets is to assess whether new projects are worth pursuing or not. Axelson and Makarov extend standard auction theory to capture this role by studying new venture financing. Paradoxically, when the information generated in the auction is valuable for making real investment decisions, the informational efficiency of the market is destroyed. To add to the paradox, as the number of market participants with useful information increases a growing share of them fall into an "informational black hole," making markets even less efficient. Contrary to the predictions of standard auction theory, social surplus and seller revenues can be decreasing in the number of bidders, the linkage principle of Milgrom and Weber (1982) may not hold, and collusion among investors may be beneficial for the seller.

Brad Barber and Ayako Yasuda, University of California, Davis

Interim Fund Performance and Fundraising in Private Equity

General partners (GPs) in private equity (PE) report the performance of an existing fund while raising capital for a follow-on fund. Barber and Yasuda document how interim performance has large effects of fundraising outcomes; the impact is greatest when backed by exits and for low reputation GPs. Faced with these incentives, GPs time their fundraising to coincide with periods of peak performance through two strategies: "exit and fundraise" and "inflated valuations." Consistent with the former, the researchers find performance peaks are greatest for funds with high realization rates. Consistent with the latter, they find low reputation GPs with low realization rates also experience performance peaks followed by erosions in performance post-fundraising.

Shai Bernstein, Stanford University and NBER; Ben Iverson, Northwestern University; and Emanuele Colonnelli, Stanford University

Asset Reallocation in Bankruptcy

This paper investigates the consequences of Chapter 7 liquidation and Chapter 11 reorganization on the reallocation and subsequent utilization of assets in bankruptcy. Bernstein, Colonnelli, and Iverson identify 129,000 bankrupt establishments and construct a novel dataset that tracks the occupancy and utilization of real estate assets over time. Asset reallocation is widespread, as nearly 80% of real estate is not occupied by bankrupt firms five years after the bankruptcy filing. Using the random assignment of judges to bankruptcy cases as a natural experiment that forces some firms into liquidation, the researchers find that liquidated assets are more likely to be vacant and employ less workers five years after bankruptcy than comparable assets that are reorganized. These effects are concentrated in thin markets with few potential users, in areas with low access to finance, and in areas with low economic growth.

Xavier Giroud, MIT and NBER, and Joshua Rauh, Stanford University and NBER

State Taxation and the Reallocation of Business Activity: Evidence from Establishment-Level Data (NBER Working Paper No. 21534)

In a sample of over 27 million establishments of U.S. firms with activities in more than one state, Giroud and Rauh estimate the impact of state business taxation on business activity. Only firms organized as subchapter C corporations are subject to the corporate tax code, whereas the income of partnerships, sole-proprietorships, and S corporations is passed through annually to the firm's owners and taxed at individual rates. For C corporations, both employment at existing establishments (intensive margin) and the number of establishments in the state (extensive margin) have corporate tax elasticities of -0.4. Pass-through entities, which serve as a control group for the corporate tax reforms, respond only to the personal tax code, with tax elasticities of -0.2 to -0.3. Around half of the effects are driven by reallocation of productive resources to other states where the treated firms have establishments. Capital shows similar patterns but is 36% less elastic than labor. A narrative approach confirms that the results are robust and strongest in the sample of tax changes that were implemented due to inherited budget deficits, long-run goals, or cross-state variation caused by federal tax reforms.

Christopher A. Parsons, University of California, San Diego; Casey Dougal, Drexel University; William J. Mayew, Duke University; and Pengjie Gao, University of Notre Dame

What's in a (school) name? Racial Discrimination in Higher Education Bond Markets

In this paper, Dougal, Gao, Mayew, and Parsons study how historically black colleges and universities (HBCUs) pay more in underwriting fees to issue tax-exempt bonds, compared to similar, non-HBCU schools. This appears to reflect higher deadweight costs of findings willing buyers: the effect is three times larger in the Deep South, where racial animus has historically been the highest. School attributes or credit quality explain almost none of the effects. For example, identical differences are observed between HBCU and non-HBCU bonds: 1) having AAA credit ratings, and 2) insured by the same company, even prior to the financial crisis of 2008. HBCU-issued bonds are also more expensive to trade in the secondary market, and when they do, sit in dealer inventory longer.

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