Corporate Finance

November 10, 2017
Shai Bernstein of Stanford University, Peter M. DeMarzo of Stanford University, and Bruce I. Carlin of the University of California at Los Angeles, Organizers

Di Li, Georgia State University; Lucian A. Taylor, the University of Pennsylvania; and Wenyu Wang, Indiana University

Inefficiencies and Externalities from Opportunistic Acquirers

If opportunistic acquirers can buy targets using overvalued shares, then there is an inefficiency in the merger and acquisition (M&A) market: The most overvalued rather than the highest-synergy bidder may buy the target. Li, Taylor, and Wang quantify this inefficiency using a structural estimation approach. They find that the M&A market allocates resources efficiently on average. Opportunistic bidders crowd out high-synergy bidders in only 7% of transactions, resulting in an average synergy loss equal to 9% of the target's value in these inefficient deals. The implied average loss across all deals is 0.63%. Although the inefficiency is small on average, it is large for certain deals, and it is larger when misvaluation is more likely. Even when opportunistic bidders lose the contest, they drive up prices, imposing a large negative externality on the winning synergistic bidders.

Victoria Vanasco, Stanford University; Brendan Daley, Duke University; and Brett Green, the University of California at Berkeley

Securitization, Ratings, and Credit Supply

Vanasco, Daley, and Green illustrate a novel interaction between credit ratings and (endogenous) securitization and explore the implications for banks' lending standards and the supply of credit. In the model, banks first privately screen and originate loans and then issue securities that are backed by the loans cash flows. Issued securities are rated and sold to investors. The researchers show that credit ratings increase the allocative efficiency of cash flows by reducing costly retention, but reduce lending standards and can lead too an oversupply of credit relative to first best. These findings are in contrast to regulators view of credit ratings as a disciplining device. They use the model to explore several commonly proposed policies and consider extensions to allow for rating shopping and manipulation. Provided investors are fully rational, both shopping and manipulation have effects similar to reducing the informativeness of ratings.

Gabriel Chodorow-Reich, Harvard University and NBER, and Antonio Falato, Federal Reserve Board

The Loan Covenant Channel: How Bank Health Transmits to the Real Economy (NBER Working Paper No. 23879)

Chodorow-Reich and Falato document the importance of covenant violations in transmitting bank health to nonfinancial firms using a new supervisory data set of bank loans. More than one-third of loans in our data breach a covenant during the 2008-09 period, providing lenders the opportunity to force a renegotiation of loan terms or to accelerate repayment of otherwise long-term credit. Lenders in worse health are less likely to grant a waiver and more likely to force a reduction in the loan commitment following a violation. Quantitatively, the reduction in credit to borrowers with long-term credit but who violate a covenant accounts for an 11% decline in the volume of loans and commitments outstanding during the 2008-09 crisis, a similar magnitude to the total contraction in credit during that period. Researhers conclude that the transmission of bank health to nonfinancial firms occurs largely through the loan covenant channel.

Roni Michaely, Cornell Tech; Stefano Rossi, Bocconi University; and Michael Weber, University of Chicago and NBER

The Information Content of Dividends: Safer Profits, not Higher Profits

Contrary to the central prediction of signaling models, changes in profits do not empirically follow changes in dividends. Michaely, Rossi, and Weber show both theoretically and empirically that dividends signal safer, rather than higher, future profits. Using the Campbell (1991) decomposition, they are able to estimate expected cash flows from data on stock returns. Consistent with their model's predictions, cash-flow volatility changes in the opposite direction from that of dividend changes and larger changes in volatility come with larger announcement returns. The researchers find similar results for share repurchases. Crucially, the data supports the prediction--unique to our model--that the cost of the signal is foregone investment opportunities. Michaely, Rossi, and Weber conclude that payout policy conveys information about future cash flow volatility. Their methodology can be applied more generally to overcoming empirical problems in testing theories of corporate financing.

Taylor Begley, Washington University in St. Louis, and Amiyatosh Purnanandam, the University of Michigan

Color and Credit: Race, Regulation, and the Quality of Financial Services

The incidence of mis-selling, fraud, and poor customer service by retail banks is significantly higher in markets with lower income and educational attainment. Further, areas with a higher share of minority population experience significantly worse outcomes even after controlling for factors such as income, education, and house price changes. Regulations aimed at improving access to credit to such areas are partly responsible for these findings. Specifically, low-to-moderate-income (LMI) areas targeted by the Community Reinvestment Act have significantly worse outcomes, and this effect is larger for LMI areas with a high-minority population share. Begley and Purnanandam's results highlight an unintended adverse consequence of such quantity-focused regulations on the quality of credit to poor and minority customers.

Lin William Cong, University of Chicago, and Yizhou Xiao, Chinese University of Hong Kong

Persistent Blessings of Luck

Persistent fund performance in venture capital is often interpreted as evidence of differential abilities among managers. Cong and Xiao present a dynamic model of venture investment with endogenous fund heterogeneity and deal flows that produces performance persistence without innate skill differences. Investors work with multiple funds and use tiered contracts to manage moral hazard dynamically. Recently successful funds receive continuation contracts that encourage greater innovation, and subsequently finance innovative projects through assortative matching. Initial luck, therefore, exerts an enduring impact on performance by altering funds' future investment opportunities. The model generates implications broadly consistent with empirical findings, such as that persistently outperforming funds encourage greater innovation and attract better entrepreneurs even with worse terms. The model further predicts "incumbent bias" in investing in funds, mean-reversion of long-term fund performance, backloading across contracts, and amplification of skill differences.

Joao Granja, the University of Chicago, and Christian Leuz, the University of Chicago and NBER

The Death of a Regulator: Strict Supervision, Bank Lending and Business Activity

An important question in banking is whether stricter supervision, especially in response to financial crises, improves the allocation of financial resources and boosts economic recovery. It could also choke off lending and amplify recent economic woes. However, estimating the effects of strict supervision is challenging. Granja and Leuz exploit the extinction of the thrift regulator (OTS) — an unprecedented change in prudential supervision, affecting ten percent of all U.S. depository institutions. Using this event, the researchers analyze the economic links between strict prudential supervision, bank lending and business activity. They first show that the OTS replacement indeed resulted in stricter supervision and enforcement of financial rules in former OTS banks. The researchers then analyze the effects of stricter supervision and show that former OTS banks increase small business loans originations by roughly 15 percent. They also find increases in business dynamism (entry and exit) in counties most exposed to OTS banks, suggesting that the increase in business lending leads to a reallocation across new and old establishments. When Granja and Leuz explore the mechanism for the lending results, they find that stricter supervision also affects well-capitalized banks, indicating it is not only bank capital that is holding back new lending by banks with non-performing loans.

Matthew Smith, Department of Treasury; Danny Yagan, the University of California at Berkeley and NBER; and Owen M. Zidar and Eric Zwick, the University of Chicago and NBER

Capitalists in the Twenty-First Century

Have passive rentiers replaced the working rich at the top of the U.S. income distribution? Using administrative data linking 10 million firms to their owners, Smith, Yagan, Zidar, and Zwick show that private business owners who actively manage their firms are key for top income inequality. Private business income accounts for most of the rise of top incomes since 2000 and the majority of top earners receive private business income — most of which accrues to active owner-managers of mid-market firms in relatively skill-intensive and unconcentrated industries. Profit falls substantially after premature owner deaths. Top-owned firms are twice as profitable per worker as other firms despite similar risk, and rising profitability without rising scale explains most of their profit growth. Together, these facts indicate that the working rich remain central to rising top incomes in the twenty-first century.

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