Finance →
- 13 Aug 2012
- Research & Ideas
When Good Incentives Lead to Bad Decisions
New research by Associate Professor Shawn A. Cole, Martin Kanz, and Leora Klapper explores how various compensation incentives affect lending decisions among bank loan officers. They find that incentives have the power to change not only how we make decisions, but how we perceive reality. Closed for comment; 0 Comments.
- 07 Aug 2012
- Working Paper Summaries
Financial vs. Strategic Buyers
What drives either financial or strategic buyers to have a more dominant position in mergers and acquisitions activity at different points in time? The question of competition matters not only because the economic magnitude of this activity is so large, but also because the balance of power between financial vs. strategic acquirers changes the ownership structure of assets and alters the incentives and governance mechanisms that surround the economic engine of our economy. This paper explores how the possibility of misvalued debt markets can both fuel merger activity and alter the balance between PE and strategic buyers. The authors use an approach based on a model of private equity (PE) and strategic merger activity in which all players in the model make value-maximizing decisions conditional on their information. Findings suggest that the possibility of misvalued debt may have important impacts on both firms and investors, on who buys whom, and for default levels in the economy. Key concepts include: Misvaluation can stem from asymmetric information between PE firms, managers, and investors. The possibility of misvalued debt not only changes the likelihood of an acquisition, it also changes the type of buyer and the way the assets are owned. This matters because although the knowledge that the debt market is under or overvalued may be impossible to possess in real time, looking backward the times when credit was particularly misvalued correspond to increased M&A activity and increased PE activity relative to strategic buyers. The level of activity of financial buyers in aggregate in the economy will correlate with default probabilities. Financial buyers will be more active and take on more debt than strategic buyers when debt is overvalued. Thus a surprisingly large number should end up in financial distress. Even though both strategic and financial buyers would like to take advantage of interest rates that are "too low" and avoid borrowing when interest rates are "too high," they are differentially impacted by the errors and are willing to pay relatively more or less depending on the sign of the error made on interest rates. Closed for comment; 0 Comments.
- 29 Jun 2012
- Working Paper Summaries
Trade Credit and Taxes
Economists have extensively analyzed the effects of taxation on many aspects of corporate financial policy, including borrowing and dividend distributions. But the effects of corporate income taxes on trade credit practices have been much less understood. Research by Mihir A. Desai, C. Fritz Foley, and James R. Hines, Jr. develops the idea that trade credit allows firms to reallocate capital in response to tax differences. Using detailed data on the foreign affiliates of US multinational firms, the authors are able to observe affiliates of the same firm operating in different countries and therefore facing different corporate income tax rates. Taken together, the findings illustrate that firms use trade credit to reallocate capital from low-tax jurisdictions to high tax jurisdictions to capitalize on tax-induced differences in pretax marginal products of capital. Their actions imply that tax rate differences across countries significantly affect capital allocation within firms, depressing investment levels in high tax jurisdictions and introducing differences between the productivity of capital deployed in different locations. Key concepts include: This paper examines the extent to which taxation influences trade credit practices by affecting returns to investment. Analysis of detailed foreign-affiliate-level data suggests that tax effects are large and statistically significant in explaining trade credit choices. Affiliates in low tax jurisdictions have higher net working capital positions than do other affiliates. Managers have incentives to set accounts receivable and accounts payable in a manner that reallocates capital from lightly taxed operations where investment opportunities have dissipated to highly taxed operations where profitable opportunities remain. This mechanism implies that net working capital positions, or the difference between accounts receivable and accounts payable, should be higher for firms facing lower tax rates. Closed for comment; 0 Comments.
- 15 Jun 2012
- Working Paper Summaries
Reaching for Yield in the Bond Market
"Reaching for yield"—investors' propensity to buy high yield assets without regard for risk—has been identified as one of the core factors contributing to the buildup of credit that preceded the financial crisis. Despite this potential importance, however, the way in which reaching for yield works and where it occurs is not well understood. Professors Bo Becker and Victoria Ivashina examine reaching for yield in the corporate bond market by looking among insurance companies, the largest institutional investor in this arena. Findings suggest that reaching for yield may limit the effectiveness of capital regulation to a time-varying and unpredictable extent. Reaching for yield may also allow regulated entities to become riskier than regulators and legislators intend, and may impose distortions on the corporate credit supply. Key concepts include: Investments by insurance companies in corporate bonds exhibit patterns that reflect reaching for yield. Insurance companies are very important to the corporate bond market: According to U.S. Flow of Funds Accounts, insurance companies are the largest institutional holder of corporate and foreign bonds. Therefore, reaching may impact credit supply to the corporate issuers. Investment decisions of insurance companies are also important because, like banks, insurance companies have liabilities to a broad population base. Insurance portfolios are systematically biased toward higher yield bonds and higher CDS bond issuers. This behavior appears to be related to the business cycle since reaching for yield is most pronounced during economic expansions. It is also more pronounced for the insurance firms for which regulatory capital requirements are more binding. Rules that discourage risk taking also provide incentives to reach for yield. Because imperfect risk measurement is itself a fundamental feature of financial markets, there are no easy fixes to reaching for yield. Closed for comment; 0 Comments.
- 17 May 2012
- Working Paper Summaries
Is a VC Partnership Greater Than the Sum of Its Partners?
Venture capital investments are an important engine of innovation and economic growth, but extremely risky from an individual investor's point of view. Furthermore, there are large differences in fund performance between top quartile and bottom quartile venture capital funds. The ability to consistently produce top performing investments implies that there is something unique and time-invariant about venture capital firms. But to what extent are the important attributes of performance a part of the firm's organizational capital or embodied in the human capital of the people inside the firm? Michael Ewens and Matthew Rhodes-Kropf find that the partner is extremely important. Additionally, results suggest that venture capital partnerships are not much more than the sum of their partners. Partners are often significantly different from each other, but "good" firms are those with a group of better partners. Thus, firms that have maintained high performance across many funds may have simply been able to retain high quality partners rather than actually provide those partners with much in the way of fundamental help. Key concepts include: Performance seems almost entirely attributable to the partner, and firm characteristics seem to matter little in venture capital investing. The organizational capital inside a venture capital firm is limited. This would imply limited size firms. Closed for comment; 0 Comments.
- 11 Apr 2012
- Research & Ideas
The High Risks of Short-Term Management
A new study looks at the risks for companies and investors who are attracted to short-term results. Research by Harvard Business School's Francois Brochet, Maria Loumioti, and George Serafeim. Closed for comment; 0 Comments.
- 04 Apr 2012
- Research & Ideas
When Founders Recruit Friends and Family as Investors
In his new book, The Founder's Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup, HBS Associate Professor Noam Wasserman tells readers how to anticipate, avoid, and, if necessary, recover from the landmines that can destroy a nascent company before it has the chance to thrive. In this excerpt, he discusses the pros and cons of recruiting friends and family members as investors. Open for comment; 0 Comments.
- 20 Mar 2012
- Working Paper Summaries
The Stock Selection and Performance of Buy-Side Analysts
Important differences between buy- and sell-side analysts are likely to affect their behavior and performance. While considerable research during the last twenty years has focused on the performance of sell-side analysts (that is, analysts who work for brokerage firms, investment banks, and independent research firms), much less is known about buy-side analysts (analysts for institutional investors such as mutual funds, pension funds, and hedge funds). This paper examines buy recommendation performance for analysts at a large, buy-side firm relative to analysts at sell-side firms throughout the period of mid-1997 to 2004. The researchers find evidence of differences in the stocks recommended by the buy- and sell-side analysts. The buy-side firm analysts recommended stocks with stock return volatility roughly half that of the average sell-side analyst, and market capitalizations almost seven times larger. These findings indicate that portfolio managers (buy-side analysts' clients) prefer that buy-side analysts cover less volatile and more liquid stocks. The study also finds that the buy-side firm analysts' stock recommendations are less optimistic than their sell-side counterparts, consistent with buy-side analysts facing fewer conflicts of interest. This and future studies may help sell-side and buy-side executives to allocate their financial and human resources more strategically. Key concepts include: The failure to find that buy-side research out-performs that of sell-side analysts raises questions about whether investment firms should continue to rely on their own research rather than using research from sell-side analysts. Buy-side firms' analysts issued recommendations for companies with lower stock return volatility and larger market capitalizations than typical sell-side firms. Buy-side firm analysts recommended stocks with stock return volatility roughly half that of the average sell-side analyst (0.42% versus 0.95%), and market capitalizations almost seven times larger ($9.1 billion versus $1.3 billion). For stocks covered by both buy- and sell-side analysts, there were no differences in the buy recommendations' performance. Resolving whether buy-side research creates value is highly relevant to managers at buy-side firms who are faced with the challenge of allocating limited research resources. Closed for comment; 0 Comments.
- 16 Jan 2012
- Research & Ideas
Private Meetings of Public Companies Thwart Disclosure Rules
Despite a federal regulation, executives at public firms still spend a great deal of time in private powwows with hedge fund managers. Eugene F. Soltes and David H. Solomon suggest that such meetings give these investors unfair advantage. Closed for comment; 0 Comments.
- 08 Dec 2011
- Working Paper Summaries
Are There Too Many Safe Securities? Securitization and the Incentives for Information Production
Markets for near-riskless securities have suffered numerous shutdowns in the last 40 years, with the recent financial crisis the most prominent example. This suggests that instability could be a general characteristic of such markets, not just a one-time problem associated with the subprime mortgage crisis. Professors Samuel G. Hanson and Adi Sunderam argue that the infrastructure and organization of professional investors are in part determined by the menu of securities offered by originators. Since robust infrastructure is a public good to originators, it may be underprovided in the private market equilibrium. The individually rational decisions of originators may lead to an infrastructure that is overly prone to disruptions in bad times. Policies regulating originator capital structure decisions may help create a more robust infrastructure. Key concepts include: Financial innovations that create near-riskless securities encourage investors to rationally choose to be uninformed. Learning from prior mistakes will not necessarily eliminate the instabilities associated with near-riskless securities. Capital structure regulation in good times can improve welfare. Specifically, it may be desirable to regulate the capital structures of securitization trusts by limiting the amount of AAA-rated debt that can be issued in good times. Informed investors are a robust source of capital capable of analyzing investment opportunities and financing positive NPV (net present value) projects even in bad times. Closed for comment; 0 Comments.
- 06 Dec 2011
- Op-Ed
Greater Fiscal Integration Best Solution for Euro Crisis
Ministers and central bankers are working to solve the debt crisis that threatens the European integration project. Is there hope? There is reason to be optimistic, according to Harvard Business School's Dante Roscini, a former investment banker. Open for comment; 0 Comments.
- 14 Oct 2011
- Working Paper Summaries
The Cost of Capital for Alternative Investments
An accurate assessment of the cost of capital is fundamental to the efficient allocation of capital throughout the economy. Alternative investments are investments made by sophisticated individual and institutional investors in private investment companies like hedge funds and private equity funds. These investments are frequently combined with financial leverage to bear risks that may be unappealing to the typical investor or that require flexibility that public investment funds may not provide. Often there is a real possibility of a complete loss of invested capital. For this paper, Jakub W. Jurek and Erik Stafford study the required rate of return for a risk-averse investor allocating capital to alternative investments. They argue that the risks borne by hedge fund investors are likely to be positive net supply risks that are unappealing to average investors, such that they may earn a premium relative to traditional assets. Key concepts include: Even with direct knowledge of the underlying risks, the commonly used tools for asset allocation and determining required rates of return are inappropriate for these types of risk. A simple put writing strategy closely matches the risks observed in the time series of the aggregate hedge fund universe. Properly evaluating the risks of alternative investments is challenging. At the individual fund level, this will be especially difficult. The calibrations in this paper suggest that despite the seemingly appealing return history of alternative investments, many investors have not covered their cost of capital. Closed for comment; 0 Comments.
- 13 Oct 2011
- Working Paper Summaries
Market Competition, Government Efficiency, and Profitability Around the World
Understanding whether and how corporate profitability mean reverts across countries is important for valuation purposes. This research by Paul M. Healy, George Serafeim, Suraj Srinivasan, and Gwen Yu suggests that firm performance persistence varies systematically. Country product, capital, and to a lesser extent labor market competition all affect the rate of mean reversion of corporate profits. Corporate profitability exhibits faster mean reversion in countries with more competitive factor markets. In contrast, government efficiency decreases the speed of mean reversion, but only when the level of market competition is held constant. The findings are useful to practitioners and scholars interested in understanding how country factors affect corporate profitability. Key concepts include: There is predictable variation in mean reversion in corporate performance across countries. At a practical level, valuation exercises can benefit from considering country as well as traditional firm and industry factors in settling on the speed with which superior or inferior profits are likely to mean revert. Different level of performance persistence in each country will affect firm-value through valuation multiples. Closed for comment; 0 Comments.
- 05 Oct 2011
- Working Paper Summaries
Doing What the Parents Want? The Effect of the Local Information Environment on the Investment Decisions of Multinational Corporations
As firms increase the scale of their global operations, monitoring operations across borders becomes increasingly challenging. Transparency in the external information environment can help multinational corporations monitor foreign subsidiaries and resolve internal agency problems. In this paper, researchers Nemit O. Shroff, Rodrigo S. Verdi, and Gwen Yu find that foreign subsidiaries located in country-industries with more transparent information environments are better able to translate local growth opportunities into investments. Key concepts include: The external information environment can help MNCs better translate growth opportunities into growth by mitigating information frictions within the firm. The role of the information environment on the sensitivity of investment to growth opportunity is greater when parents and subsidiaries are (1) located in countries that speak different languages, (2) geographically more distant, and (3) located in different countries. Closed for comment; 0 Comments.
- 28 Sep 2011
- Research & Ideas
The Profit Power of Corporate Culture
In the new book The Culture Cycle, Professor Emeritus James L. Heskett demonstrates that developing the right corporate culture helps companies be more profitable and provides sustainable competitive advantage. Open for comment; 0 Comments.
- 29 Aug 2011
- Research & Ideas
Decoding Insider Information and Other Secrets of Old School Chums
Associate Professors Lauren H. Cohen and Christopher J. Malloy study how social connections affect important decisions and, ultimately, how those connections help shape the economy. Their research shows that it's possible to make better stock picks simply by knowing whether two industry players went to the same college or university. What's more, knowing whether two congressional members share an alma mater can help predict the outcome of pending legislation on the Senate floor. Open for comment; 0 Comments.
- 22 Jul 2011
- Working Paper Summaries
Corporate Social Responsibility and Access to Finance
Corporate social responsibility may benefit society, but does it benefit the corporation? Indeed it does, according to a new study that shows how CSR can make it easier for firms to secure financing for new projects. Research was conducted by George Serafeim and Beiting Cheng of Harvard Business School and Ioannis Ioannou of the London Business School. Key concepts include: The better a firm's CSR performance, the fewer capital restraints it will face. Better CSR performance is the result of improved stakeholder engagement, which in turn reduces the likelihood of opportunistic behavior and pushes managers to adopt a long-form strategy. This introduces a more efficient form of contracting with key constituents. Firms with good CSR performance are likely to report their CSR activities, thus increasing their overall transparency. Higher levels of transparency ease the fears of potential investors, making them more likely to invest. Closed for comment; 0 Comments.
- 01 Jun 2011
- Working Paper Summaries
The First Deal: The Division of Founder Equity in New Ventures
When starting a company, entrepreneurs must decide how to divide shares among the founders. The simplest way is to split the shares equally, which is what one third of startups decide to do. But that may not be the fairest or most effective way—especially in cases where some founders are doing more for the company than others. In this paper, Thomas F. Hellman (University of British Columbia) and Noam Wasserman (Harvard Business School) examine when and whether teams are likely to divide shares equally among all the founders, and explore whether such an equity split is good for the company. Key concepts include: The researchers consider four founder characteristics: years of work experience, prior founding experience, whether the founder contributed to the founding idea, and the amount of capital invested into the venture. They find that greater team heterogeneity in entrepreneurial experience, idea generation, and capital contributions predict a lower probability of equal splitting. The larger the founding team, the less likely it is to divide shares equally. The more combined work experience a team has, the less likely the team will split the shares equally. Teams where founders are related through family are more likely to split the equity equally. An equal split is associated with a lower valuation than an unequal split, especially in cases of quick negotiations. Founders who split equally when they should split unequally may be giving up a substantial amount of financial value. (Related research suggests that such teams may also be less stable.) Closed for comment; 0 Comments.
- 07 Apr 2011
- Working Paper Summaries
The Consequences of Financial Innovation: A Counterfactual Research Agenda
While financial innovation is often praised as a positive force for societal growth, it also takes much of the blame for the recent global financial crisis. In this paper, Harvard Business School professors Josh Lerner and Peter Tufano explore financial innovation and discuss how it differs from other types of innovation. Key concepts include: Financial innovation is defined as the act of creating and then popularizing new financial instruments, as well as new financial technologies, institutions, and markets. Economists initially tended to consider financial innovation in the same way that they consider manufacturing innovation. However, financial innovation differs from other types of new product development in several ways: predicting the social consequences of the innovation can be challenging, due to how interconnected the financial system is; the consequences of the innovation may change over time, due to the dynamic nature of the business; and new financial products and services are especially susceptible to regulation. The researchers suggest several promising approaches for future research. These include using counterfactual "thought experiments" to explore systemic impacts; looking at settings where there are big constraints on financial innovation, such as sharia-compliant financial structures; using experimental techniques; and studying the social impact of financial innovation using the same tools used to analyze the impact of new products. Closed for comment; 0 Comments.
The Acquirers
Associate Professor Matthew Rhodes-Kropf sets out to discover why public companies dominate some M&A waves while private equity firms win others. Open for comment; 0 Comments.