Governing Misvalued Firms

For decades, economists have argued that stocks can get priced irrationally and that this divergence from fundamental value may impact managerial decisions. If overvaluation leads to misbehavior and if strong governance curbs misbehavior, then governance should be particularly valuable in times of overvaluation. This simple yet powerful idea surprisingly has not been explored in the literature. In this paper, the authors fill the gap and ask whether strong corporate governance is especially important during periods of overvaluation when agency costs of managerial misbehavior are high. Results of joint tests of the perverse effects of overvaluation and the ability of governance to counteract them suggest that boards and shareholders looking to create long run value need to increase vigilance and oversight during times when the firm's stock is outperforming. This vigilance is especially important when CEOs have powerful pay-for-performance incentives. Read More

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; 3 Comments posted.

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. Read More

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. Read More

Investment Cycles and Startup Innovation

In this paper, HBS professors Nanda and Rhodes-Kropf examine how the environment in which a new venture was first funded relates to its ultimate outcome, by specifically looking at what happened to venture capital-backed startups funded between 1980 and 2004. Results show that firms that were funded in "hot" markets were more likely to fail but created more value and had more highly cited patents when they succeeded. These results suggest that that flood of capital in hot markets lowers the cost of experimentation for early stage investors, and therefore allows them to fund more novel projects in periods of heated financial activity. Read More

Financing Risk and Bubbles of Innovation

While start-up firms are key to any technological revolution, they also run a high risk of failure. To that end, investors often provide limited capital in several careful stages, gaining confidence in a firm before doling out another round of funding. However, these investors still face the possibility that other investors won't provide follow-on funding, even when the firm's prospects remain sound. That's a big risk for individual investors who can't afford to fund a new firm all by themselves, and whose investment will flounder if others don't invest, too. Research by HBS professors Ramana Nanda and Matthew Rhodes-Kropf explores why future investors may not fund the project at its next stage even if the fundamentals of the project have not changed. Read More