Do firm boundaries affect the allocation of resources? This question had spawned significant research in economics since it was raised in Coase (1937). A large body of work has focused on comparing the resource allocation in conglomerates relative to stand-alone firms to shed light on this issue. Theoretically, there are competing views on this aspect. On the one hand, Alchian (1969), Wiliamson (1985), and Stein (1997), among others, have put forth the view that conglomerates, by virtue of exerting centralized control over the capital allocation process, may do a better job in directing investments than the external capital markets. On the other hand, the “dark side” view of internal capital markets argues that problems of corporate socialism are more prevalent in conglomerates making them less efficient in resource allocation (Rajan, Servaes, and Zingales, 2000; Scharfstein and Stein, 2000).
Posts Tagged ‘Capital allocation’
In an open capital market economy, guided by market signals, firms (and their managers) play an important role in the allocation of capital. Zingales (2000) proposes that the media may also play a role, perhaps positive, perhaps negative, in guiding firms (and their managers) in making capital allocation decisions. Dyck and Zingales (2002) develop this idea more fully. Given that the media collect, aggregate, disseminate, and amplify information, and to the extent that this information affects managers’ reputations, they propose that managers are sensitive to the way in which the media report and comment upon their decisions. Managers may even be sensitive to whether the media reports on their decisions at all. After all, a bad decision that goes unnoticed may be no worse than a good decision that goes equally unnoticed.
In our paper, The Role of the Media in Corporate Governance: Do the Media Influence Managers’ Capital Allocation Decisions?, forthcoming in the Journal of Financial Economics, we investigate whether, and to what extent, managers of publicly-traded U.S. corporations are sensitive to public news media in making one specific type of capital allocation decision. To wit: the decision of whether to complete or abandon a large proposed corporate acquisition that is accompanied by a negative stock market reaction at the announcement (“value-reducing acquisition attempt”). More specifically, we investigate whether the likelihood that a value-reducing acquisition attempt is abandoned is related to the level of media attention given to the attempt and to the tone of media coverage regarding the acquirer’s attempt at the time of the acquisition announcement.
Do firm boundaries mediate the effect of shocks to the financial intermediation sector? When the functioning of the intermediation sector is impaired – as was the case in the recent financial crisis – shocks can be transmitted to the broader economy since funds may not flow to highest value use without incurring significant cost. This issue has been extensively explored in the credit channel literature (e.g., Kashyap and Stein ; Bernanke and Blinder [1988; 1992], and Bernanke and Gertler ). However, unlike what is assumed in this literature, firms may be able to reallocate resources internally – for instance, between divisions in different industries – to ameliorate the effect of financial shocks. If so, external credit market conditions will impact the nature of resource allocation inside firms and between industries differently than they would in an economy with no internal capital markets. Diversified firms constitute a large part of economies around the world; therefore, resource allocation within firms can be of significant importance. In this paper we propose that firms shift resources between industries in response to shocks to the financial sector. We estimate a structural model to quantify the forces driving this reallocation decision, and show that these forces dampen shocks to the financial sector in economically significant ways.
I will first give some general remarks on the reasons for the low level of U.S. IPO volume this decade and the implications for job creation and economic growth, and then make some suggestions on the specific bills that the Senate is considering.
First, there is no doubt that fewer American companies have been going public since the tech stock bubble burst in 2000, and the drop is particularly pronounced for small companies. During 1980-2000, an average of 165 companies with less than $50 million in inflation-adjusted annual sales went public each year, but in 2001-2011, the average has fallen by more than 80%, to only 29 small firm IPOs per year. The patterns are illustrated in Figure 1.
Recently, the House of Representatives passed H.R. 3606, the “Jumpstart Our Business Startups Act.” It is clear to me that H.R. 3606 in its current form weakens or eliminates many regulations designed to safeguard investors. I must voice my concerns because as an SEC Commissioner, I cannot sit idly by when I see potential legislation that could harm investors. This bill seems to impose tremendous costs and potential harm on investors with little to no corresponding benefit.
H.R. 3606 concerns me for two important reasons. First, the bill would seriously hurt investors by reducing transparency and investor protection and, in turn, make securities law enforcement more difficult. That is bad for ordinary Americans and bad for the American economy. Investors are the source of capital needed to create jobs and expand businesses. True capital formation and economic growth require investors to have both confidence in the capital markets and access to the information needed to make good investment decisions.
In our paper, The Flight Home Effect: Evidence from the Syndicated Loan Market During Financial Crises, forthcoming in the Journal of Financial Economics, we study whether lenders, when hit by shocks that negatively affect bank wealth in their home market, have a tendency to rebalance their portfolio away from international markets to their domestic market. We explore this flight home effect in the context of the syndicated loan market, a large and highly internationalized financial market.
After controlling for demand shocks in foreign markets, we explore whether foreign lenders not only transmit shocks to foreign markets, as established in existing literature, but also whether they amplify these effects by substituting foreign loans for domestic loans. To establish whether this is the case, we analyze how the relative importance of a bank’s domestic and foreign loans varies following negative shocks.
Our results are consistent with the existence of a flight home effect. The proportion of loans granted to domestic borrowers increases by approximately 20 percent if the home country of the bank experiences a banking crisis, or more generally, if banks’ stock prices in the home country show a large decline. Lenders with less stable funding sources, being more vulnerable to negative liquidity shocks (Demirgüç-Kunt and Huizinga, 2010; Ivashina and Scharfstein, 2010), exhibit a stronger flight home effect. Overall, the results indicate that the home bias in the international allocation of syndicated loans increases in the presence of adverse economic shocks affecting the net wealth of international lenders.
In my paper, Managerial Investment and Changes in GAAP: An Internal Consequence of External Reporting, which was recently made publicly available on SSRN, I investigate whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. I hypothesize that the relation between changes in GAAP and investment manifests for at least two non-mutually exclusive reasons. First, I hypothesize that changes in GAAP can affect investment because the numbers reported in financial statements have a direct bearing on contractual outcomes. For example, debt contracts often contain covenants based on numbers reported in financial statements (Leftwich ). Consequently, if a change in GAAP has an unfavorable (favorable) impact on current and future financial statements, and debt covenants are not adjusted to incorporate the changes, the change in GAAP will likely tighten (loosen) covenant slack. As a result, managers may alter their actions to avoid covenant violation. Specifically, since most investments have an uncertain future outcome and some positive probability that the outcome is a loss, they increase the probability of violating covenants in the future by adversely impacting future financial ratios. Consequently, managers might respond to changes in GAAP that adversely affect financial statements by cutting investment in risky assets with the goal of preserving net worth and preventing deterioration of financial ratios.
In the paper, On the Importance of Internal Control Systems in the Capital Allocation Decision: Evidence from SOX, which was recently made publicly available on SSRN, I investigate the effects of information problems across corporate hierarchies on internal capital allocation decisions by using the Sarbanes-Oxley Act (SOX) as a quasi-natural experiment of a shock to the level of information frictions across corporate hierarchies. SOX requires firms to enhance their internal control systems in order to improve the reliability of financial reporting across corporate hierarchies.
I find that after SOX the capital allocation decision is more sensitive to performance as reported by the business segments. The changes in sensitivity of investment to performance are more pronounced for conglomerates that are more prone to information problems across corporate hierarchies, such as conglomerates with more segments and conglomerates that restated their earnings in the past. Moreover, in the post-SOX era, firms do not rely on past performance in their capital allocation decision when auditors report material weaknesses in their internal controls. The productivity advantage of conglomerates over stand-alone firms increases after SOX. In addition, conglomerates and segments that are more affected by SOX exhibit a larger increase in future profitability after SOX. Furthermore, the excess value of conglomerate firms relative to stand-alone firms increases (i.e., the conglomerate discount decreases). These changes in the internal capital allocation process are not associated with economic activities, financial constraints, or tensions between the management and shareholders.
In the paper, Why Does the Law Matter? Investor Protection and its Effects on Investment, Finance, and Growth, forthcoming in the Journal of Finance, we study how investor protection affects firm-level resource allocations. We test for these effects using both ex-ante and ex-post measures of efficiency. We conduct our analyses in a large sample of firms from 44 countries during the period 1990 to 2007. We show that the relations between q and investment and q and external finance are stronger in countries with stronger investor protection laws. These findings are consistent with the notion that investor protection laws encourage accurate share prices, efficient investment, and better access to external finance.
In my paper Empire-Building or Bridge-Building? Evidence from New CEOs’ Internal Capital Allocation Decisions, which was recently accepted for publication in the Review of Financial Studies, I examine CEOs’ decision-making processes for capital allocation in the context of power and relationships within corporations by investigating whether the job histories of CEOs influence their capital allocation decisions when they preside over multi-divisional firms. I investigate the capital allocation decisions made by 265 new CEOs at 230 diversified firms after turnovers between 1993 and 2002. CEO turnovers provide a good opportunity for this study because CEOs are likely to be most vulnerable to political complications at work when they are new to the post. In particular, I focus on the 98 new CEOs in my sample who advanced through the ranks from certain, but not all, divisions in their firms. I call these CEOs specialists and separate the segments in their firms into two groups based on their affiliation with the CEOs: divisions that the CEOs advanced through the ranks from (labeled the in-group), and the rest of the divisions (labeled the out-group). The empirical analysis in the paper focuses on changes in segment capital expenditures around CEO turnovers to determine whether specialist CEOs treat the in-group and the out-group segments differently when allocating capital after succession, and if so, whether they favor the in-group (“empire-building”) or the out-group (“bridge-building”) in their allocation decisions.
My results are broadly consistent with the bridge-building hypothesis. I find that, on average, the out-group segments experience a significant increase in capital expenditures after CEO turnover relative to the in-group segments. The average change in segment investment ratio (capital expenditures over assets) after a specialist CEO takes office is 0.013 higher for the out-group than the in-group, statistically significant at the 5% level or better. This difference of 0.013 is economically meaningful as it represents more than 20% of the average pre-turnover investment ratio of 0.06. Moreover, these findings also hold for specialist CEOs hired from outside the firm and are robust to the inclusion of segment-level, firm-level, and turnover-related controls as well as changes in the test specifications including the definition of specialists, the measure for capital expenditures, the time frame around turnover, and the sample period. I further test for the bridge-building hypothesis by examining whether the in-group and out-group difference in capital allocation change around turnover is related to the specialist CEO’s relative bargaining power within the firm. I find that the difference is more pronounced if the specialist CEO does not hold a corporate-level executive title such as chief operating officer or president before succession or if the in-group segments and the out-group segments are not in related industries. The results from the finer tests are consistent with the prediction of the bridge-building hypothesis that a specialist CEO with less power should engage in more bridge-building efforts, which imply a more pronounced pattern of reverse-favoritism in capital allocation.
While my results are consistent with the bridge-building hypothesis, a key concern is the issue of endogeneity. CEOs are chosen by the board of directors, and the job histories of CEOs are observable by the board and may be an important selection criterion in the board’s choice for nomination. Even though the most obvious and natural endogeneity story is one that would lead to a bias that works in precisely the opposite direction to the empirical findings in this paper, I consider alternative versions of the endogeneity story in which the CEO might be chosen to grow the segments in the out-group or to reduce investments in the in-group, leading to the relative increase in the capital expenditures of the out-group segments observed in the data. I use two approaches to address this concern. First, I try to discriminate against this type of endogeneity story by identifying weak divisions in the firm based on segment cash flow and segment Q. I find that the in-group and the out-group segments experience differential capital allocation change regardless of segment operating performance and segment investment opportunity. The difference in capital expenditure change is significant and of the same magnitude even when one compares the strong segments in the in-group with the weak segments in the out-group, inconsistent with what the endogeneity story might suggest. Second, I estimate a segment’s propensity to be a member of the out-group based on pre-turnover segment characteristics, and use the propensity scores as a summary measure to match the out-group segments and the in-group segments. Again, I find a relative increase in the average change in capital expenditures for the out-group compared with those of the in-group after a specialist CEO takes office. The magnitude and significance level of the estimate are similar to those of the main results, further alleviating the concern that endogeneity might account for the findings.
Finally, I investigate whether having a specialist CEO affects segment investment efficiency by studying the changes in the sensitivity of segment investment to Q before and after the CEO turnover. My results show that the sensitivity of segment investment to Q increases significantly after CEO turnover in a generalist’s firm, indicating an improvement in investment efficiency. Segments under a specialist CEO, however, do not experience such improvements: the investment sensitivity to Q for these segments is virtually unchanged after the turnover. In addition, I examine the market’s reaction to the announcement of the appointment of specialist versus generalist CEOs and find that the cumulative abnormal returns around announcements are significantly higher for incoming CEOs who are generalists. The market’s response corroborates the finding that generalist CEOs are associated with improved segment investment efficiency after turnover and suggests that appointments of generalist CEOs are perceived by the market as positive news for the conglomerates.
Overall, my results suggest that the job histories of CEOs are an important determinant of their capital allocation decisions and that new specialist CEOs are affected by political concerns in the capital allocation process. New specialist CEOs use the capital budget as a bridge-building tool to elicit cooperation from powerful divisional managers in previously unaffiliated divisions.
The full paper is available for download here.