In our paper, The Real Effects of Financial Markets: The Impact of Prices on Takeovers, forthcoming in the Journal of Finance, we provide evidence on the real effect of financial markets. Using non-fundamental shocks to market prices — occurring due to non-discretionary trades by mutual funds that face liquidation pressure from investors’ outflows — as an instrumental variable, we show that market prices affect takeover activity. A non-fundamental decrease in the stock price creates a profit opportunity for acquirers, and increases the probability that the firm will be taken over. Using an instrument for price changes is essential for identifying this effect since market prices are endogenous and reflect the likelihood of an upcoming acquisition. This may explain the weak relationship between prices and takeover activity found by prior literature. By modeling the relationship between prices and takeovers as a simultaneous system that accounts for anticipation, and identifying using an instrument, we find a significantly stronger effect of prices on takeovers than previous research.

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As we enter 2012 and as the U.S. economy continues to stabilize, there appears to be a growing sense of optimism about further recovery in the M&A market. During the first half of 2011, the M&A market continued a resurgence that began in the latter part of 2010, with higher aggregate deal value than had been seen since before the financial crisis. Though worldwide M&A activity declined in the second half of 2011, reflecting uncertainties regarding the volatile global financial climate, it has continued at a relatively strong pace, and a number of significant transactions have recently been announced, including Kinder Morgan’s $38 billion acquisition of El Paso, United Technologies’ $18 billion acquisition of Goodrich, and Gilead’s $11 billion acquisition of Pharmasset.

…continue reading: Mergers and Acquisitions in 2012

In our paper, Executive Stock Options, Differential Risk-Taking Incentives, and Firm Value, forthcoming in the Journal of Financial Economics, we examine how executive stock options (ESOs) give chief executive officers (CEOs) differential incentives to alter their firms’ systematic and idiosyncratic risk. Since ESOs give CEOs incentives to alter their firms’ risk profile through both their sensitivity to stock return volatility, or vega, and their sensitivity to stock price, or delta, we examine both effects.

Theory suggests that vega gives risk-averse managers more of an incentive to increase total risk by increasing systematic rather than idiosyncratic risk, since, for a given level of vega, an increase in systematic risk always results in a greater increase in a CEO’s subjective value of his or her stock-option portfolio than does an equivalent increase in idiosyncratic risk. This differential risk-taking incentive manifests because a CEO who can trade the market portfolio can hedge any unwanted increase in the firm’s systematic risk. Consistent with this prediction, we provide evidence of a strong positive relationship between vega and the level of both total and systematic risk. However, we do not find vega and idiosyncratic risk to be significantly related.

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Two important sources of company value are governance and diversification. In our paper, How Much of the Diversification Discount Can Be Explained by Poor Corporate Governance? forthcoming in the Journal of Financial Economics, we investigate links between these two attributes. We seek to determine whether the negative association between firm value and diversification, established in many other studies, can be partly attributed to the quality of corporate governance in conglomerate firms.

We estimate a wide range of panel data regression models similar to those used in prior studies of the diversification discount. We estimate our regressions with and without a large set of corporate governance control variables. Our analysis indicates that between 16% and 21% of the diversification discount arises because of conglomerate firms’ choices about which corporate governance parameters to adopt. Our conclusions are based on the degree to which the estimated diversification discount narrows and moves closer to zero when governance variables are added to our regressions.

…continue reading: Poor Corporate Governance and the Diversification Discount

In the paper, Acquirer Valuation and Acquisition Decisions: Identifying Mispricing Using Short Interest, which was recently made publicly available on SSRN, we provide new evidence helping to resolve an ongoing academic debate about the factors that lead firms to acquire other firms. In the center of the debate are two views. According to the neoclassical approach, acquisitions are an efficient way for firms to expand. The prediction of this school of thought is that mergers are more likely to take place for firms with high Tobin’s Q which is indicative of high investment opportunities. In contrast, the behavioral school of thought argues that firms that are temporarily overvalued have an incentive to engage in stock acquisitions in order to exchange their overvalued equity for real assets. Resolving the debate requires distinguishing overvaluation from high investment (or growth) opportunities. To date, most studies use variations of the market-to-book ratio to measure overvaluation as well as to measure investment opportunities. Hence, in order to distinguish between the two hypotheses, one needs an instrument to separate these two economic variables.

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In our paper, Effects of Local Director Markets on Corporate Boards, which was recently made publicly available on SSRN, we examine how local director labor markets affect board composition and the quality of corporate governance. We document that the supply of potential directors in the local labor market strongly affects board composition of S&P 1500 companies, namely, the proportion and expertise of independent directors. For instance, in an average sample firm, a third of independent directors in S&P 1500 firms holding executive positions are employed locally.

Our empirical tests show that access to a larger local pool of prospective directors has a positive effect on the proportion of independent directors and a negative effect on the proportion of gray and inside directors found on a typical board of directors. At firms located near larger local pools of prospective directors, a significantly higher fraction of independent directors are employed locally. Overall, boards of firms located near larger pools of managerial talent include a larger percentage of independent directors who are executives from other nearby firms.

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In the paper, Accounting Conservatism, Going-Concern Horizon, and Earnings Informativeness, which was recently made publicly available on SSRN, I examine how accounting conservatism shapes the relation between a firm’s going-concern status and the informativeness of its earnings for firm valuation. I extend earnings-persistence-based valuation theory to develop the study’s key insight that the difference between the earnings informativeness of a firm with a finite going-concern horizon and the earnings informativeness of a firm with an infinite going-concern horizon is a positive function of the proportion of capitalized value that is reflected in the earnings of future periods. Based on this insight, I predict that because of the asymmetric persistence implications of accounting conservatism, negative shocks to a firm’s assessed going-concern horizon diminish the informativeness of good news earnings but have no effect on the informativeness of bad news earnings. Using the setting of intra-industry bankruptcy to capture shocks to the market’s assessment of firms’ going-concern horizons, I provide empirical evidence consistent with my predictions.

This study makes several contributions to extant literature. First, my analysis and results provide additional insights into the dynamics of the going-concern assumption and firm valuation. In particular, I provide evidence that the negative relation between probability of bankruptcy and earnings informativeness is not symmetric across good and bad news realizations, as suggested implicitly by prior literature.

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In our paper, Advisory Directors, which was recently made publicly available on SSRN, we study the characteristics and effects of directors dedicated to providing strategic counsel to the chief executive officer (CEO). The question of how to structure corporate boards for effective oversight of top management has attracted significant academic and regulatory efforts in recent years. In contrast, how best to structure the board for optimal advising remains an important but much less investigated topic.

In an attempt to bridge this gap, we propose that the board’s advising functions are best performed by a distinct class of independent directors minimally involved in monitoring management. Specifically, we define an advisory director as an independent director who does not serve on any of the principal monitoring committees but serves on at least one advisory committee if the company has any. We argue that such directors are best positioned for effective advising because their minimal involvement in monitoring enables them to develop a trusting relationship with the CEO and provides the time needed to focus on strategic issues. This facilitates information exchange with the latter, makes him more likely to seek their opinions, and provides a friendly sounding board for important strategic proposals.

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Previous empirical studies on the benefits of “good” governance perform comprehensive and detailed analyses of corporate governance structures and regulations, but make no reference to the board’s intellectual capital, or knowledge, thereby substantially limiting the understanding of the role of corporate governance in organizational value creation. In the paper, Intellectual Capital, Corporate Governance, and Firm Value, which was recently made publicly available on SSRN, I address this gap.

I use the number of scientists on the board of directors as a proxy for the board’s intellectual capital and investigate the impact of directors-scientists on firm value in the population of publicly-listed U.S. firms. I expect a positive contribution of scientists to firm value in knowledge-intensive sectors, such as information technology, pharmaceuticals and chemical products, characterized by significant R&D activities, product innovation, and long-term projects. Boards with strong scientific expertise are more likely to make effective strategic R&D decisions and subsequently monitor these decisions effectively than boards with limited scientific experience. Directors with scientific background are also expected to have a longer decision horizon than other directors; the boards with strong scientific expertise are therefore more likely to select long-term projects that maximize the firm’s net present value instead of the projects that focus on current profits.

…continue reading: Intellectual Capital, Corporate Governance, and Firm Value

In our paper, External Networking and Internal Firm Governance, forthcoming in the Journal of Finance, we use panel data on S&P 1500 companies to identify external network connections between directors and CEOs. We observe network connections stemming from shared external board seats, prior employment in other firms, education, or charitable and leisure activities. We test whether these ties affect firm policies and performance.

A well-functioning board of directors provides both valuable advice to management and a check on its policies. An effective director should not just rubber stamp management’s actions, but should take a contrarian opinion when management’s proposals are not in the interest of the firm’s shareholders. Thus, it is important to identify director characteristics which affect their ability or willingness to bring valuable new information into the firm and to properly perform their monitoring role. Our results suggest that having directors with external network ties to the CEO may undermine the effectiveness of corporate governance.

…continue reading: External Networking and Internal Firm Governance