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With Amil Dasgupta
An important recent theoretical literature argues that the threat of exit can be an effective form of governance when the blockholder is a principal. However, a significant fraction of blockholders are delegated portfolio managers. How do agency frictions arising from such delegation affect the ability of blockholders to govern via the threat of exit? Fund managers are often subject to short-term flow-performance relationships and differ in the degree to which they care about investor flows. We show that when blockholders are sufficiently concerned about investor flows, exit will fail as a disciplining device. Our result generates testable implications across different classes of funds: only those funds who have relatively high powered incentives will be effective in using exit as a governance mechanism. We also show that the threat of exit can complement shareholder voice, and thus provide a potential explanation for the empirically observed variation across different types of portfolio managers’ use of voice.
This paper contrasts profit-maximizing individual investors with career-concerned portfolio managers in terms of their effect on firms' funding, economic welfare, and shareholder wealth. The finance literature has shown the negative effects of portfolio managers' career concerns. In contrast, I show a positive side: I find that delegated portfolio managers allocate capital more efficiently than do individual investors, which promotes investment, fosters firm growth, and enriches shareholders. Funding markets require information, but individual speculators are sometimes disinclined to acquire it; in contrast, the career concerns of portfolio managers lead them endogenously to embed information into prices and to trade more often. Finally, I show that career-concerned speculators mitigate the effect of the winner's curse and thereby reduce the discount in a seasoned equity offering.
With Jason R Donaldson
Expert portfolio managers hold assets on behalf of inexpert clients, but managers' incentives differ from clients'. Managers write restrictive covenants into their contracts, typically including investment mandates that make contracts contingent on assets' credit ratings. In an economy in which competitive, risk- averse informed agents offer contracts to a risk-averse, uninformed investor, the equilibrium contract is affine in wealth and depends on credit ratings, like most real-world delegated investment contracts. It implements the first-best allocation, but the inclusion of credit ratings shuts down risk-sharing and makes everyone worse off. Credit ratings serve only to allow agents to compete more intensely by writing state-contingent contracts. We advocate the regulation of credit rating agencies to prohibit their publishing information in forms conducive to inclusion in rigid contracts. Further, our model provides a contract-based explanation for cyclical trends in mutual funds' flows.
With Jason R Donaldson
This paper models a credit market in which lenders offer entrepreneurs either arm’s-length or relationship loans and shows that competition in the credit market affects both the loans banks offer and the projects entrepreneurs undertake. Relationship lending is expensive, but it allows lenders to finance projects that would be unprofitable if funded at arm’s-length because they require monitoring. These projects are always efficient, but often entrepreneurs don’t undertake them or lenders do not fund them. In fact, we show that for only in-between credit competitiveness is investment efficient and innovation possible. The inefficiency is partially solved when VCs enter the market: they finance innovative projects that banks do not fund. As competitiveness in the credit market increases VCs provide a larger share of capital but never fully crowd out banks and may be still scarce in the perfect competition limit. Even though no type heterogeneity on either side of the market is assumed, VCs fund high NPV projects and banks fund low NPV projects in equilibrium..
With Jason R Donaldson
Firms issue securities to fund projects in an opaque market in which investors cannot infer the value of assets. As a result, good firms, unable to differentiate themselves, bypass profitable investment opportunities: informational inefficiency leads to allocational inefficiency. A rating agency enters the market, providing certification for a fee; it not only fails to inform investors and encourage investment, but also captures a tidy share of firms’ rents. With two agencies competing in fees and disclosure rules, though, problems disappear—information is complete and investment efficient. When the agencies interact repeatedly they are prone to collusion. When investment opportunities are plentiful they rate honestly, but charge fees so high that some positive NPV projects go unfunded. On the other hand, when there are few investment opportunities in the economy they overrate and good firms don’t invest. Regulatory prescriptions of bundling ratings with CDS issues and flooring fees solve the problem.