NBER Reporter: Summer 2001

Corporate Finance

Members and guests of the NBER's Program on Corporate Finance met in Cambridge on April 20. Program Director Raghurami G. Rajan chose the following papers for discussion:

Raymond Fisman, Columbia University, and R. Glenn Hubbard, NBER and Columbia University, "Endowments, Governance, and the Nonprofit Form"

Tobias J. Moskowitz and Annette Vissing-Jorgensen, University of Chicago, "The Private Equity Premium Puzzle"

Julie Wulf, University of Pennsylvania, "Do CEO's of Target Firms Trade Power for Premium? Evidence From 'Mergers of Equals'"

Alberto Bisin, New York University, and Anriano A. Rampini, Northwestern University, "Exclusive Contracts and the Institution of Bankruptcy"

Andrei Shleifer, NBER and Harvard University, and Robert W. Vishny, NBER and University of Chicago, "Stock Market Driven Acquisitions"

Owen A. Lamont, NBER and University of Chicago, and Christopher Polk, Northwestern University, "Does Diversification Destroy Value? Evidence from Industry Shocks"

Mark J. Roe, Harvard University, "The Quality of Corporate Law Argument and its Limits"

Simon Johnson, NBER and MIT, and Todd Mitton, Brigham Young University, "Who Gains from Capital Controls? Evidence from Malaysia"

Nicola Cetorelli, Federal Reserve Bank of Chicago, "Does Bank Concentration Lead to Concentration in Industrial Sectors?"

In for-profit enterprises, shareholders are the residual bearers of risk. By contrast, because nonprofits have no residual claimants, something else must absorb financial shocks to the organization. Nonprofit managers often describe the endowment, or fund balance, as serving this function. In this paper, Fisman and Hubbard examine the role of the endowment as a precautionary savings device for nonprofit organizations. They find very strong evidence in support of the role of the endowment in allowing for smoothing of program expenditures. However, providing managers with a large discretionary fund raises significant concerns regarding the governance of the organization. The authors are also concerned with free cash flow in for-profit enterprises when shareholders do not carefully monitor the behavior of managers, and about the possibility of expropriation of discretionary funds by nonprofit managers. Taking advantage of differences in nonprofit oversight across states in the United States, the authors show that organizations in poor governance states, relative to strong governance states: have managerial compensation that is more highly correlated with inflows of donations; derive a smaller percentage of their revenues from donations; and save a smaller proportion of current donations for future expenditures. This provides some evidence of governance problems in the nonprofit form, and suggests an important role for oversight for overcoming these difficulties.

Moskowitz and Vissing-Jorgensen document that investment in private equity is extremely concentrated. Yet despite the very poor diversification of entrepreneurs' portfolios, the returns to private equity are similar to the returns on public equity. Given the large premium required by investors in public equity, it is puzzling why households willingly invest substantial amounts in a single privately held firm with a far worse risk-return tradeoff. The authors examine various explanations and conclude that private nonpecuniary benefits of control must be large and/or entrepreneurs must greatly overestimate their probability of success in order to explain the observed concentration of wealth in private equity.

Wulf studies abnormal returns in a sample of "mergers of equals" transactions in which the two firms are approximately equal in post-merger shareholdings and board representation. Mergers of equals (MOEs) are friendly mergers generally characterized by extensive pre-merger negotiations between firms with comparable bargaining positions resulting in both lower target premiums and greater shared control (board and management) between target and acquiring firms. On average, acquirer shareholders capture more of the gains in MOEs measured by event returns, while target shareholders capture less, in comparison to a matched sample of transactions with unequal board representation ("mergers of non-equals" or MONEs). However, the value created by MOEs measured by combined event returns is not significantly different than the matched sample. Moreover, both the value created and target shareholders' capture of the gains are related systematically to variables representing control fights in the merged firm. The evidence suggests that target CEOs with stronger bargaining positions and incentives negotiate shared control in the merged firm in exchange for lower target shareholder premiums.

Bisin and Rampini suggest a motivation for the institution of bankruptcy: whenever exclusive contracts cannot be enforced ex ante, for example, a bank cannot monitor whether the borrower enters into contracts with other creditors, bankruptcy enables the enforcement of exclusivity ex post, and hence relaxes the incentive constraints. In general, though, while a bankruptcy institution improves on non-exclusive contractual relationships, it is not a perfect substitute for ex ante exclusivity.

Shleifer and Vishny present a model of mergers and acquisitions based on stock market misvaluations of the combining firms. The model explains who acquires whom, whether the medium of payment is cash or stock, what the valuation consequences of mergers are, and why there are merger waves. Some of the key predictions of the model are: 1) acquisitions are disproportionately for stock when market valuations are high, and for cash when they are low; 2) targets in cash acquisitions earn low returns prior to the acquisitions, whereas bidders in stock acquisitions earn high returns; 3) long-run returns to bidders in stock acquisitions are likely to be negative, while those to bidders in cash acquisitions are likely to be positive; 4) despite negative long-run returns, acquisitions for stock serve the interest of long-run shareholders of the bidder; 5) diversification strategies serve the interest of bidding shareholders even when they earn negative announcement returns; 6) such diversifying acquisitions are likely to be for stock; 7) management resistance to cash tender offers is often in the interest of shareholders; and 8) acquisition targets are likely to have managers and shareholders with relatively shorter horizons than the bidders.

Lamont and Polk examine changes in the within-firm dispersion of industry investment, or "diversity." They find that exogenous changes in diversity, caused by changes in industry investment, are related negatively to firm value. Thus diversification destroys value, consistent with the inefficient internal capital markets hypothesis. Measurement error does not cause this finding. Also, exogenous changes in industry cash flow diversity are related negatively to firm value.

Roe notes that strong theory has emerged in recent years that the quality of corporate law determines whether securities markets will arise, whether ownership will separate from control, and whether the modern corporation will prosper. Ownership cannot readily separate from control when managerial agency costs are especially high. Further, the business judgment rule, under which judges do not second-guess managerial mistake, puts the full panoply of agency costs - such as over-expansion, over-investment, and reluctance to take on profitable but uncomfortable risks - beyond any direct legal inquiry. The consequence is that even if corporate law as usually conceived is "perfect," it eliminates self-dealing, not managerial mistake. But managers can lose for shareholders as much, or more, than they can steal from them, and law controls only the second cost, not the first. If the risk of managerial error varies widely from nation to nation, or from firm-to-firm, then ownership structure should vary equally widely, even if conventional corporate law tightly protects shareholders. There is also good reason, and some new data, consistent with this analysis: by measurement, several nations have fine enough corporate law; distant stockholders are well-protected from controlling stockholder and managerial thievery, but uncontrolled agency costs seem to be especially high in those very nations.

The stock prices of politically connected Malaysian firms fell disproportionately in the early stages of the Asian financial crisis but rose more than the market once capital controls were imposed in September 1998. Capital controls primarily benefited well-connected firms without access to international capital markets. These results hold for both financial and non-financial firms separately and are robust to controlling for firm size, sector, profitability, pre-crisis growth, and whether a firm is favored because it is officially Bumiputera (with ethnic Malay ownership over 50 percent). Johnson and Mitton's findings are consistent with the view that capital controls provide a screen behind which politicians can support particular firms.

Cetorelli explores the effect of banking market structure on the market structure of industrial sectors. She asks whether concentration in the banking market promotes the formation of industries constituted by a few, large firms, or rather, whether it facilitates the continuous entry of new firms, thus maintaining unconcentrated market structures across industries. From a sample of 35 manufacturing industries in 17 OECD countries, and adopting a methodology that allows controlling for other determinants of industry market structure common across industries or across countries, Cetorelli finds that bank concentration enhances industries' market concentration, especially in sectors highly dependent on external finance. That effect is weaker however in countries characterized by higher overall financial development.


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