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Investment and Financing under Reverse Asset Substitution The traditional trade-off theory of capital structure holds that firms choose their leverage by balancing the benefits of tax shielding with the ex-ante expectation of deadweight loss in the event of bankruptcy. However, leverage levels observed in practice are quite conservative if expected cost of distress is the only counterweight. This is the ``under-leverage puzzle''. This paper proposes an agency problem as the other counterweight to even the balance - reverse asset substitution. Equity holders in the firm are apprehensive that debt holders will constrain investment policy, thus reducing firm value. If the expected reduction in firm value due to the imposition of constraints that come with more debt are high enough, then it appears that the firm chooses leverage conservatively if distress cost is the only concern. Using firm, bank and bank loan data, I find empirical evidence that shows the existence of this agency problem in data. I document that when a lending relationship is active, a firm's investment decisions are strongly influenced by considerations that should not be important for optimal investment policy. This explains why profitable firms with large growth options and hence more to lose with investment constraints, take on less leverage.
Heterogeneity in Corporate Governance: Theory and Evidence We propose that the amount of management autonomy in a firm is chosen as a best response to exogenous firm characteristics, such as output variance. Management has private information about firm output. Shareholders face a trade-off regarding autonomy as higher autonomy increases firm productivity but also leads to increased private benefits. The information disadvantage between the shareholders and management increases with exogenous variance in performance. Shareholders in firms with higher exogenous variance attempt to reduce this disadvantage by reducing autonomy of management. Thus, in practice, we observe a range of governance control which is negatively correlated to the variance of firm output. In addition, we find that over time, this information gap has decreased in US capital markets and in recent times cannot be statistically identified to be present. This may be encouraging evidence for proponents of laws that seek to increase corporate transparency, such as Sarbanes-Oxley.
Effort, Risk and Walkaway under High Water Mark Style Contracts We study a hedge fund style contract where performance fees with a high water mark drive a fund manager's effort expenditure and risk choices and walkaway decisions by both the fund manager and the investor. Modeling such a relationship, we derive clear empirical predictions of the impact of the return process, in particular the distance from the high water mark (HWM), on effort, risk and walkaway behavior. Testing empirical data, we find as distance from the HWM increases, effort expended falls, incidence of walkaway increases and risk appetite of the manager increases. All of these effects are most stark when the fund is closer to a HWM and fade once it is further away. Additionally, we find risks taken by funds further from their HWM to be less efficient in terms of generating higher expected returns than those closer to their HWM. In addition to being consistent with predictions from our model, these results resonate well with the economic intuition that such contracts are akin to the fund managers holding call options with varying degrees of moneyness (depending on distance from the HWM) on the return stream to the investor's funds.