Knowledge that Transforms

Between 1993 and 2000, at least 18 countries saw publication of guidelines proposing minimum representation of outside directors on corporate boards. Underlying this movement is an apparent presumption that boards with significant outside directors will make different and, perhaps, better decisions than boards dominated by insiders. As the first-mover in this movement, the United Kingdom provides a laboratory for a “natural experiment” to examine this presumption empirically. We find that UK boards that complied with the exogenously imposed standard were more likely to appoint outside chief executive officers (CEOs). Additionally, announcement period stock returns indicate that investors appear to view appointments of outside CEOs as good news. Apparently, boards with more outside directors make different (and perhaps better) decisions.

Many studies use the book value of debt as a proxy for its market value because most corporate debt does not trade. I call this practice the book value of debt (BVD) approximation, and it appears to be justified by the observation that the average market value of debt is close to its book value. Many corporate bonds, however, trade at values significantly different from their book values, and consequently the BVD approximation can create important biases. I compare the accuracy of the BVD approximation to Merton's option pricing (OPT) model of corporate debt valuation, and find consistent evidence that the Merton model provides more accurate estimates. I also show that this model is an easily estimated alternative to the BVD approximation. In short, the BVD approximation not only creates significant biases, but it is also an unnecessary simplification.

We examine the underinvestment rationale for corporate hedging and test the hypothesis that if firms hedge to reduce both their reliance on external funds and the volatility of internal cash flow, then their investment spending should be less sensitive to prehedged cash flow. Our results are consistent with this hypothesis and indicate that investment spending is less sensitive to cash flow for hedgers than for nonhedgers. We also find that among hedgers, investment spending is less sensitive to cash flow when the extent of hedging is higher. Our results are generally robust to five different measures of cash flow.

We reexamine the post-listing puzzle by studying the stock performance of 2103 firms that moved from NASDAQ to NYSE or AMEX, or from AMEX to NYSE during 1973–1999. The matched four-factor regressions demonstrate that the listing firms do not underperform. Size-and-book-to-market matched factor regression finds that the “post-listing drift” is confined to the small set of firms moving from NASDAQ to AMEX during 1981–1990, within size deciles 3–6 and book-to-market quintiles 1–3. A further control of the industry effect is able to resolve the remaining abnormal returns. Our results are consistent with the pseudo market timing hypothesis in Schultz, (2003) [Schultz, P., 2003. Pseudo market timing and the long-run underperformance of IPOs. J. Fin. 58, 483–517.].

A major prediction of agency theory is that there is a trade-off between risk and incentive compensation. Aggarwal and Samwick (1999) [Aggarwal, R., Samwick, A., 1999. The other side of the trade-off: the impact of risk on executive compensation. Journal of Political Economy, 107, 65–105.] directly test and find results consistent with agency theory—pay-performance sensitivity is decreasing in risk. However, Prendergast, 2002, Prendergast, 2000 [Prendergast, C. 2002. The tenuous trade-off between risk and incentives. Journal of Political Economy 110 (5), 1071–1102; Prendergast, C. 2000. What trade-off risk and incentives? The American Economic Review 90 (2), 421–425.] offers a number of reasons why the sensitivity of pay to performance can be higher in risky environments. We use data from a sample of Internet firms for 1997–1999 to provide empirical evidence on these competing arguments regarding the relation between risk and CEO compensation. Consistent with Aggarwal and Samwick (1999), our results show that pay–performance sensitivity declines with increases in variance in a base model. After controlling for size, we find that pay–performance sensitivity is positively related to risk, consistent with the theoretical predictions in Prendergast, 2002, Prendergast, 2000. However, sensitivity tests in later periods show that the Aggarwal and Samwick (1999) results are more robust to changes in the economic environment.

We study the problem of compensating a manager whose career concerns affect his investment strategy. We consider contracts that include cash, shares, and call options, focusing on the role of options in aligning incentives. We find that managers are optimally paid in cash, supplemented by a small amount of call options; shares are excluded. The options are struck at-the-money, consistent with the near-uniform practice of compensation committees. The convexity of option payoffs helps to overcome managerial conservatism, although a nontrivial underinvestment problem persists. Our model yields several testable implications regarding cross-sectional variation in the size of option grants and pay-for-performance sensitivity.

This paper seeks to provide an answer to the following question: when and how does privatization work? Using a sample of 230 firms headquartered in 32 developing countries, we document a significant increase in profitability, efficiency, investment and output. Our analysis shows that the changes in performance vary with the extent of macro-economic reforms and environment, and the effectiveness of corporate governance. In particular, economic growth is associated with higher profitability and efficiency gains, trade liberalization is associated with higher levels of investment and output, while financial liberalization is associated with higher output changes. Further, control relinquishment by the government is a key determinant of profitability, efficiency gains and output increases. Finally, we find higher improvements in efficiency for firms in countries in which stock markets are more developed and where property rights are better protected and enforced. These results for a sample of developing countries differ from those reported in a contemporaneous study by D'Souza et al. [D'Souza, J., Megginson, W.L., Nash, R.C., 2001. Why do privatized firms improve performance? Evidence from developed countries. Unpublished working paper. University of Oklahoma] which focuses on developed countries. These diverging findings suggest that privatization in developing countries indeed obeys to particular constraints and has a dynamic of its own.

Using data from the 1998 proxy season, we find that higher levels of potential dilution from management-sponsored, executive-only stock option plans result in significantly negative cumulative abnormal returns in the 3-day period surrounding the proxy date. We also present evidence of a significantly negative relationship between the percentage vote against the option proposal and the percentage change in executive pay from the 1998 to 1999 compensation years. We interpret this finding to support the idea that boards of directors are responsive to shareholder concerns about CEO option awards following a high level of shareholder opposition.

We investigate the relation between outside director compensation and the investment opportunities of firms. The sample of cases is drawn from the period 1996 to 2001. We find that elements of outside director compensation are significantly related to the investment opportunity set. Firms with more investment opportunities pay a higher level of compensation to their outside directors than firms with fewer investment opportunities. In addition to paying more total compensation, firms with greater investment opportunities compensate directors more heavily with stock-based forms of compensation than with cash. The result is consistent with the hypothesis that board compensation policy is designed to: (1) attract directors whose marginal productivity interacts with the investment opportunities of the firm to produce the maximal gain, and (2) mitigate agency problems. We also document a positive relation between total compensation of outside directors and firm size. A separate analysis indicates the results are economically significant. We conclude that firms pay more and emphasize incentive-based compensation to motivate outside directors to act in the interests of shareholders when the costs of monitoring are high.

This study adds to the empirical evidence that privatization improves the performance of divested firms and offers preliminary evidence as to why these performance improvements occur. Using a sample of 129 share-issue privatizations from 23 developed (OECD) countries, we first document significant increases in profitability, efficiency, output, and capital expenditure following privatization. Our data indicate that ownership (both private and foreign), degree of economic freedom, and level of capital market development significantly affect post-privatization performance. A comparison to the findings of Boubakri et al. (2005) [Boubakri, N., Cosset, J., Guedmani, O., 2005. Liberalization, corporate governance, and the performance of newly privatized firms. Journal of Corporate Finance (this issue)] suggests that several determinants of post-privatization performance improvements differ between developed and developing countries.