Knowledge that Transforms

The recent financial crisis has shown that short-term collateralized borrowing may be a highly unstable source of funds in times of stress. In this paper, we develop a dynamic equilibrium model and analyze under what conditions such instability can be a consequence of market-wide changes in expectations. We derive a liquidity constraint and a collateral constraint that determine whether such expectations-driven runs are possible and show that they depend crucially on the microstructure of particular funding markets that we examine in detail. This provides insights into the differences between the tri-party repo market and the bilateral repo market, which were both at the heart of the recent financial crisis.

This study examines the financing of innovation in the presence of adverse selection in the capital market. An entrepreneur with private information needs outside funding for a project requiring costly experimentation. Equilibrium contracts use the duration of the experimentation period, together with pay-for-performance, to signal information to outside investors. As a result, investment is delayed, entrepreneurs with stronger growth options receive vested stock options, and entrepreneurs with a lower probability of success are compensated in case of failure. These predictions are in line with empirical evidence on venture capital contracts, and on the impact of internal financing on risk taking.

We examine whether constraints on public firms affect firms' efficiency by testing if going private improves plant-level productivity relative to peer control groups. We find that, despite increases in productivity after going private, there is little evidence of efficiency gains relative to peer groups of plants constructed to control for industry, age, size, past productivity, and the endogeneity of the going-private decision. Going-private firms do extensively restructure their portfolio of plants, selling and closing plants more quickly than others. Our findings cast doubt on the view that public markets cause listed firms to operate plants less efficiently due to overinvestment but indicate that going private increases restructuring activity.

The increasingly large role played by financial intermediaries, such as venture capitalists and angels, in nurturing entrepreneurial firms and in promoting product market innovation has led to great research interest in the area of entrepreneurial finance and innovation. This paper introduces the special issue of the Review of Financial Studies dedicated to entrepreneurial finance and innovation and highlights some of the promising topics for future research in this area. The special issue combines papers presented at the June 2010 "Entrepreneurial Finance and Innovation (EFIC)" conference, which was jointly sponsored by the Kauffman Foundation and the Review of Financial Studies, with other related papers.

Using bottom-up information from corporate financial statements, we examine the relation between aggregate investment, future equity returns, and investor sentiment. Consistent with the business cycle literature, corporate investments peak during periods of positive sentiment, yet these periods are followed by lower equity returns. This pattern exists in most developed countries and survives controls for discount rates, equity flows, valuation multiples, operating accruals, and other investor sentiment measures. Higher aggregate investments also precede greater earnings disappointments, lower short-window earnings announcement returns, and lower macroeconomic growth. We conclude aggregate corporate investment is an alternative, and possibly sharper, measure of market-wide investor sentiment.

We analyze participation decisions in employee stock purchase plans. These plans allow employees to buy company stock at a discount from the market price and resell it immediately for a sure profit. Although an average employee stands to gain $3,079 annually, only 30% of individuals take advantage of this risk-free opportunity. Participation is more likely among employees who are familiar with stocks, are more educated, are less financially constrained, and make fewer errors in valuing financial securities. Our results suggest that compensation plans requiring active decisions by individuals can result in poor financial outcomes for employees of lower socioeconomic status.

We propose a labor market model in which agents with heterogenous ability levels choose to work as bankers or as financial regulators. When workers extract intrinsic benefits from working in regulation (such as public-sector motivation or human capital accumulation), our model jointly predicts that bankers are, on average, more skilled than regulators and their compensation is more sensitive to performance. During financial booms, banks draw the best workers away from the regulatory sector and misbehavior increases. In a dynamic extension of our model, young regulators accumulate human capital and the best ones switch to banking in mid-career.

We exploit a 2004 credit reform in Brazil that simplified the sale of repossessed cars used as collateral for auto loans. We show that the reform expanded credit to riskier, self-employed borrowers who purchased newer, more expensive cars. The legal change has led to larger loans with lower spreads and longer maturities. Although the credit reform improved riskier borrowers' access to credit, it also led to increased incidences of delinquency and default. Our results shed light on the consequences of a credit reform and highlight the crucial role that collateral and repossession play in the liberalization and democratization of credit.

Investors face significant barriers in evaluating the performance of hedge funds and commodity trading advisors (CTAs). The only available performance data comes from voluntary reporting to private companies. Funds have incentives to strategically report to these companies, causing these data sets to be severely biased. And, because hedge funds use nonlinear, state-dependent, leveraged strategies, it has proven difficult to determine whether they add value relative to benchmarks. We focus on commodity trading advisors, a subset of hedge funds, and show that during the period 1994-2007 CTA excess returns to investors (i.e., net of fees) averaged 85 basis points per annum over US T-bills, which is insignificantly different from zero. We estimate that CTAs on average earned gross excess returns (i.e., before fees) of 5.4%, which implies that funds captured most of their performance through charging fees. Yet, even before fees we find that CTAs display no alpha relative to simple futures strategies that are in the public domain. We argue that CTAs appear to persist as an asset class despite their poor performance, because they face no market discipline based on credible information. Our evidence suggests that investors' experience of poor performance is not common knowledge.

We provide a rationale for window dressing wherein investors respond to conflicting signals of managerial ability inferred from a fund's performance and disclosed portfolio holdings. We contend that window dressers make a risky bet on their performance during a reporting delay period, which affects investors' interpretation of the conflicting signals and hence their capital allocations. Conditional on good (bad) performance, window dressers benefit (suffer) from higher (lower) investor flows compared with non–window dressers. Window dressers also show poor past performance, possess little skill, and incur high portfolio turnover and trade costs, characteristics which in turn result in worse future performance.