Knowledge that Transforms

This paper examines the relation between closed-end fund premia and returns. Additional evidence is provided on Thompson's (1978) finding that fund premia are negatively correlated with future returns. Funds with 20% discounts have expected twelve-month returns that are 6% greater than nondiscounted funds. This correlation is attributed to premium mean-reversion, not to anticipated future portfolio performance. Economically motivated explanations do not account for this effect.

A number of studies have presented evidence rejecting the validity of the Sharpe-Lintner capital asset pricing model (CAPM). Possible alternatives include risk-based models, such as multifactor asset pricing models, or nonrisk-based models which address biases in empirical methodology, the existence of market frictions, or the presence of irrational investors. Distinguishing between the alternatives is important for applications such as cost of capital estimation. This paper develops a framework which shows that, ex ante, CAPM deviations due to missing risk factors will be very difficult to detect empirically, whereas deviations resulting from nonrisk-based sources are easily detectable. The results suggest that multifactor pricing models alone do not entirely resolve CAPM deviations.

This paper examines the relation between corporate takeovers and the board of directors as alternative control mechanisms to discipline top management. Previous research shows that CEO turnover subsequent to corporate takeovers is inversely related to pre-takeover market-related performance. We find this relation is concentrated in targets with inside-dominated boards of directors. Our results support the notion that, as an alternative control device, takeovers serve as a “substitute” for outside directors. Further, we show that the discipline associated with corporate takeovers extends beyond top management to effect restructuring of the entire board. The nature of the discipline depends on the composition of the target board prior to the takeover. Disciplinary takeovers result in two general effects: (1) for inside-dominated targets, the number of inside directorships decreases while the number of outside directorships remains about the same; and (2) for outside-dominated boards, the number of inside directorships increases while the number of outside directorships decreases. As a result, the board is recomposed toward a more even balance between inside and outside directorships.

I focus on the incentive effects of asset ownership in franchising. Franchise contracts give a manager ownership of some local assets; the franchisor owns other assets, notably the trademark. Under double moral hazard, the allocation of ownership effects the incentives of both the franchisor and the franchisee. I compare franchising with company-ownership of all assets. Franchising the local unit gives the manager strong incentives, but gives the central firm weak incentives. Franchising may be the preferred organizational form when the local manager's effort has a relatively small effect on the unit's current profit, but a large effect on the unit's future profit.

The literature on contracts predicts that some principals will pay agents rents, that is, amounts larger than those necessary to keep the agent in the contract. We calculated the earnings of the average franchisee in seventy franchise systems in various industries to determine whether rents are paid as a solution to the agency problem in franchise contracts. We found that many but not all systems paid rents, both ex post and ex ante, to the average franchisee. The results confirm those of Kaufmann and Lafontaine (1994), who found rents associated with McDonald's, but the magnitude of rents within the systems we study was generally much lower than those of McDonald's.

This paper reviews recent research on franchising and capital structure. Several key variables that affect capital costs and are common to franchised businesses are identified. The question whether or not franchising exists because franchisees provide capital that has no close substitutes for pioneering entrepreneurs is explored and criticized because alternatives to franchisees' funds are readily available and not used by franchisers. The role of franchisee financing is also examined as a key feature of capital structure in these types of industries.

An earlier version of this paper was presented at the Conference on Franchise Contracting, Organization, and Regulation, Michigan Business School. I am indebted to the conference participants, and particularly to G. Frank Mathewson, for helpful suggestions. I also received perceptive comments from the conference organizers, Francine Lafontaine and Scott Masten. I have benefited from discussions of the subject matter of this paper with Tasneem Chipty, James Delaney, Robert Fenili, Tom Hogarty, Robert Lande, Jim Peck, and Anthony Robinson. None of the above should be implicated in the conclusions put forth below.

The empirical literature on franchising suggests that the proportion of risk borne by franchisees increases as the amount of risk to be shared goes up. This has been interpreted by some as evidence that franchisors use franchising as a way to “shed” risk. This paper argues against this conclusion. First we show that the evidence is weak given the problems associated with measuring risk in franchising. Second, we show how a model emphasizing incentive issues and informational problems can give rise to the patterns found in the data. We conclude that risk shedding need not be invoked to explain franchising.