Investor activism The costs and benefits of active monitoring Incentives of an active monitor

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1 Investor ativis The osts and benefits of ative onitoring Inentives of an ative onitor Iortant tois in ororate governane o anks vs stok arkets o Conentrated vs disersed ownershi Costs and benefits of ative onitoring o Costs Monitoring osts Sarity rents to onitors Monitor illiquidity o enefits Learning by lending Externalities to non-onitoring investors Control (hater 10) Tore Nilssen Cororate Governane Set 9 Slide 1

2 asi odel of investor ativis Fixed-investent odel o Risk neutral entrereneur has assets A and a rojet needing I > A. Projet yields R if suess, 0 if failure. Suess robability H if entrereneur works, L = H if not. No onitoring o enefit fro shirking. o Funding to rojet if exeted ledgeable inoe exeeds investors exenses: H (R ) I A Monitoring o The onitor oves first. o The extent of oral hazard is redued. o The benefit fro shirking redued fro to b <. o Monitor s rivate ost: o Interretation Manager iks aong three rojets: good, bad and ad. y inurring ost, onitor eliinates ad rojet but still annot tell good fro bad. Tore Nilssen Cororate Governane Set 9 Slide 2

3 o With a onitor resent, entrereneur s inentive onstraint is R b b o Inentives for the onitor Also onitor is risk neutral When not inurring ost, the onitor annot revent shirking Monitor s reward R ust satisfy R o Suose first that onitoring aital is abundant: there is a large suly of onitors willing to invest their aital. A onitor is available sulying investent I suh that his net ayent equals his osts: H R I = o Funding ossible if non-onitoring investors breakeven onstraint is satisfied: H (R R b R ) I A I H (R H (R b b ) (I + ) I A I ) I A + Monitoring redues the oral-hazard roble at ost. o Investent by onitor: blokholding I = H R = H = ( H 1) = L Return on the investent: H R I H H L L Tore Nilssen Cororate Governane Set 9 Slide 3

4 o Monitoring has a role to lay when it inreases ledgeable inoe, whih haens when H b + < H H < ( b) o Entrereneur s utility equals NPV under onitoring U b = H R I. The entrereneur will only enlist a onitor when this is neessary to obtain funding. Strong firs are finaned without onitoring. Eirial evidene: Legal systes with oor investor rotetion have also onentrated ownershi. o High leads to high needs for onitoring by a onitor holding a blok of shares. Overonitoring The onitor exerts two kinds of externalities o A ositive externality on other investors o A negative externality on the entrereneur A odel of variable onitoring intensity. o The onitor identifies the ad rojet with rob x, and learns nothing with rob 1 x. o The greater onitoring osts inurred, the greater is the robability x: = (x), > 0, > 0. Tore Nilssen Cororate Governane Set 9 Slide 4

5 o orrower s utility equals NPV and deends on x: U b (x) = x H R + (1 x)( L R + ) I (x) o NPV is axiized at onitoring level x*, where (x*) = ( )R o Suose that this onitoring level is suffiient for funding, while no onitoring is not. o The onitor s inentives: he axiizes [x H + (1 x) L ]R (x) o In order to get the onitor to hoose the orret onitoring level, it is neessary for the entrereneur that ( )R = (x*) = ( )R R = R o The entrereneur not getting funding without onitoring ilies that R b < R = R. Therefore: < R R b R b + R < R o In order to get the roer onitoring level, the entrereneur needs other, non-onitoring investors in addition to the onitor. If the onitor holds all external shares, there is no ositive externality on other outside investors, only a negative externality on the entrereneur exessive onitoring. o A large onitoring investor ay also aggravate the roble of soft budget onstraints, by failitating renegotiations daen the entrereneur s inentives to oe u with new ideas. Tore Nilssen Cororate Governane Set 9 Slide 5

6 Sare onitoring aital Peole with both skills in onitoring and own aital to invest ay be sare. Polar ase onitor has no own aital: I = 0. o Exale: onitors as non-owning board ebers. o Monitor s inentive onstraint: R o Monitor earns a rent: H R = L. o orrower s utility is no longer equal to NPV. NPV = H R I U b = H R I L = HR I o A derease in the soe for onitoring, and an inrease in the ourrene of no funding. More generally, a high return on onitor s investent, beause of investent oortunities elsewhere: = H R I o Monitor s rent: > H L M = H R I = H R H H H R (1 1 ) = (L H o orrower s utility: H R I M. o Funding ossible if H (R b ) M I A = ) > 0. o The sarer onitor aital is, the higher is, the higher is M, and therefore the ore diffiult it is to get funding. Tore Nilssen Cororate Governane Set 9 Slide 6

7 Monitor-entrereneur ollusion A three-tier hiearhy o rinial-suervisor-agent o here: investor-onitor-entrereneur o two inentive robles: agent and suervisor o in addition: the agent ay try to ersuade the suervisor into not erforing o Ex ante ollusion: the agreeent to ollude is ade before the onitor deides to ollet inforation. o Ex ost ollusion: the onitor ollets inforation and then offers to the entrereneur to be ooerative, by not ruling out the ad rojet. A odel of ex ost ollusion o The entrereneur bribes the onitor into olluding by diverting ororate resoures. The diversion reates a gain G > 0 to the onitor but uniforly redues the suess robability by > 0: fro H to H if entrereneur works, fro L to L if not. o The diversion is wasteful: G < R. Diret ayents not ossible. o Collusion ours if both onitor and entrereneur gain fro it: G ( + )R ( + )R b o In order to revent ollusion, onitor s stake ust be raised fro to G, if the latter is higher. Tore Nilssen Cororate Governane Set 9 Slide 7

8 The onitor as advisor oard ebers and others erfor two tasks: onitoring and advising. Advisory ativity is rodutive, like that of the entrereneur. o A double-sided oral hazard roble o The advisor inreases NPV and is useful even without own aital. o Strong entrereneurs do not need ure onitors to get funding and are therefore ore interested in a ure advisor. A odel of ure advising o Fixed investent I, entrereneur s own funds A < I. o Suess robability is + q Entrereneur deterines { H, L } and earns when isbehaving. Advisor deterines q {q H, q L = 0} and inurs non-verifiable ost to give a useful advie raising suess robability by q H. o Suose advising is soially effiient: ( q)r = q H R >. o Cruial differene between entrereneur and advisor: Entrereneur owns the idea and deides whether or not to hire advisor. o enhark: no advisor. Funding if A A = I H (R ) n orrower s utility: U = H R I. b Tore Nilssen Cororate Governane Set 9 Slide 8

9 o Suose that advisors aital is abundant. o In ase of suess, entrereneur reeives R b, advisor R, and other investors R R b R. o Advisor s inentive onstraint binding: R = o Investent deanded fro advisor: I = ( H + q H )R = ( H + q H ) q. q o orrower s utility equals NPV, sine advisor does not reeive rent: U = ( b H + q H )R I. o The entrereneur refers advising as long as she an n afford it, sine U > U. b b o ut does advising ake funding easier? o Other investors breakeven onstraint with advising: ( H + q H )(R ( H + q H )(R q ) I A I ) I A A Â = I ( H + q H )(R ) + o Funding failitated by advising if and only if o Two ases q H (R If q H R > > q H (R ) > ), then advising inreases NPV but akes funding ore diffiult. Advisor hired by strong firs only. If q H (R ) >, then advising hels on funding. Advisor hired by all funded firs. Tore Nilssen Cororate Governane Set 9 Slide 9

10 A onitor arising endogenously Suose, instead of the entrereneur enlisting hi (a rivate deal), the onitor needs to arise through share urhases in the stok arket. To start with, external shares are held by disersed owners. A otential large onitor akes an unonditional and unrestrited tender offer of rie P er share on all external shares. o Unonditional and unrestrited: the offer stands irresetive of how any shares it attrats. A free-rider roble o Getting a onitor enhanes the value of the fir. o Selling to the otential onitor sulies a ubli good to other urrent share owners. In order to attrat any shares, the otential onitor has to offer a rie orresonding to the ex ost value of the fir. The otential onitor has hiself to bear the full ost of onitoring. In equilibriu, there will no onitoring. Ways to onitoring in equilibriu o Liquidity traders, aking it ossible for the otential onitor to disguise his offer. o Risk aversion aong urrent investors. o The entrereneur selling shares. Tore Nilssen Cororate Governane Set 9 Slide 10

11 Learning by lending An additional effet fro onitoring o Not only alleviating the oral hazard roble o ut also roviding the onitor with inforation about the borrower that the onitor an rofit fro later on. Coetition aong asyetrially infored investors. Model: Fixed investent. Two eriods. Disount fator. No ash initially: A = 0. No savings between eriods. Short-ter ontrats only. Date 1: Entrereneur has a rojet requiring I > 0. Private benefit without onitoring,, is large: no funding unless a onitor is enlisted. With onitor, rivate benefit b <. No sarity of onitors. o Assue ledgeable inoe suffiient even with no ontinuation rojet: H (R b ) I + Date 2: Indeendently of what haens at date 1, the entrereneur has a new rojet, statistially indeendent of the first rojet, and idential to it, with one differene: o With robability, the date-2 rofitability is high: suess robability has inreased uniforly by. If the entrereneur behaves, the suess robability is H + ; if not, it is L +. ut is so large that the rojet still gets no funding without onitoring. o With robability (1 ), the suess robabilities are unhanged fro date 1. Tore Nilssen Cororate Governane Set 9 Slide 11

12 Syetri inforation: no-one learns date-2 rofitability. No gain to the borrower fro having the sae onitor in both eriods. Asyetri inforation: only the date-1 onitor (the inubent) learns date-2 rofitability. o Suose the entrereneur autions off the osition as ative onitor. o The inubent has an inforational advantage. o Sequential-ove bidding gae where inubent oves last: ure-strategy equilibriu. Stage 1 of date-2 bidding gae: Entrereneur offers a 2 onitor a stake R = / in the date-2 rojet and seeks 2 bids of investent ontribution I for the osition of ative onitor. Stage 2: New investors bid. Stage 3: Inubent onitor bids. Stage 4: Uninfored investors ontribute the residual investent: I 2 I. o Adverse seletion: it never ays for uninfored investors to bid aording to a higher date-2 suess robability than H ; if it is in fat higher, uninfored bidders will be outbid. o Monitor investent at date 2: 2 2 I = H R = H o Date 1: eause of the exeted inforational rent at date 2, investors are willing to ontribute u to I = H 1 + = ( L + ) o The onitor osition aquired at a reiu and aintained at a disount. Tore Nilssen Cororate Governane Set 9 Slide 12

13 Disussion: Learning by lending o Endogenous date-2 rofitability: a hold-u roble Suose the entrereneur, through an effort, an affet the hane of inreased date-2 rofitability. The inubent onitor s inforational advantage deteriorates the entrereneur s inentives to erfor. o Eirial studies indiate a value to being assoiated with a long-ter investor. Firs with lose ties to investors are less liquidity onstrained than others. Firs with a bank relationshi observe ositive reations in stok rie. o The ossibility of oitent. o The entrereneur s own knowledge about date-2 rofitability. o Coetition aong investors: with ierfet oetition aong available investors, the ossibility for the onitor to reou exenses later on is further inreased, failitating funding at date 1 even ore. Eirial evidene: onentrated banking arkets ay failitate funding for weak firs. Tore Nilssen Cororate Governane Set 9 Slide 13

14 Liquidity needs aong onitors Tradeoff: oitent vs liquidity Coarative ororate governane o Market-based systes: lak of investor oitent o ank-based systes: lak of investor liquidity A onitor ay have liquidity needs before rojet returns arrive. Liquidity vs aountability just as with the borrower (hater 4). o Late oensation to the onitor is good for aountability, sine ore inforation about the rojet is known, but bad for onitor liquidity. Perforane easures along the way ay give the onitor an exit otion. o A role for assive onitoring in roviding liquidity to the ative onitor. A odel of onitor liquidity o asi odel of investor ativis, with onitor liquidity needs added. Fixed-investent odel. Risk neutral entrereneur has asset A and a rojet needing I > A at date 0. Projet yields R if suess, 0 if failure, at date 2. Suess robability H or L. At date 1, the onitor faes a liquidity shok with robability : An investent oortunity transforing an interediate oensation r into r, where > 1. Strategi exit: the onitor ay hoose to exit even without a liquidity shok. Tore Nilssen Cororate Governane Set 9 Slide 14

15 Ierfet erforane easureent at date 1: After the onitor learns about the liquidity shok, seulative inforation arrives whih is inforative about effort, but whih is not a suffiient statisti: the final outoe is even ore inforative. o The robability of an H signal is q H with effort and q L without effort, where q q q H L H L H H Sare onitoring aital o Monitor earns a gross surlus U = I, where + 1 is the onitor s return on alternative investents. Illiquid ontrat: Monitor reeives R at date 2, if suess, and nothing at date 1. o Partiiation onstraint of onitor: H R = I o Inentive onstraint of onitor: R o The ost of enlisting an ative onitor exeeds the ost of onitoring C IL = H R I = H L L H o orrower s utility: U b = H R I C IL o Pledgeable inoe: H (R b ) CIL Tore Nilssen Cororate Governane Set 9 Slide 15

16 Liquid ontrat: {r, R }. The onitor reeives o r at date 1 if signal is H and nothing at date 2, in the ase of a liquidity shok. o R on date 2 if suess and nothing at date 1, in the ase of no liquidity shok. Assue L is so low that, if he does not onitor, the ative onitor refers reeiving r than waiting for an unlikely R, even without a liquidity shok. Without onitoring, he earns q L r + (1 )q L r = [ + 1 ]q L r Truth-telling onstraint when there is no liquidity shok: H R q H r With onitoring, the ative onitor earns U = q H r + (1 ) H R Inentive onstraint for the onitor: q H r + (1 ) H R [ + 1 ]q L r The onstraint is binding, and so the onitor earns U = [ + 1 ]q L r The ost of hiring the onitor with a liquid ontrat is C L = q H r + (1 ) H R I = q H r + (1 ) H R ( 1)q H r I = U U + ( 1)qH r = + r [(1 1 )( + 1 )ql ( 1)q H ] = + Kr > if and only if K > 0. Tore Nilssen Cororate Governane Set 9 Slide 16

17 Providing the onitor with liquidity that is, giving hi a liquid ontrat is otial if C L < C IL. o Sile ase: L = 0 C IL =. o We have C L < = C IL if and only if (1 1 )( + 1 )ql < ( 1)q H qh q q H L > 1 1 ( 1 1) o The liquid ontrat is ore likely to be the otial one when The onitor s liquidity shok is likely: high The value of the onitor s reinvestent oortunity is high: high Seulative inforation is of high quality: qh q q H L high Seulative ativity hels in roviding liquidity for large, onitoring shareholders. Monitoring aital is not too sare: low When sarity is high, too uh of the benefit fro liquidity is ket by the onitor and not returned to the entrereneur. Tore Nilssen Cororate Governane Set 9 Slide 17