In her opening remarks Maria José Constancio, Director of Economic Research at Caixa Geral de Depósitos, made a brief presentation on recent developments in the Portuguese economy and on the activities of the Caixa. In ‘Efficiency of Bankrupt Firms and Industry Conditions: Theory and Evidence’, Vojislav Maksimovic and Gordon Philips (both University of Maryland) investigated the costs of bankruptcy and the factors influencing sales and closures of assets of Chapter 11 firms. They showed that industry demand and the amount of productive capacity are relevant, and that both are more important to bankruptcy than Chapter 11 status. The proportion of plants in Chapter 11 falls monotonically, moving from low-growth to high-growth industries. In industries facing declining demand, firms become bankrupt as a result of excess industry capacity, but their productivity is no different from their counterparts, nor does it decline during the Chapter 11 period. In high-growth industries, bankruptcy is associated with a firm-specific inefficiency and there is evidence of decline during Chapter 11 proceedings. For these reasons, more asset sales occur in high-growth industries and, in these industries, bankrupt firms sell their more productive assets thus improving the productivity of the new owners.

Henri Servaes (University of North Carolina) commented that inclusion of data on capital structure might indicate whether the efficiency of transfers depends on the level of debt. Colin Mayer (Oxford University and CEPR) suggested the paper could also include a more general discussion of alternative ways of restructuring firms, and that some comparisons of performance under different forms of restructuring would be of interest.

In their paper on ‘Managerial Compensation and Capital Structure’, Elazar Berkovitch (Tel Aviv University), Ronel Israel (University of Michigan) and Yossef Spiegel (Tel Aviv University) developed a theory that accounts for the interdependence between capital structure and managerial compensation. Issuing debt has two effects: a job-security effect (debt commits the entrepreneur to an aggressive replacement policy, which may motivate managers to exert more effort); and a wage-bargaining effect (debt repayments reduce the cash-flow that managers can seek to capture through bargaining, which can lower motivation). These effects determine the level of managerial effort and monetary compensation. They also determine the firm’s incentive to replace the manager and, hence, managerial ability. This theory yielded four predictions. First, the market value of equity and debt will decrease if the manager is replaced; second, companies that reveal their intention to retain their manager should experience positive price reactions; third, leverage, managerial compensation and cash-flows in firms that retain their managers are positively correlated; and fourth, the probability of management turnover is negatively correlated with firm value.

For Rafael Repullo (CEMFI, Madrid, and CEPR), the most interesting results were those on managerial turnover, but he criticized the model used to deliver the compensation outcomes. For its conclusions on managerial turnover, the model had to resort to simulations, which reduced the robustness of the empirical regularities the authors were seeking to establish. Furthermore, the model did not indicate an optimal debt level. Christian Laux (University of Mannheim) suggested the need to look at both capital structure and monetary payments when analysing incentives for managers. In addition, the results presented were very sensitive to the assumptions about the underlying negotiation process, i.e. who participates and how the gains are split.

The capital-budgeting process is affected by two interactive incentive problems: the CEOs’ motivation to collect information to evaluate projects; and their motivation to accept them. In ‘Capital Budgeting and Stock Options Plans’, presented by Haizhou Huang (LSE) and Javier Suárez (CEMFI, Madrid, and CEPR), stock options plans were seen as the optimal compensation schemes for CEOs when the above problems arise. The Managers have incentives to extract maximum profitability from a project in order to benefit from the possibility of exercising their option. The shares received through the exercise promote their acceptance of good projects and the exercise price reduces acceptance of bad ones. Specific additional results included the following: 1) under optimal compensation schemes for CEOs, the capital-budgeting process is not characterized by the NPV rule as an investment criterion; 2) under- (over-) investment can occur if the CEO is optimally compensated, as long as the investment is profitable (unprofitable) on average; 3) the smaller the evaluation costs, the greater is the attraction of stock options plans to managers; and 4) a non-monotonic relationship is suggested between Tobin’s Q and the

award of stock options.

Ulrich Hege (Tilburg University and CEPR) noted that stock options schemes allow managers to make independent decisions on investment and exercise of the options. This fact is not recognized in the model, where is not possible both to refuse an investment and exercise the option. The model also remained silent about the scope for renegotiation, especially after the manager has extracted information on the profitability of the project. Gilles Chemla (University of British Columbia and CEPR) questioned the robustness of the optimal stock options plan, as described in the paper, and noted the importance of the manager’s access to the credit market. Chemla also stressed that stock options are mainly used to promote long-term relationships and that managers are usually required to keep their options for several years.

‘Entrenchment and Managerial Turnover’, by Walter Novaes (University of Washington) and Luigi Zingales (University of Chicago, NBER and CEPR) focused on the proportion of employees’ compensation determined by implicit contracts. The authors assumed that there is a value-maximizing trade-off between implicit and explicit contracts, and wondered whether a properly motivated manager would implement it. Without constraints, managers would permit too many implicit contracts, thus creating large managerial rents. However, boards have two instruments available for influencing managerial behaviour: incentive schemes and firing. The first induces the manager to choose the right organizational structure (i.e. the balance between explicit and implicit contracts), and the second reduces the manager’s rent. The two instruments are not independent, because the model showed that the optimal mechanism requires some managerial turnover. The model also linked organizational structure and the two instruments used by the board, and showed that the deadweight loss from delegating the choice of incentives to the manager increases with the relative inefficiency of explicit contracts. Finally, the authors suggested some links between the two instruments and the firm’s characteristics, such as size, technology and industrial sector.

Sudipto Bhattacharya (LSE and CEPR) commented on the authors’ assumption that the productivity function of replacement is decreasing in the manager’s choice of implicit contracts. He saw the paper as an innovative advance in efforts to integrate recent hypotheses about entrenchment with agency-theoretic control mechanisms. Michel Habib (LBS) questioned the practical value of the model’s predictions, but he did note that it was unlikely that a manager would be fired if, in consequence, the company’s productivity would decline. It would be useful to distinguish between two types of implicit contracts: those that involve most employees, and those for top employees only.

Thomas Copeland (Mckinsey & Co, New York), Yash Joshi (Kids 1 Inc, New York) and Maggie Quenn (Bear Stearns, New York) presented ‘A New Approach for Corporate FX Risk Management Programs: The Probability of Business Disruption’. The authors defended the adoption of hedging strategies by firms in order to reduce the probability of business disruption due to foreign-exchange (FX) risk. They showed that naïve transaction hedging and reductions in the volatility of operating cash-flows are insufficient to minimize this probability over a given period of time. The probability depends on the variance of hedge cash-flows, on the ratio of operating cash-inflows to cash-outflows, and on the drift in operating costs caused by FX hedging costs. The optimal hedge ratio is adjusted by the hedging costs per unit of variance in the FX contract.

Ronald Anderson (Université Catholique de Louvain
and CEPR) noted that the paper did not refer to managerial risk aversion and that when the expected time horizon is infinite only the least risk-averse managers will not hedge or will tend to speculate on their position. He also mentioned that global hedging is used by many firms. Todd Milbourn (LBS) suggested that capital structure issues, firm-valuation approaches and agency problems represented topics for further research.

Hedging strategies were also the subject of ‘Funding Risk and Hedge Valuation’, a joint paper by Antonio Mello (University of Wisconsin-Madison and CEPR) and John E Parsons (Charles Rivers Associates). Firms use such strategies to reduce the probability that they will have to resort to external financing and to reduce the cost of such financing. A hedge may decrease the long-term requirement for external financing, but at the same time increase the short-term requirement. The trade-off between the two effects is complex. Moreover, the cost of external financing cannot be specified without looking at its hedging strategy. The authors showed that a hedge does not necessarily create its own liquidity and so the funding risk it creates is an important factor in determining its value. The paper developed a model for evaluating alternative hedging strategies with a view to minimizing the cost of external financing. The model permitted the determination of the extent to which the firm’s value is raised or lowered under each hedge.

Yaakov Bergman (Hebrew University of Jerusalem) stressed the value of the paper’s conclusion that a trade-off exists between maximizing the firm’s value and hedging, under the assumptions that the firm faces financial constraints and asymmetric information as the source of imperfection. Pierre Mella-Barral (LSE and CEPR) noted the high volatilities revealed under the hedge strategies and wondered whether it might be preferable to issue equity instead of debt. Hayne Leland (Haas School of Business, Berkeley), referred to the relationship between the risks faced by debtholders and shareholders and asked how different hedging strategies would influence the levels of risk and the transfer of risk between the two sets of agents.

Recent surveys have shown that one of the motives for a firm to go public is to increase publicity about, and enhance the image of its products. ‘IPOs and Product Quality’, by Neal M Stoughton (University of Hong Kong), Kit Pong Wong (University of California-Irvine) and Josef Zechner (Universität Wien and CEPR), set out to explain the motivation for firms to undertake an IPO (initial public offering, or flotation, of its shares). A firm’s share price incorporates information about potential profits arising from consumer demand, while the product market utilizes information transmitted through the stock price. When consumers observe a stock being traded in the financial market, that fact and the price at which the stock trades become indicators of the product’s quality. Firms are willing to incur costs in going public in order to gain a higher reputation in the product market. The authors presented a model of the underlying relationships and of the links between IPOs, underpricing and the stock reactions of rival firms. They found that if a firm is considered in isolation, undertaking an IPO has a positive impact on sales. When the existence of competitor firms is taken into account, however, the likelihood of going public is found to depend on whether the rivals are public or private firms. On underpricing, their finding was that this is positively correlated with future stock price growth.

Luís Cabral (LBS and CEPR) noted there are many ways of signalling product quality and the model only refers to one. Thus alternative signals could be introduced. Yossef Spiegel concurred with this view. He also discussed the application of the model and noted that it could not be used in services industries or in respect of products whose quality is known to the consumer in advance of purchase. Furthermore, the assumptions that the consumer knows that the company has undertaken an IPO and knows the stock price may not hold true.

Ekkehart Bohmer (Humboldt-Universität zu Berlin) presented ‘Industry Groups, Ownership Structure, and Large Shareholders: An Analysis of German Takeovers’. Bohmer used a sample of German takeovers between 1984 and 1988, and information on the bidders’ ownership structure, to analyse the NPV of the takeover and to isolate the effect of shareholder structure on the NPV. He found that both bidders and non-bidders had a similar ownership structure, suggesting that this had not affected the likelihood of becoming a bidder. The NPV analysis showed that the highest NPV (measured as the cumulative abnormal return) was obtained when bidders’ controlling interests were foreign companies or families. By contrast, bidders controlled by financial companies, or with no ‘blockholders’, did not create positive NPV. The largest negative NPVs accrued to government-controlled bidders. All the results were consistent with agency problems, in that the worst takeovers were by management-controlled bidders. From regression analysis, two further conclusions were drawn: bidders with minority ‘blockholders’ made better acquisitions; and bidders with direct bank shareholders made worse acquisitions.

José Correia Guedes (Universidade Católica Portuguesa) believed this paper was the first to show a connection between the return on takeover and shareholder structure. He suggested the analysis be extended to study managers’ competence in takeover decisions. Alexander Ljungqvist (Merton College, Oxford, and CEPR) also felt the paper developed an unresearched area. He enquired whether an understanding of the targets’ ownership structures would help to interpret the empirical findings. A second question concerned the form of payment in the merger: US evidence pointed to an important role for cash versus equity. Finally, the long-run performance of merged German firms would need to be explored, in the light of US and UK evidence which indicated that merger benefits are reversed in the longer term.

In ‘Bidding Strategies and State-Contingent Expected Payoff in Take-overs’, Sandra Betton (Concordia University) and B Espen Eckbo (Stockholm School of Economics) presented an empirical analysis of the joint effects of the bidder’s choice of ‘toehold’ (pre-bid ownership of target shares), tender-offer premium and payment method on contest outcome probabilities and conditional expected payoffs. The bidder’s decision problem was captured by an event-tree, characterizing all tender-offer contests. Using traditional estimation techniques, the authors found that toeholds were lower the higher the pre-contest run-up in the target’s stock price, the higher the initial takeover premium, the less favourable the target management’s reaction to the initial bid and the greater the degree of observed competition in the contest. In addition, they found that the probability of a rival bidder winning the contest was higher the lower the toehold of the initial bidder, and in contests where the target’s management opposed the first bid. Target management resistance was less likely the greater the toehold, and the smaller the equity value of the target. With independent or joint estimations of probabilities and pay-offs, the probability of success in a single bid contest depended on the initial toehold and offer premium. Moreover, when the initial bidder made its second bid, the probability that the rival bidder would win the contest increased with the initial bidder’s toehold.

In the opinion of Fernando Branco (Universidade Católica Portuguesa and CEPR), while this was a difficult area for theorizing, the theoretical background of the paper was weak. The models might have been mis-specified and the results were hard to interpret. Fausto Panunzi (University College London, Università Bocconi and CEPR) pointed out that one important variable not considered in the paper was the ownership structure of the target firm. Moreover, the definition of success was peculiar in that, according to that definition, several bidders can be successful in the same contest. Evidence suggests that diversification has not been beneficial for US companies over the last three decades.

Karl Lins and Henri Servaes (both University of North Carolina) studied the same question in respect of German, Japanese and UK firms in 1994–5 in their paper on ‘International Evidence on the Value of Corporate Diversification’. The authors argued that the institutional environment in Germany and Japan was very different from that in the United States or the United Kingdom and that the differences were important in evaluating the results of diversification. They found no evidence of a diversification discount in Germany, but there was a discount of 10–15% for Japanese and UK firms. Ownership concentration was one of the factors related to the discount in Germany: the higher the ownership concentration the smaller the discount. In Japan, ownership concentration had no effect, and in the United Kingdom the results were inconclusive.

Luigi Guiso (Banca d’Italia and CEPR) raised the problem of aggregation bias and suggested the separation between related and unrelated diversifications in relation to the discount. He also called for further explanation of the paper’s interesting results. Antonio Mello noted that there were other possible explanations for the diversification discount, apart from ownership concentration. He also
considered that the causes of the differences
between countries warranted a closer look.

‘Block Premia in Transfers of Corporate Control’ was the title of the paper presented by Mike Burkart (Stockholm School of Economics), Denis Gromb (MIT and CEPR) and Fausto Panunzi. According to recent research, ownership structure and the level of concentration was an important determinant of many corporate decisions. ‘Blockholders’ (even of minority blocks) have voting power which can be used to resolve conflicts in their favour. Control thus confers private benefits, and sales of blocking shareholdings involve reallocation of control and its benefits. The authors showed that both the incumbent and the new, controlling party preferred block trades to public tender offers as a method of transferring control. They examined the determinants of block premia. Among the results were; that the premium per share and the acquirer’s profit decreased with the block size, and; that ‘greenmail’ and block trading had many common features.

David Webb (LSE) suggested that investigation of the origin and ownership of blocks, and of the identity of companies in which blocks are more prevalent, were potential areas for new research. Luigi Zingales raised the question of breaking up of blocks. The paper implied there was an incentive to buy blocks, but no incentive to break them up after the acquisition. However, there was evidence available to support the reverse argument, and smaller blocks were more common.