Ajay Subramanian

CEO Education, CEO Turnover, and Firm Performance

This paper analyzes the relationship between CEO education, CEO turnover and firm performance. Our primary interest is on the role that CEO education plays in a firms decision to replace its current CEO, the role that it plays in selecting a new CEO, and on whether CEO education significantly affects performance. We use six main measures of CEO education: whether or not the CEO attended a Top-20 undergraduate school, whether or not the CEO has an MBA, law or masters‟ degree, and whether or not the MBA or law degree is from a Top-20 program. Our study includes more than 14,500 CEO-years and more than 2,600 cases of CEO turnover from 1993-2007. Our results show that CEO education does not play a large role in the decision by a firm to replace its current CEO; poorly performing CEOs are replaced, regardless of their education. Education, however, does play a significant role in the selection of the replacement CEO; there is a significantly positive correlation between the education levels of new CEOs and those of the CEOs they replace. Further, hiring new CEOs with MBA degrees leads to short-term improvements in operating performance. We, however, do not find a significant systematic relationship between CEO education and long-term firm performance. CEO education does not seem to be an appropriate proxy for CEO ability. Our results lead to the puzzling implication that, while CEO education appears to play an important role in the hiring of CEOs, it does not affect the long-term performance of firms.

Investment Under Uncertainty, Heterogeneous Beliefs and Agency Conflicts

We develop a structural model to investigate the effects of asymmetric beliefs and agency conflicts on dynamic principal--agent relationships. Optimism has a first-order effect on incentives, investments, and output, which could reconcile the private equity puzzle. Asymmetric beliefs cause optimal contracts to have features consistent with observed venture capital and research and development (R&D) contracts. We derive testable implications for the effects of project characteristics on contractual features. We calibrate our model to data on pharmaceutical R&D projects and show that optimism indeed significantly influences project values. Permanent and transitory components of risk have opposing effects on project values and durations. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Manager Characteristics and Capital Structure: Theory and Evidence

We investigate the effects of manager characteristics on capital structure in a structural model. We implement the manager’s optimal contracts through financial securities that lead to a dynamic capital structure, which reflects the effects of taxes, bankruptcy costs, and manager-shareholder agency conflicts. Long-term debt declines with the manager’s ability, inside equity stake, and the firm’s long-term risk, but increases with its short-term risk. Short-term debt declines with the manager’s ability, increases with her equity ownership, and declines with short-term risk. We show support for these implications in our empirical analysis.

Dynamic Contracting Under Imperfect Public Information and Asymmetric Beliefs

We develop a dynamic principal–agent model to show how imperfect public information and asymmetric beliefs about payoff-relevant parameters, agency conflicts, and the agents implicit incentives to influence the principals posterior beliefs through his unobservable actions interact to affect optimal dynamic contracts. We make a methodological contribution to the literature by solving the continuous-time contracting problem using a discrete-time approximation approach. We obtain a simple characterization of optimal renegotiation-proof contracts in terms of the solution to a nonlinear ordinary differential equation (ODE). We then exploit the properties of the ODE to derive a number of novel implications for the dynamics of long-term contracts that alter the intuition gleaned from the previous literature. Optimism has a first-order impact on incentives, investment and output that could reconcile the “private equity” puzzle. Consistent with empirical evidence, the interaction between asymmetric beliefs, risk-sharing and adverse selection costs could cause the time-paths of the agents incentive intensities to be increasing or decreasing. Our results also suggest that the incorporation of imperfect public information and asymmetric beliefs could potentially reconcile empirical evidence of an ambiguous relation between risk and incentives, and a non-monotonic relation between firm value and incentives. Permanent and transitory components of risk have differing effects on incentives, which suggest that empirical investigations of the link between risk and incentives should appropriately account for different components of risk.

Product Market Competition, Managerial Compensation and Firm Size in Market Equilibrium

We develop a tractable equilibrium model of competing firms in an industry to show how the distribution of firm qualities, moral hazard, and product market characteristics interact to affect firm size, managerial compensation, and market structure. Different determinants of product market competition have contrasting effects on firm size and managerial compensation. Although both firm size and managerial compensation increase with the entry cost, they increase with the elasticity of substitution if and only if firm size exceeds a high threshold but decrease if it is below a low threshold. Aggregate shocks to the firm productivity distribution affect incentives in our equilibrium framework. We show statistically and economically significant empirical support for several hypotheses derived from the theory that relates product market characteristics to managerial compensation, firm size, and the number of firms in the industry. Different determinants of competition indeed have contrasting effects, as predict...

Capital Structure under Heterogeneous Beliefs

We develop a structural model to quantitatively analyze the effects of asymmetric beliefs and agency conflicts on capital structure. Capital structure reflects the dynamic tradeoff between the positive incentive effects of managerial optimism and the negative effects of risk-sharing costs. Consistent with empirical evidence, long-term debt declines with optimism, whereas short-term borrowing increases. Permanent and transitory risk components have contrasting effects. Long-term debt increases with the intrinsic risk, but varies nonmonotonically with the transient risk. Short-term borrowing declines with the intrinsic risk, but increases with the transient risk. Overall, our findings show that asymmetric beliefs significantly influence firms’ financial policies.

Project Characteristics, Incentives, and Team Production

We develop a model to show how agency conflicts, free-rider effects, and monitoring costs interact to affect optimal team size and workers’ incentive contracts. Team size increases with project risk, decreases with profitability, and decreases with monitoring costs as a proportion of output. Our predictions are consistent with empirical evidence that firm-specific risk has increased over time, average corporate earnings have declined, and firms’ organizational structures have also flattened. The predicted effects of monitoring costs on team size are supported by evidence that improvements in information technology likely to lower monitoring costs lead to larger teams. Further, firms with relatively more intangible assets, where monitoring costs are likely to be higher, are smaller. Optimal incentive intensities decrease with risk and increase with profitability. The endogenous determination of team size accentuates the positive effects of a decline in risk and an increase in profitability on incentives. This paper was accepted by Gustavo Manso, finance.

Optimal Dynamic Risk Taking

We analyze a continuous-time stochastic control problem that arises in the study of several important issues in financial economics. An agent controls the drift and volatility of a diffusion output process by dynamically selecting one of an arbitrary (but finite) number of projects and the termination time. The optimal policy depends on the projects’ risk-adjusted drifts that are determined by their drifts, volatilities, and the curvature (or relative risk aversion) of the agent’s payoff function. We prove that the optimal policy only selects projects in the spanning subset. Furthermore, if the projects’ risk-adjusted drifts are consistently ordered for all output values, then the optimal policy is characterized by at most K − 1 switching triggers, where K is the number of projects in the spanning subset. We also characterize the optimal policy when the consistent ordering condition does not hold, and we outline a general and tractable computational algorithm to derive the optimal policies.

Aggregate Risk, Bank Competition and Regulation in General Equilibrium

We develop a general equilibrium model of competitive banks to examine the optimal design of bank regulation. There is a continuum of equilibria of the unregulated economy that feature varying relative sizes of the financial and real sectors. The unregulated economy underinvests (overinvests) in production when aggregate risk is below (above) a threshold. An efficient allocation is implemented by a range of regulatory policies comprising of capital and liquidity requirements, deposit insurance, and bailouts financed by taxes, but there is a unique regulated equilibrium for a given regulatory policy. Capital and liquidity requirements move in opposing directions; an optimal regulatory policy that features a stricter capital requirement has a looser liquidity requirement. When aggregate risk is low, the efficient allocation can be implemented via deposit insurance and taxation, but capital and liquidity requirements are necessary to ensure a unique regulated equilibrium. When aggregate risk is high, all four regulatory tools are essential components of an optimal regulatory policy. Capital and liquidity requirements that implement efficient regulatory policies do not vary with aggregate risk when it is below a threshold, but become tighter as aggregate risk increases above the threshold. Depositor subsidies via deposit insurance and tax shields are efficient when aggregate risk is low, but inefficient when it is high.

Agency Conflicts, Bank Capital Regulation and Accounting Measurement

We develop a model to show how shareholder-creditor agency conflicts interact with accounting measurement rules to influence the design of bank capital regulation. Relative to a benchmark autarkic regime, higher capital requirements mitigate inefficient asset substitution, but exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances the distortions created by underinvestment and asset substitution, while also incorporating the excess cost of equity relative to debt financing for banks. The optimal regulatory policy can be implemented using historical cost accounting for low values of the excess cost of equity. For intermediate levels of the excess cost of equity, fair value accounting is necessary for regulation to optimally respond to interim performance signals by imposing higher capital requirements that mitigate asset substitution. If the excess cost of equity is sufficiently high, however, the optimal regulatory policy features forbearance by permitting asset substitution to mitigate underinvestment. Overall, our results highlight the importance of accounting measurement in influencing the design of bank regulation through the implementation of capital requirements.