Paolo Fulghieri

Information production, dilution costs, and optimal security design

Abstract We investigate the problem of a firm wishing to finance a project by issuing securities under asymmetric information. We find that, when outside investors can produce (noisy) information on the firms quality, the degree of information asymmetry resulting in equilibrium is endogenous and depends on the information sensitivity of the security issued. Thus, in contrast to the prediction of the pecking order theory (see, e.g. Myers and Majluf, J. Financial Econom. 13 (1984) 187) a security with low sensitivity to private information, such as debt, does not always dominate one with high information sensitivity, such as equity. A firms preference for equity rather than debt depends on the costs of information production, the precision of the information-production technology, and the extent of the information asymmetry. We also study the optimal security design problem and find that, depending on the cost and precision of the information-production technology, risky debt or a composite security with a convex payoff emerges as optimal securities.

Why Include Warrants in New Equity Issues? A Theory of Unit IPOs

We develop a theory of unit IPOs in which the firm going public issues a package of equity with warrants. We model an equity market where insiders have private information about the riskiness as well as the expected value of their firms future cash flows. We demonstrate that, in equilibrium, high risk firms issue underpriced “units” of equity and warrants; lower risk firms, on the other hand, issue underpriced equity alone. In contrast to the existing literature, underpricing arises as a signal in our model in the context of a one-shot equity offering. Though developed in the context of IPOs, our model can also explain the issuance of seasoned equity offerings packaged with warrants. Further, the intuition behind the model generalizes readily to provide a new rationale for packaging call-option-like claims with risky securities other than equity, including convertible debt and debt with warrants.

Organization and Financing of Innovation, and the Choice between Corporate and Independent Venture Capital

This paper examines the impact of competition on the optimal organization and financing structures in innovation-intensive industries. We show that as an optimal response to competition, firms may choose external organization structures established in collaboration with specialized start-ups where they provide start-up financing from their own resources. As the intensity of the competition to innovate increases, firms move from internal to external organization of projects to increase the speed of product innovation and to obtain a competitive advantage with respect to rival firms in their industry. We also show that as the level of competition increases, firms provide a higher level of financing for externally organized projects in the form of corporate venture capital (CVC). Our results help explain the emergence of organization and financing arrangements such as CVC and strategic alliances, where large established firms organize their projects in collaboration with external specialized firms and provide financing for externally organized projects from their own internal resources.

Uncertain Liquidity and Interbank Contracting

We study a version of the Diamond and Dybvig (Journal of Political Economy, 1983, 91, 401 419) model, where banks would like to obtain insurance against shocks on returns on liquid assets through an interbank borrowing and lending program. We show that if investments in liquid assets and their realized returns are private information to individual banks, the first-best allocation is not incentive-compatible; we then characterize the second-best interbank contract.

Capital markets, financial intermediaries, and liquidity supply

Abstract We study a dynamic economy endowed with a sequence of overlapping generations of consumers and production processes, and where productive assets are illiquid and consumption preferences are subject to uninsurable demand for liquidity. We characterize the steady states that can be achieved with alternative financial systems. We show that infinitely lived financial intermediaries offering a liability with age-dependent restrictions may implement a social optimum with full insurance. If, instead, they offer anonymous, unrestricted contracts, then only second-best consumption allocations with partial insurance obtain. We also examine the consumption allocations available when agents can trade shares in competitive stock markets. While allowing for trade across generations may or may not improve upon generational autarky, we show that this competitive equilibrium is not a social optimum, and is dominated by a system of infinitely lived, unrestricted intermediaries.

Mergers, Spinoffs, and Employee Incentives

This paper studies mergers between competing firms and shows that while such mergers reduce the level of product market competition, they may have an adverse effect on employee incentives to innovate. In industries where value creation depends on innovation and development of new products, mergers are likely to be inefficient even though they increase the market power of the post-merger firm. In such industries, a stand-alone structure where independent firms compete both in the product market and in the market for employee human capital leads to a greater profitability. Furthermore, our analysis shows that multidivisional firms can improve employee incentives and increase firm value by reducing firm size through a spin-off transaction although doing so eliminates the economies of scale advantage of being a larger firm and the benefits of operating an internal capital market within the firm. Finally, our paper suggests that established firms can benefit from creating their own competition in the product and labor markets by accommodating new firm entry, and the desire to do so is greater at the intermediate stages of industry/product development.

Corporate Governance, Finance, and the Real Sector

We present a theory of the linkages between corporate governance, corporate finance, and the real sector of an economy. Using a structural model of industry equilibrium with endogenous entry, we show that poor corporate governance leads to low levels of competition, and to firms with high insider ownership and leverage. In contrast, good corporate governance promotes the adoption of more efficient technologies and development of sectors more exposed to moral hazard. We use our model to study equity market liberalization, and we show that liberalizations facilitate entry and adoption of more productive technologies, especially in countries with good corporate governance.

The Ownership and Financing of Innovation in R&D Races

This paper develops a theory of the organization form and financing of innovation activities where integration, venture capital financing, and strategic alliances emerge as optimal responses to competitive pressures of the R&D race, the stage of the research and product development, and the severity of the financial constraints. We model the relationship between a research unit and its downstream firm in the context of a R&D race with a competing pair. We show that the choice of organization and financial structure of the R&D activity plays a strategic role by committing a research unit and its downstream firm to an accelerated R&D activity. We find that integrated organization structures are more likely to emerge when the downstream firm is more productive than the research unit, competition in the R&D race is more intense or the R&D cycle involves late-stage research, and when the research unit is financially constrained. Non-integration and independent venture capital financing are more likely to emerge when the research unit is more productive than the downstream firm, when competition in the R&D race is less intense or the R&D cycle involves early-stage research, and when the research unit is not financially constrained. Finally, corporate venture capital and strategic alliances are more likely to emerge when competition in the R&D race is more intense, the R&D cycle involves late-stage research, and when the productivity of the research unit is high.

Asymmetric Information and the Pecking (Dis)Order

In this paper we show that when growth options represent a significant component of overall firm value, equity financing can dominate (i.e., be less dilutive than) debt financing under asymmetric information. In particular, we find that equity is more likely to dominate debt for younger firms with larger investment needs and with riskier growth opportunities. Thus, our model can explain why high-growth firms may prefer equity over debt, and then switch to debt as they mature. We also fid that equity financing is relatively more attractive when a firm already has debt in its capital structure. In addition, equity can dominate debt in multidivisional firms. Finally, we provide new predictions on the cross-sectional variation of capital structures.

On the strategic role of high leverage in entry deterrence

Abstract This paper examines the strategic role of high levels of debt and bankruptcy threats in deterring entry into monopolistic markets. In the context of an infinite horizon entry game, we show that if a potential entrant has access to debt financing with limited liability, the unique sub-game perfect equilibrium involves the entrant successfully issuing a high level of debt, entering the market and being met with cooperation. If, in addition to the entrant, the incumbent also has access to debt with limited liability, it will be highly levered and will completely pre-empt any entry in equilibrium. Finally, if the incumbent faces a variety of potential entrants with differing abilities to capture market shares, its optimal capital structure will help pre-empt the entry of the tougher entrants, while allowing the weaker ones to share the market. The results of extreme leverage are also shown to hold in an alternative formulation analyzed by Kreps and Wilson (1982) and Milgrom and Roberts (1982), and thus are robust to model specifications. The empirical implications and possible application to high leverage industries are briefly discussed.