Paul Povel

The U-Shaped Investment Curve: Theory and Evidence

This paper examines how the investment of financially constrained firms varies with their level of internal funds. We develop a theoretical model of optimal investment under financial constraints. Our model endogenizes the costs of external funds and allows for negative levels of internal funds. We show that the resulting relationship between internal funds and investment is U-shaped. In particular, when a firms internal funds are negative and sufficiently low, a further decrease leads to an increase in investment. This effect is driven by the investors participation constraint: when part of any loan must be used to close a financing gap, the investor will provide funds only if the firm invests at a scale large enough to generate the revenue that enables the firm to repay. We test our theory using a data set with close to 100,000 firm-year observations. The data strongly support our predictions. Among other results, we find a negative relationship between measures of internal funds and investment for a substantial share of financially constrained firms. Our results also help to explain some contrasting findings in the empirical investment literature.

Financial Constraints and Product Market Competition: Ex-ante vs. Ex-post Incentives

This paper analyzes the interaction of financing and output market decisions in a duopoly in which one firm is financially constrained and can borrow funds to finance production costs. Two ideas have been separately analyzed in previous work: Some authors argue that debt strategically affects a firm’s output market decisions, typically making it more aggressive; others argue that the threat of bankruptcy makes debt financing costly, typically making a firm less aggressive. Our model integrates both ideas; moreover, unlike most previous work, we derive debt as an optimal contract. Compared with a situation in which both firms are unconstrained, the constrained firm produces less, while its unconstrained rival produces more; prices are higher for both firms. Both firms’ outputs depend on the constrained firm’s internal funds; the relationship is U-shaped for the constrained firm and inversely U-shaped for its unconstrained rival. The unconstrained rival has a higher market share, not because of predation but because of the cost disadvantage of the financially constrained firm. D 2004 Elsevier B.V. All rights reserved.

Optimal Investment under Financial Constraints: The Roles of Internal Funds and Asymmetric Information

We study how a firms optimal investment varies with two different measures of financial constraints: the firms internal funds and the extent of asymmetric information between the firm and outside investors. We derive the financial contract between firm and investor endogenously; in our model, a debt contract is optimal. Decreases in internal funds and more asymmetric information both worsen the financial situation of the firm. However, they differ in their effects on the firms investment because they change the marginal cost of debt finance in different ways. More asymmetric information generally leads to lower investment, and investment becomes more sensitive to changes in internal funds. The relationship between internal funds and investment, in contrast, is U-shaped: depending on the level of a firms internal funds, a decrease in internal funds may lead to decreased, unchanged, or even increased investment. Our results explain seemingly contradictory findings in the recent empirical literature.

Multiple Banking as a Commitment Not to Rescue

We show why investors may prefer not to be a firm’s unique lender, even if they are in a strong bargaining position. Some firms need additional funds after a first investment: providing additional funds is rational after the first investment is sunk, but together the two investments are unprofitable. A unique lender will always provide additional funds and make losses. Two creditors can commit not always to provide funds: inefficient negotiations over debt forgiveness may end with a project’s liquidation, which is harmful ex post, but helpful ex ante, if it keeps entrepreneurs with nonpromising projects from initially requesting funds.

Boom and Gloom

We study the performance of investments made at different points of an investment cycle. We use a large data set covering hotels in the U.S., with rich details on their location, characteristics and performance. We find that hotels built during hotel construction booms underperform their peers. For hotels built during local hotel construction booms, this underperformance persists for several decades. We examine possible explanations for this long-lasting underperformance. The evidence is consistent with information-based herding explanations.

The Information Content of Put Warrant Issues

We show that put warrant issues can be used to signal a firms superior prospects to a market that is not aware of them. One benefit of using put warrants to signal, particularly for growth firms, is that a firm receives cash when sending the signal, instead of paying out cash. We establish conditions under which put warrants are issued in a separating equilibrium. We then test our theory using a new data set on put warrant issues. The data support our model: put warrant issuers strongly outperform their peers in the years after the put warrant issues.

Competition for Talent Under Performance Manipulation: CEOs on Steroids

We study how competition for talent affects CEO compensation, taking into consideration that CEO decisions and CEO skills or talent are not observable, and CEOs can manipulate performance as measured by outsiders. Firms compete by offering contracts that generate rents for the CEO. We derive the equilibrium compensation contract, and we describe how competition changes that contract and the outcome. Intuitively, competition increases realized CEO compensation. It also strengthens the incentive power of the contracts. While competition mitigates inefficiencies caused in its absence, it also generates inefficiencies of its own. Competition replaces a downward distortion by an upwards distortion (incentive power is excessively strong), and it switches the focus of equilibrium effort distortions from low-talent CEOs to high-talent CEOs. Competition leads to higher effort but also to more manipulation of measured performance. If the cost of manipulating performance is low, the distortions can outweigh those that are mitigated, and competition for talent may reduce the overall surplus. We discuss possible remedies, including regulatory limits to incentive compensation.

An Experimental Analysis of Risk Shifting Behavior

a New York University, Economics Department, Abu Dhabi, UAE. b University of Houston, Bauer College of Business, Houston, TX 77204. c Universidad de los Andes, School of Business and Economics, Santiago, Chile. Email: pablo.hernandez@nyu.edu (Hernández), povel@uh.edu (Povel), gsertsios@uandes.cl (Sertsios). We thank Colin Camerer, Gary Charness, Igor Cunha, Erik Gilje, Becky Morton, Kim Peijnenburg, participants at the Experimental Finance conference 2014 (Zurich), AEW 2014 (Barcelona, UPF), the Institutions and Innovation conference 2014 (Boston, HBS), SEEDEC 2014 (Bergen, NHH) and seminar participants at New York University and Universidad de los Andes for very helpful comments. The authors declare that they have no relevant or material financial interests that relate to the research described in this paper. Each of the authors obtained IRB approval at their respective institutions: NYU Abu Dhabi (Pablo Hernández), University of Houston (Paul Povel), Universidad de los Andes (Giorgo Sertsios). Do firms really increase the riskiness of their cash flows in the presence ofWe study risk-shifting behavior in a laboratory experiment, a setup that overcomes methodological hurdles faced by empiricists in the past. The participants are high-level managers. We observe risk shifting in a simple setup, but less in a setup with a continuation value. Reputation effects also reduce risk shifting. When combined, a continuation value and reputation effects eliminate risk shifting. Our findings shed light on environments in which risk-shifting is unlikely to happen, and why earlier studies produced conflicting results. In particular, our findings show that managers’ concerns with their own reputations are an important factor that mitigates risk shifting.

Capital Structure under Collusion

We study the financial leverage of firms that collude by forming a cartel. We find that cartel firms have lower leverage ratios during collusion periods, consistent with the idea that reductions in leverage help increase cartel stability. Cartel firms have a surprisingly large economic footprint (they represent more than 20% of the total market capitalization in the U.S.), so understanding their decisions is relevant. Our findings show that anti-competitive behavior has a significant effect on capital structure choices. They also shed new light on the relation between profitability and financial leverage.