Radhakrishnan Gopalan

Why Do Firms Form New Banking Relationships

Using a large loan sample from 1990 to 2006, we examine why firms form new banking relationships. Small public firms that do not have existing relationships with large banks are more likely to form new banking relationships. On average, firms obtain higher loan amounts when they form new banking relationships, while small firms also experience an increase in sales growth, capital expenditure, leverage, analyst coverage, and public debt issuance subsequently. Our findings suggest that firms form new banking relationships to expand their access to credit and capital market services, and highlight an important cost of exclusive banking relationships.

Asset Liquidity, and Stock Liquidity

We study the relation between asset liquidity and stock liquidity. Our model shows that the relation may be either positive or negative depending on parameter values. Asset liquidity improves stock liquidity more for firms that are less likely to reinvest their liquid assets (i.e., firms with less growth opportunities and financially constrained firms). Empirically, we find a positive and economically large relation between asset liquidity and stock liquidity. Consistent with our model, the relation is more positive for firms that are less likely to reinvest their liquid assets. Our results also shed light on the value of holding liquid assets.

The Optimal Duration of Executive Compensation: Theory and Evidence

While much is made of the ills of “short-termism” in executive compensation, in reality very little is known empirically about the extent of short-termism in CEO compensation. This paper develops a new measure of CEO pay duration that reflects the vesting periods of different components of compensation, thereby quantifying the extent to which compensation is short-term and the extent to which it is long-term. It also develops a theoretical model that generates three predictions for which we find strong empirical support using our measure of pay duration. First, optimal pay duration is decreasing in the extent of mispricing of the firm’s stock. Second, optimal pay duration is longer in firms with poorer corporate governance. Third, CEOs with shorter pay durations are more likely to engage in myopic investment behavior, and this relationship is stronger when the extent of stock mispricing is larger.

Compensation Goals and Firm Performance

How is firm performance related to executive compensation goals? Using a large dataset of performance goals employed in incentive contracts we study this question. A disproportionately large number of firms exceed their goals by a small margin as compared to the number that fall short of the goal by a small margin. This asymmetry is particularly acute when compensation is contingent on a single goal or if there is a discontinuous jump in compensation earned for meeting the goal. Firms that just exceed their EPS goals have higher abnormal accruals as compared to firms that just miss their EPS goals. Firms that just exceed profit goals have lower R&D and SG&A expenditures, and experience lower long-run stock returns as compared to firms that just miss their profit goals. Overall our results highlight some unintended costs of linking executive compensation to specific performance goals. JEL Classification: G30, J33 ∗PhD student in Finance, W.P. Carey School of Business, Arizona State University. Corresponding author. e-mail: bfbennett@asu.edu. †Research Professor of Finance, W.P. Carey School of Business, Arizona State University ‡Associate Professor, Olin Business School, Washington University §Hubert C. and Dorothy R. Moog Professor of Finance, Olin Business School, Washington University in St. Louis.Using a large data set of performance goals employed in executive incentive contracts, we find that a disproportionately large number of firms exceed their goals by a small margin as compared to the number that fall short of the goal by a similar margin. This asymmetry is particularly acute for earnings goals, when compensation is contingent on a single goal, when the pay-performance relationship around the goal is concave-shaped, and for grants with non-equity-based payouts. Firms that exceed their compensation target by a small margin are more likely to beat the target the next period and CEOs of firms that miss their targets are more likely to experience a forced turnover. Firms that just exceed their Earnings Per Share (EPS) goals have higher abnormal accruals and lower Research and Development (R&D) expenditures, and firms that just exceed their profit goals have lower Selling, General and Administrative (SG&A) expenditures. Overall, our results highlight some of the costs of linking managerial compensation to specific compensation targets.

Do Business Groups Use Dividends to Fund Investments

In this paper we offer a theory of dividends in business groups. We hypothesize that business groups operate a type of internal capital market and use dividends as a transparent means of transferring cash across group firms. The intuition, formalized in a simple model, is that insiders use their share of dividends to finance investment in member firms, thereby limiting the dilution of their equity stake when firms raise outside capital. The correlation between dividends and investments is predicted to be stronger for smaller and more profitable investments and when the legal regime is more protective of shareholder rights. We test our predictions using firm level data from 23 countries from Asia and Europe. Our evidence is consistent with the predictions. Changes in group firm dividends are positively associated with changes in both contemporaneous and subsequent equity-financed investments in other member firms. The association is stronger for smaller and more profitable investments and in firms located in countries with strong legal regimes. Aggregate dividends paid by group firms in a year finance upto 10% of insider equity investment in the next year. Consistent with our model, insider holding in group firms is positively related to dividend distribution from the other member firms.

Strategic Flexibility and the Optimality of Pay for Luck

While standard contract theory suggests that a CEO should be paid relative to a benchmark that removes the effects of sector performance (otherwise referred to as luck), there is overwhelming evidence that CEO pay is strongly and positively related to such luck. In this paper we offer an explanation for the observed pay for luck. We model a CEO charged with selecting the firms strategy which in turn affects the firms exposure to sector performance. To incentivize the CEO to optimally choose her firms sector exposure, pay contracts will be positively and sometimes asymmetrically related to sector performance. Using a multitude of proxies to capture the extent of strategic flexibility offered by firms to alter sector exposure we find strong empirical support for our model prediction of greater pay for luck. Our results indicate that the pay for luck is almost fully confined to firms in industries with high R&D expenditure and in multi-divisional firms. Our evidence is robust to alternate explanations such as CEO entrenchment.

The Role of Deferred Pay in Retaining Managerial Talent

We examine the role of deferred vesting of stock and option grants in reducing executive turnover. To the extent an executive forfeits all unvested stock and option grants if she leaves the firm, deferred vesting will increase the cost (to the executive) of early exit. Using pay Duration proposed in Gopalan, et al. (2014) as a measure of the extent of deferred vesting, we find that CEOs and non-CEO executives with longer pay Duration are less likely to leave the firm voluntarily. Employing the vesting of a large prior-year stock/option grant as an instrument for Duration, we find the effect to be causal. Consistent with long pay Duration reflecting firms’ retention intentions, CEOs with longer pay Duration are also less likely to experience a forced turnover and the sensitivity of forced turnover to firm performance is significantly lower among firms that grant longer pay Duration. Overall, our study highlights a strong link between compensation design and turnover of top executives.

Managerial Compensation in Multi-Division Firms

Using hand-collected data on division manager (DM) pay contracts, we document that DM pay is related to the performance of both the DM’s division and the other divisions in the firm. There is substantial heterogeneity in DM pay for performance. DM pay for division performance is lower in industries with less informative accounting earnings. DM pay is more sensitive to other-division performance if the DM’s division is related to the rest of the firm, if the DM’s division has fewer growth opportunities, and if the DM’s division receives less capital from the rest of the firm. Consistent with optimal contracting view, DMs receive greater pay for other-division performance in better-governed firms. Overall, our evidence suggests that DM compensation is structured to account for the information and agency problems in multidivision firms. The Internet appendix is available at https://doi.org/10.1287/mnsc.2016.2672. This paper was accepted by Amit Seru, finance.

Analyst Coverage Networks and Corporate Financial Policies

This paper shows that sell-side analysts play an important role in propagating corporate financial policy choices, such as leverage and equity issuance decisions across firms. Using exogenous characteristics of analyst network peers as well as the “friends-of-friends” approach from the network effects literature to identify peer effects, we find that exogenous changes to financial policies of firms covered by an analyst leads other firms covered by the same analyst to implement similar policy choices. We find that a one standard deviation increase in peer firm average leverage is associated with a 0.35 standard deviation increase in a firms leverage, and a one standard deviation increase in the frequency of peers’ equity issuance leads to a 29.6% increase in the likelihood of issuing equity. We show evidence that these analyst network peer effects are distinct from industry peer effects and are more pronounced among peers connected by analysts that are more experienced and from more influential brokerage houses.

Insider Ownership and Shareholder Value: Evidence from New Project Announcements

How does insider ownership affect shareholder value? We answer this question by examining how the marginal valuation of new investment projects announced by Indian firms varies with the level of insider holding in the firm, and other firm and project characteristics. We find that among projects announced by firms affiliated with business groups, announcement returns are significantly lower, and usually negative, for projects announced by firms with low insider holding. This effect is mainly driven by projects that result in either the firm or the business group diversifying into a new industry. On average, diversification projects announced by firms with low insider holding have negative announcement returns. The negative effect of low insider holding is larger in firms with high level of free cash flows. Overall, our results are consistent with insiders expropriating outside shareholders by selectively housing more (less) valuable projects in firms with high (low) insider holding.