Rajesh K. Aggarwal

Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence

We examine compensation contracts for managers in imperfectly competitive product markets. We show that strategic interactions among firms can explain the lack of relative performance-based incentives in which compensation decreases with rival firm performance. The need to soften product market competition generates an optimal compensation contract that places a positive weight on both own and rival performance. Firms in more competitive industries place greater weight on rival firm performance relative to own firm performance. We find empirical evidence of a positive sensitivity of compensation to rival firm performance that is increasing in the degree of competition in the industry.

EMPIRE-BUILDERS AND SHIRKERS: INVESTMENT, FIRM PERFORMANCE, AND MANAGERIAL INCENTIVES

Do firms systematically over- or underinvest as a result of agency problems? We develop a contracting model between shareholders and managers in which managers have private benefits or private costs of investment. Managers overinvest when they have private benefits and underinvest when they have private costs. Optimal incentive contracts mitigate the over- or underinvestment problem. We derive comparative static predictions for the equilibrium relationships between incentives from compensation, investment, and firm performance for both cases. The relationship between firm performance and managerial incentives, in isolation, is insufficient to identify whether managers have private benefits or private costs of investment. In order to identify whether managers have private benefits or costs, we estimate the joint relationships between incentives and firm performance and between incentives and investment. Our empirical results show that both firm performance and investment are increasing in managerial incentives. These results are consistent with managers having private costs of investment. We find no support for overinvestment based on private benefits.

Stock Market Manipulations

We present theory and evidence of stock price manipulation. Manipulators trade in the presence of other traders seeking information about the stocks true value. More information seekers imply greater competition for shares, making it easier for manipulators to trade and potentially worsening market efficiency. Data from SEC enforcement actions show that manipulators typically are plausibly informed parties (insiders, brokers, etc.). Manipulation increases volatility, liquidity, and returns. Prices rise throughout the manipulation period and fall postmanipulation. Prices and liquidity are higher when manipulators sell than when they buy. When manipulators sell, prices are higher when liquidity and volatility are greater.

The performance of emerging hedge funds and managers

This paper provides the first systematic analysis of performance patterns for emerging funds and managers in the hedge fund industry. Emerging funds and managers have particularly strong financial incentives to create investment performance and, because of their size, may be more nimble than established ones. Performance measurement, however, needs to control for the usual biases afflicting hedge fund databases. After adjusting for such biases and using a novel event time approach, we find strong evidence of outperformance during the first two to three years of existence. Each additional year of age decreases performance by 42 basis points, on average. Cross-sectionally, early performance by individual funds is quite persistent, with early strong performance lasting for up to five years.

Corporate Political Donations: Investment or Agency?

We examine corporate donations to political candidates for federal offices in the United States from 1991 to 2004. Firms that donate have operating characteristics consistent with the existence of a free cash flow problem, and donations are negatively correlated with returns. A

The Impact of Fundamentals on IPO Valuation

10,000 increase in donations is associated with a reduction in annual excess returns of 7.4 basis points. Worse corporate governance is associated with larger donations. Even after controlling for corporate governance, donations are associated with lower returns. Donating firms engage in more acquisitions and their acquisitions have significantly lower cumulative abnormal announcement returns than non-donating firms. We find virtually no support for the hypothesis that donations represent an investment in political capital. Instead, political donations are symptomatic of agency problems within firms. Our results are particularly useful in light of the Citizens United ruling, which is likely to greatly increase the use of corporate funds for political donations.

Hidden Survivorship in Hedge Fund Returns

We examine how IPO valuation has changed over time by focusing on three time-periods: 1986-1990, January 1997 through March 2000 (designated as the boom period), and April 2000 through December 2001 (designated as the crash period). Our goal is to see whether there were systematic changes in the valuation of fundamental factors over time. Using a sample of 1,655 IPOs, we find that firms with more negative earnings have higher valuations than do firms with less negative earnings and firms with more positive earnings have higher valuations than firms with less positive earnings. This Vshaped pattern to the relation between value and earnings suggests that inference based solely on firms with positive earnings is incomplete. This is especially true for the boom and crash periods, suggesting that there were systematic shifts in the valuation of fundamentals. Our results suggest that negative earnings are a proxy for growth opportunities for internet firms and that such growth options are a significant component of IPO firm value. We also find that investment bankers and first-day investors assign different weights to post-IPO ownership and changes in ownership around the IPO for different classes of pre-IPO shareholders (CEOs, VCs, other blockholders, and officers and directors) when pricing the IPO. JEL classification: G1; G32; M41

Access, Common Agency, and Board Size

This study identifies a previously unreported bias in the TASS database. Owing to a merger with the Tremont database, 60 percent of the funds added to the TASS database between April 1999 and November 2001 are likely to be survivors (i.e., funds that were selected only from funds that were live as of 31 March 1999). The resulting survivorship bias is substantial, averaging more than 5 percent a year. What would normally be termed the backfill period actually represents hidden survivorship. A sorting algorithm to exclude these fund histories is proposed.

The Risk of Emerging Hedge Fund Managers

We study the impact of the size of a firms board of directors on managerial incentives. We present a model where a risk-averse agent (the top management team) performs multiple tasks for a firm that is controlled by multiple principals (the board of directors) who differ in the relative value they place on each task. We show that the agents incentives are lower than they would be had the board been smaller. Our empirical results are consistent with the models predictions. We find that the number of social objectives (community, diversity, environment, etc.) that a firm pursues is positively related to board size. Board size is negatively related to managerial incentives. We also find that firms incorporated in states with alternative constituency statutes (allowing boards to consider the interests of constituencies other than shareholders) pursue more objectives, have larger boards, and lower managerial pay-performance sensitivities. Our results are robust to the inclusion of various board and firm control variables and to a myriad of specifications.

Chapter 17 – Executive Compensation and Incentives

This study analyzes the risk profile of emerging hedge funds and managers using a clean definition of age that is not affected by backfill bias. Emerging funds and managers have particularly strong financial incentives to create investment performance but, because of the concavity of performance fees, may also have incentives to assume greater risk. We find that the typical fund volatility, whether adjusted for the sector or not, tends to be higher in the early years. This result, however, is entirely driven by the sample of dead funds. We also find that funds that belong to a multi-fund family tend to have less risk, as do funds run by managers who have previously run another hedge fund. Both findings confirm the importance of reputation effects. Finally, we find that smaller funds have higher risk and greater attrition.