Tag: GIM

Learning and the Disappearing Association between Governance and Returns

Lucian Bebchuk, Alma Cohen, and Charles C.Y. Wang are all affiliated with Harvard Law School’s Program on Corporate Governance.

The Journal of Financial Economics has recently accepted for publication our study, Learning and the Disappearing Association between Governance and Returns. The paper, which was earlier issued as a working paper of the Program on Corporate Governance, is available here.

Our study seeks to explain a pattern that has received a great deal of attention from financial economists and capital market participants: during the period 1991-1999, stock returns were correlated with the G-Index based on twenty-four governance provisions (Gompers, Ishii, and Metrick (2003)) and the E-Index based on the six provisions that matter most (Bebchuk, Cohen, and Ferrell (2009)). We show that this correlation did not persist during the subsequent period 2000-2008. Furthermore, we provide evidence that both the identified correlation and its subsequent disappearance were due to market participants’ gradually learning to appreciate the difference between firms scoring well and poorly on the governance indices. Consistent with the learning hypothesis, we find that:

(i) The disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants;
(ii) Until the beginning of the 2000s, but not subsequently, stock market reactions to earning announcements reflected the market’s being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms;
(iii) Stock analysts were also more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms until the beginning of the 2000s but not afterwards;
(iv) While the G-Index and E-Index could no longer generate abnormal returns in the 2000s, their negative association with Tobin’s Q and operating performance persisted; and
(v) The existence and subsequent disappearance of the governance-return correlation cannot be fully explained by additional common risk factors suggested in the literature for augmenting the Fame-French-Carhart four-factor model.

Here is a more detailed account of our analysis:


Pricing Corporate Governance

Lucian Bebchuk is Professor of Law, Economics, and Finance and Director of the Corporate Governance Program at Harvard Law School. This post is Professor Bebchuk’s most recent op-ed in his column series titled “The Rules of the Game,” written for the international association of newspapers Project Syndicate, which can be found here. This op-ed draws on his study with Alma Cohen and Charles C.Y. Wang, “Learning and the Disappearing Association between Governance and Returns,” available here.

Do markets appreciate and correctly price the corporate-governance provisions of companies? In new empirical research, Alma Cohen, Charles C.Y. Wang, and I show how stock markets have learned to price anti-takeover provisions. This learning by markets has important implications for both managements of publicly traded companies and their investors.

In 2001, three financial economists – Paul Gompers, Joy Ishii, and Andrew Metrick – identified a governance-based investment strategy that would have yielded superior stock-market returns during the 1990’s. The strategy was based on the presence of “entrenching” governance provisions, such as a classified board or a poison pill, which insulate managements from the discipline of the market for corporate control.

During the 1990’s, holding shares of firms with no or few entrenching provisions, and shorting shares of firms with many such provisions, would have outperformed the market. These findings have intrigued firms, investors, and corporate-governance experts ever since they were made public, and have led shareholder advisers to develop governance-based investment products.


Do Shareholder Rights Affect the Cost of Bank Loans?

In our paper Do Shareholder Rights Affect the Cost of Bank Loans? which was recently accepted for publication in the Review of Financial Studies, we analyze the relationship between firm-level corporate governance measured by the governance index of Gompers, Ishii, and Metrick (2003, henceforth GIM) and the cost of bank loans issued to publicly traded firms.

We use a panel data set of over 6000 loans issued to a wide cross-section of US firms between 1990 and 2004 as the basis for our analysis. Our basic result shows that firms that are more vulnerable to takeovers (i.e., firms with higher shareholder rights) are charged significantly higher loan spreads. To quantify this result, we follow GIM and construct corner portfolios of firms with the highest (democracy) and the lowest levels (dictatorship) of shareholder rights. We show that for a typical firm in our sample a switch from the democracy to the dictatorship portfolio decreases the expected loan spread by almost 25% (30 basis points) after controlling for the default risk as well as various firm-level factors and specific features of loan contracts.

In interaction regressions, we find that democracies with low leverage are charged significantly higher loan spreads. This provides evidence that the possibility of an increase in financial risk is an important consideration through which takeover vulnerability gets priced in bank loans. Additionally we find that conditional on high takeover vulnerability, long maturity loans have higher spreads than loans with short maturities. Loans with longer maturity expose banks to takeover risk for a longer time-period and our results indicate that banks charge a premium for taking such risks.

Though our focus remains on debt pricing, bank loan covenants and collateral can also mitigate a bank’s concern about potential losses in takeover. Consistent with this argument, we find that banks charge higher loan spread to those high takeover vulnerability borrowers that have fewer covenants or those who obtain unsecured loans. To investigate whether banks can also protect their interests by having bargaining power over their borrowers, we analyze the effect of syndicate size on the pricing effect of takeover vulnerability. We find that the effect of takeover vulnerability is significantly higher for loans with smaller syndicate size i.e., when the bargaining power is likely to be high. Thus, the bargaining power channel is less likely to explain away our results.

Our results have important implications for understanding the link between a firm’s governance structure and its cost of capital. Our study suggests that firms that rely too much on corporate control market as a governance device are punished by costlier bank loans. The full paper is available for download here.