Financial markets, governance and

managerial finance

Professor Jens Hagendorff

Managerial Finance
Session 1

Learning Objectives

Understand the basic functions of managerial finance

Explain the financial system context in which managerial finance
functions are conducted
Appreciate the differences in financial systems and their implications
for corporate governance globally.
Understand the indicators and performance implications of good and
bad corporate governance

1
 What is managerial finance?

Investment

What long term investments will you make?

Financing

Where will you get long-term financing for your long term
projects?

Liquidity

How will you manage your everyday activities?

Firms are set in a financial system

2
 Financial systems
can be broken down into

Markets
Primary markets sell new security issues sold to initial buyers
Secondary markets trade previously issued securities
Organised Exchanges. Stock exchanges (LSE, EURONEXT, NYSE), foreign exchange
markets, futures markets (LIFFE, CME), and options markets (CBOE, EUREX)
Over-the-Counter (OTC) Markets

Intermediaries
Depository Institutions (Banks)
Contractual Savings Institutions (Life insurance companies, Fire & casualty insurance
companies, Pension funds, government retirement funds)
Investment Intermediaries (Mutual funds, money market mutual funds)

Intermediaries are the dominant

suppliers of external finance

Why? Perhaps because they:

1. Reduce transaction costs

Lower screening costs. Economies of scale. Experience, credit
ratings
delegated monitor
2. Offer better risk transformation
Direct saver-lender relationship is very risky. Intermediaries
provide diversified portfolio.
Risks can be pooled across a large portfolio to help savers
achieve diversification benefits
3. Offer better maturity transformation
the maturities of assets may differ from the maturities of
liabilities.

3
 Financial systems

The importance of Markets and Intermediaries

as a source of finance varies across countries.

What explains these differences?

Implications for governance systems

Corporate governance deals with the ways in which the suppliers

of finance to corporations assure themselves of getting a return
on their investment.
Shleifer & Vishny, J Finance, 1997

Market-based financial system

UK, US, Australia

Banks face strong competition from debt and equity markets
Equity and bonds markets very liquid
Decline in traditional banking activities such as taking deposits and
making out loans
Many listed companies. Shares are diffusely-held
Strong minority shareholder protection & corporate governance
codes
Households more exposed to financial markets
English Common Law legal tradition

4
 Sources of External Funds for
Non-financial Business, 1995-2015

90.00%

80.00%

70.00%

60.00%
Bank
50.00%
Equity
40.00%
Leasing
30.00%

20.00%

10.00%

0.00%
China

France

Germany

Indonesia

Italy

Malaysia

Pakistan

Spain

Sweden

United Kingdom

United States
Source: Worldbank, Financing Patterns across the World, 2015

Size of global equity markets

5
 Bank-based financial systems

Germany, Japan, (Russia, Korea)

Strong banking sector. Exhibit less developed financial markets
Few listed companies. SMEs more dominant
Concentrated share ownership
Less investor protection (e.g. dual class shares)
Code Law legal tradition

% of Listed Firms with a Majority

Shareholder

90 Ownership concentration
81.4
80 varies
73.6
68 68.8
70
64.2 There is no clear relationship to
60 56.1
country income

50 Family-controlled firms are

widespread ownership model
40
32.6
30
Bank-based systems have
concentrated ownership
20
Far-reaching effects for
10
2.4 3.7 corporate governance system
0
UK

USA

Spain

Italy

Germany

Austria

emerg. Asia

China

India

Source: Goergen (2007) & Allen et al. (2006)

6
Example of a pyramid in a bank-based system:
Telecom Italia (2006)

Ownership example from the UK:

Tullow Oil (2012)

7
 Legal systems around the world

Corporate governance
and financial systems

Market-based system
Agency conflict between managers and atomistic shareholders
Managers are risk averse and shareholders risk neutral
Performance-based pay and external monitoring (shareholders) to
solve agency conflict
But, who monitors the monitor?

Bank-based system
No/little separation of ownership and control
Conflict between majority shareholder and minority shareholders
Large investment by majority shareholder ensures long-term interest
in firm performance
But, majority controlled firm open to abuse by owners. Powerless
minority shareholders?

8
 Is there an optimal system?

Causality to wealth? No evidence

Causalities to Legal System? Common law countries tend to have

more developed capital markets. But this does not suggest
causality

But, historically, code law countries were not bank-based financial

systems

Jackson & Roe (2009): key distinguishing feature between financial

systems is not the legal framework, but regulation and the political
will to enforce regulations

A resource-based view of investor protection

Source: Jackson and Roe, Journal of Financial Economics (2009)

9
 What is corporate governance?

What is corporate governance?

Corporate governance deals with the ways in which the suppliers of

finance to corporations assure themselves of getting a return on their
investment.
Shleifer & Vishny, J Finance, 1997

The directors of such [joint-stock] companies, however, being the

managers rather of other peoples money than of their own, it cannot
well be expected, that they should watch over it with the same anxious
vigilance with which the partners in a private co-partnery frequently
watch over their own.
Adam Smith, The Wealth of Nations, 1776

10
 Governance and agency conflicts

Type I Type II
Relationship Relationship
between between majority
managers and shareholders and
shareholders minority investors

Theoretical foundations

Agency costs of equity

As the owner-managers fraction
of the equity falls, her fractional
claim on the outcomes falls and
this will tend to encourage her to
appropriate larger amounts of
the corporate resources in the
form of perquisites.
Firm value

Agency costs of debt

Bankruptcy costs and risk shifting
Managers expenditure on non-monetary benefits
Highly leveraged firms are rare
For different levels of managerial equity ownership
Manager utility functions

11
 Do managers act in shareholders interests?

Managerial Compensation
Performance based pay

Control of the Firm

Are shareholders powerful?

Shareholder Rights
Do shareholders have a facility to call managers to account?

Proxy Voting
A grant of authority by a shareholder allowing another individual to
vote his or her shares.

Fund management
and corporate governance

The asset management industry, as a key institutional investor, is at the

forefront of bringing about changes in governance
Stewards of the economy

1980s saw deterioration in CG standards (age of hostile takeovers fuelled

by junk bond market), followed by recent trends to improve CG
In the UK, Cadburys Report (1992) & the Combined Code
(2003)
Deal with responsibilities of directors, remuneration, etc.
In US, Sarbanes Oxley Act (2002) & Dodd Frank Act (2010)

12
 History of corporate governance in the UK

Shareholder rights in the United Kingdom were weak until the 1950s
shares widely- held, but
pyramid structures common (e.g. Beechams, Cadbury, Colman,
Rowntree were dominated by their owners and had little
professional management)

Continued pressure from institutional investors on boards to rapidly rid

the UK of these structures.
Pressures for LSE to have takeover rules that make pyramids
untenable
Control blocks sold and pyramids dismantled from the early 20th
century

The UK history is in conflict with a widely held view that for shares to be
widely-held shareholder rights need to be strong.

European asset management industry

as a supplier of finance to firms

Debt securities issued by euro area residents held by European asset managers
% euro area % euro area % euro area
EUR bn debt securities bank lending bank lending
financing (excl. mortgages)
2009 3,761 24.73% 31.91% 42.69%
2010 3,704 23.46% 30.24% 40.48%
2011 3,539 21.53% 28.71% 38.55%
2012 3,875 23.35% 31.77% 42.84%

Equity issued by euro area residents and managed by European asset managers
EUR bn % European % European
quoted shares free float
2009 1,371 31.09% 43.79%
2010 1,418 30.95% 40.19%
2011 1,212 31.23% 40.29%
2012 1,374 30.51% 39.37%

Data on debt and equity financing are from the ECB Monetary and Financial Statistics

Source: Hagendorff (2014)

13
 Some indicators of strong
shareholder control of a firm

Board &
CEO not overly CEO tenure
committee
powerful
independence

CEO/Chair are Manager

Board size
split roles? compensation

The Gompers et al. (2003) index

of shareholder rights
Gompers et al. (2003) build an entrenchment index
Shareholder rights vary across firms. Using the incidence of 24
governance rules, they construct a Governance Index
proxies for the level of shareholder rights at about 1,500 large
US firms during the 1990s.
An investment strategy that bought firms with the strongest
shareholder rights (democracies) and sold firms with the
weakest rights (dictatorships) would have earned abnormal
returns of 8.5% p.a. during the sample period.
Firms with stronger shareholder rights had higher firm value,
higher profits, higher sales growth, lower capital expenditures,
and made fewer corporate acquisitions.

14
 Have the returns to
good governance gone away?

Bebchuk et al (2009) show that only 6 governance provisions consistently explain

returns (E-index) : www.law.harvard.edu/faculty/bebchuk/data.shtml.

1. Staggered board
2. Limitation on amending bylaws
3. Limitation on amending the charter
4. Supermajority to approve a merger
5. Golden parachute
6. Poison pill

Bebchuk et al (2013) show the correlation between governance indices and

abnormal returns documented for 19901999 subsequently disappeared as
investors paid increasing attention to governance.
Governance no longer basis for a profitable trading strategy, but governance still
correlates with accounting performance.
29

Managerial compensation and risk-taking

Equity-based pay (shares and call options on shares) are

designed to overcome managerial risk aversion.

Options provide convex CEO pay-offs from firm risk-taking.

The value of CEO option holdings are convex
functions
of the volatility of stock prices.
The volatility of stock prices = total firm risk

More options lead to riskier investment choices and bind

corporate resources to riskier activities (Nam et al. 2003; Coles
et al. 2006; Guay 1999; Hagendorff and Vallascas, 2011).

15
 Managerial compensation and risk-taking

Vega captures the change in CEO

wealth resulting from a 1% change
in stock return volatility

Example: Harris Simons

CEO of Zions Bank Corp.
in 1993, vega = $900
in 2006, vega = $140,000

Some data available:

http://sites.temple.edu/lnaveen/d
ata/

31

Pay off functions linked to

Call Bonus
Options contracts

32

16
 Debt-based CEO pay

So-called inside debt

Ties a CEOs personal wealth to the wealth of external creditors
Deferred compensation and pension plans
In the US, SERP pensions are unfunded & unsecured
Key characteristics:
Accrues over the CEOs tenure and only released upon retirement
contingent on the firm remaining solvent
Turns CEOs into an unsecured firm creditor

Does inside debt matter?

Evidence from the US banking

1.5
Industry-adjusted Distance-to-Default (IADD)

industry
.5 1

Bank CEOs within the lower

half of pensions use
0

acquisitions to build riskier

-.5

banks
-1.5 -1

-200 -100 -11 11 200

Pre-Acquisition Window Post-Acquisition Window

Low Inside Debt High Inside Debt

Source: Srivastav et al. (2014)

17
 Optimal debt & equity compensation incentives

Costs
Agency
Costs

CEO risk CEO risk

taking; aversion;
Mainly costs Mainly costs
to
to creditors shareholders

1.0 Debt/equity
incentives

Female board participation

"My clear line is that if Lehman The Lehman Sisters fancy

Brothers had been 'Lehman
Sisters,' would the crisis have
happened like it did? No.
Generally, women have a
better ear to listen, and they
are less likely to pretend to
know everything themselves.
They are team players with less
ego.
Neelie Kroes, August 19, 2009
assumes that women are less
risk-taking, less obsessed with
money and status and generally
less full of themselves than
men, and so would have had
more sense than to respond to
the flawed incentives that
brought down the financial
system.
The Economist, August 6, 2009

36

18
 Female board participation

Adams and Ferreria (2009) show that

Female directors are more diligent monitors.
Female directors linked to CEO dismissal following underperformance.
Yet, on average higher % of female directors linked to lower performance.
Authors show that female directors enhance value when corporate
governance is weak (high Gompers et al. (2003) index) where it is plausible
that additional board monitoring can enhance firm value. There are
detrimental effects on value in companies with strong shareholder rights.

There is empirical evidence of a glass ceiling in the US & UK

But selection issues: Women who choose a career path leading to a
directorship are unlikely to be the same as the women in the
population

Risk aversion and gender

Measures of testosterone and risk-aversion from Sapienza et al. (2009) from

Chicago MBAs

38

19
 Concluding remarks

Governance matters
Good governance is rooted in culturesnot in statute books
Has good governance peaked?
More shareholder-oriented boards are linked to more
shareholder-friendly outcomes
Pay can be used by shareholders and bondholders to affect
risky outcomes

Case: Porsche / VW Takeover

000'S VOLKS W AGE N - MARKET V ALUE
120 FROM 10/1/96 TO 10/1/11 MONTHLY

Takeover battle
100

80
Build up of Porsche position in
VW without investor
knowledge.
60

40
short squeeze

20
Illustrates the dangers for
asset managers when operating
in low-protection environment
0
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Thomson Reuters Datastream

40

20


Managerial Finance (MBA)

To accompany Session 1



Please read the enclosed article in The Economist relating to what now is an
historicyet still ongoingcase.



1. Who are the main players involved in the takeover battle for
Volkswagen?


2. How can a relatively small firm like Porsche take over a much larger
firm such as Volkswagen?


3. What is shorting? Why did it cause large swings in the price of
Volkswagen shares during the takeover battle?


4. Are Porsches practices illegal? Are they immoral?


5. What is the harm in pursuing Porsches takeover strategy?

 Porsche and VW

Squeezy money
How Porsche fleeced hedge funds and roiled the worlds financial markets

Oct 30th 2008 | From the print edition

GREAT cornering and eye-popping acceleration make Porsche's cars popular among thrill-
seeking bankers and hedge-fund managers. Now its clients are discovering that the carmaker
itself has an unexpected talent for cornering markets. In a few tumultuous days it is thought to
have made a cool 6 billion-12 billion ($7.5 billion-15 billion) on the share price of Volkswagen
(VW)a coup that has roiled the world's financial markets.

Porsche's gambit was as old as finance itself. For about three years it had been steadily
increasing its stake in VW, a much larger yet less profitable carmaker with which it shares a little
production. Its buying had driven up the price of VW's shares to above the level at which it would
make any economic sense for Porsche to buy VW. Seeing this, hedge funds sold shares in VW
that they did not own. One strategy was a bet that VW's share price would fall. Some also bought
shares in Porsche, in a wager that shares of both would converge.

The risks of short selling should have been apparent to the brightest hedge-fund managers in
Mayfair and Greenwich because of widespread suspicion that Porsche, a dab hand in currency-
derivatives markets, was also mucking about with options on VW stock. Adam Jonas of Morgan
Stanley warned clients on October 8th of the danger of playing billionaire's poker by betting
against Porsche. Max Warburton of Alliance Bernstein said Porsche could make billions by
squeezing short-sellers of VW's shares.

At the time Porsche dismissed these musings as a fairy-tale. But on October 26th it executed a
handbrake turn, saying that it owned nearly 43% of VW's shares outright and had derivative
contracts on nearly 32% more. That meant it had tied up almost all of the freely available shares
(the rest are held by the state government and index funds). Hedge funds quickly did the maths,
concluding that they could be caught in an infinite squeeze in which they were forced to buy
shares at any price.

Their frenzied buying sent VW's share price soaring (see chart). After languishing below 200
last year, it jumped to more than 1,005 at one point on October 28th, briefly making VW the
world's most valuable company. Porsche may have made paper gains of 30 billion-40 billion in
what one analyst described as one of the most brilliantly conceived wealth transfers ever.
Porsche says it never intended to make money on derivatives and only bought them to protect its
planned purchases of VW stock. On October 29th it said that it would settle up to 5% of its VW

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 sending the price down again.

Hedge funds that take bad bets may garner little

sympathy, but the VW saga does more than punish a
few locusts. On October 28th shares in Morgan
Stanley, Goldman Sachs and Socit Gnrale
wobbled on worries (denied by all) that they might
also be exposed to VW. If the losses are big enough to
cause the failure of even a few hedge funds, that
would spell more pain for the battered banking
system. Other casualties include buyers of passive
funds that track the German market who will end up
with a disproportionate stake in VW within their portfolios. With VW's share price falling again,
those who sell now will lock in a loss.

The greatest damage is to the reputation of Germany's capital markets, where regulators are now
belatedly investigating what went on. Allowing acquirers to build large secret stakes in bid
targets does nothing for confidence. Even Porsche may come to rue its coup. They may struggle
to sell 911s to hedge-fund managers for years and years to come, says one investor.

From the print edition: Finance and economics

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