Favoritism or Favoritism or Markets in Capital Markets in Capital

Allocation?Allocation?Mariassunta GiannettiMariassunta Giannetti

Stockholm School of Economics, CEPR and ECGIStockholm School of Economics, CEPR and ECGI

Xiaoyun YuXiaoyun YuIndiana UniversityIndiana University

BackgroundBackground Capital allocation is often driven by Capital allocation is often driven by

favoritism rather than by markets and favoritism rather than by markets and information about future expected information about future expected returnsreturns Financial intermediaries convey funds to Financial intermediaries convey funds to

their cronies (La Porta, Lopez-de-Silanes and their cronies (La Porta, Lopez-de-Silanes and Zamarripa 2003)Zamarripa 2003)

Entrepreneurs reinvest funds in their Entrepreneurs reinvest funds in their business (Khanna and Yafeh 2006)business (Khanna and Yafeh 2006)

Firms do not to list on exchange but raise Firms do not to list on exchange but raise capital from family and friends (Pagano, capital from family and friends (Pagano, Panetta and Zingales 1998)Panetta and Zingales 1998)

Two regimes for capital Two regimes for capital allocationallocation

FavoritismFavoritism Financiers do not investigate new investment Financiers do not investigate new investment

opportunities and fund only entrepreneurs they are opportunities and fund only entrepreneurs they are familiar withfamiliar with

Inefficiencies may arise if entrepreneurs differ in Inefficiencies may arise if entrepreneurs differ in productivityproductivity

Entrepreneur

Financier

Information is freely available

Risk free technology

Entrepreneur

Financier

Information is freely available

Two regimes for capital Two regimes for capital allocation IIallocation II

““Markets”: Markets”: Financiers acquire information, identify distant Financiers acquire information, identify distant

investment opportunities, and possibly fund distant investment opportunities, and possibly fund distant investment opportunitiesinvestment opportunities

Entrepreneur

Financier

Information is freely available

Risk free technology

Entrepreneur

Financier

Information is freely availablecost of discovering a distant entrepreneur

Research questionsResearch questions When does favoritism (or markets) emerge When does favoritism (or markets) emerge

as an equilibrium out come?as an equilibrium out come? When does favoritism lead to an efficient When does favoritism lead to an efficient

allocation of capital?allocation of capital?

Preview of resultsPreview of results Favoritism is an equilibrium outcome if saving Favoritism is an equilibrium outcome if saving

is low and/or if information is unreliable and is low and/or if information is unreliable and costlycostly Financiers’ incentive to investigate distant Financiers’ incentive to investigate distant

investment opportunities depend on the quality investment opportunities depend on the quality and reliability of informationand reliability of information

Favoritism can achieve an efficient allocation Favoritism can achieve an efficient allocation when domestic saving is lowwhen domestic saving is low

Markets become crucial for achieving an Markets become crucial for achieving an efficient allocation of capital as the economy’s efficient allocation of capital as the economy’s saving increasessaving increases Favoritism can still be an equilibrium outcomeFavoritism can still be an equilibrium outcome Market remain imperfect in equilibrium Market remain imperfect in equilibrium

if it is difficult to identify the highest quality if it is difficult to identify the highest quality entrepreneurs, low productivity entrepreneurs are entrepreneurs, low productivity entrepreneurs are fundedfunded

Preview of results IIPreview of results II

Why do not markets triumph?Why do not markets triumph? Entrepreneurs may have no incentive to spur Entrepreneurs may have no incentive to spur

institutional changes that leads to a more institutional changes that leads to a more efficient allocation of capitalefficient allocation of capital They have to pay higher returns to external They have to pay higher returns to external

financiersfinanciers Trade-off between rents per unit of capital Trade-off between rents per unit of capital

invested and level of investmentinvested and level of investment

In equilibrium, even high quality In equilibrium, even high quality entrepreneurs may prefer that there are entrepreneurs may prefer that there are many low quality entrepreneurs aroundmany low quality entrepreneurs around

A quick glance of related A quick glance of related literatureliterature

Financial systems and economic Financial systems and economic developmentdevelopment Allen and Gale (2000)Allen and Gale (2000)

Winner picking effect and allocation Winner picking effect and allocation of capitalof capital Stein (1996)Stein (1996)

The model: FinanciersThe model: Financiers A continuum A continuum II risk neutral financiers risk neutral financiers

Endowed with an initial capital Endowed with an initial capital kk > 0 > 0 Total capital available in the economy (the pool of Total capital available in the economy (the pool of

saving): saving): kIkI A financier either funds an entrepreneur or A financier either funds an entrepreneur or

invests in a risk free technologyinvests in a risk free technologyEntrepreneur

Financier

Information is freely available

Risk free technology

Entrepreneur

Financier

Information is freely availablecost of discovering a distant entrepreneur

The model: The model: EntrepreneursEntrepreneurs

A number of A number of NN risk neutral entrepreneurs risk neutral entrepreneurs No capital endowmentNo capital endowment Type Type HH and and LL based on their productivity based on their productivity Probability of encountering one type of entrepreneur: Probability of encountering one type of entrepreneur:

HH, and , and LL.. Each type has the same mass of close financiersEach type has the same mass of close financiers

Compete Compete a laa la Bertrand to attract capital from Bertrand to attract capital from financiers by offering a return on capital financiers by offering a return on capital investedinvested Equivalent to offer a share of company’s future cash Equivalent to offer a share of company’s future cash

flowsflows They can discriminate across investors depending on They can discriminate across investors depending on

their alternative investment opportunitiestheir alternative investment opportunities Empirical evidence on the allocation of IPOs and Empirical evidence on the allocation of IPOs and

tranching supports this assumptiontranching supports this assumption

The model: The The model: The technologiestechnologies

Entrepreneur’s productivityEntrepreneur’s productivity Constant return to scale technology Constant return to scale technology AAHH, and , and

AALL, the return per unit of capital invested, the return per unit of capital invested AAHH > > AALL..

Risk free technologyRisk free technology Offers a return Offers a return gg(() per unit capital invested) per unit capital invested gg(()/)/ < 0, < 0, gg(()/)/ > 0 > 0 gg(0) > (0) > AAHH

.. Llim g(x)<Ax

Timing of the eventsTiming of the events Time 0Time 0

Financiers choose whether to acquire information Financiers choose whether to acquire information on a distant entrepreneuron a distant entrepreneur

Financiers allocate their capitalFinanciers allocate their capital Financiers who evaluate only the close entrepreneur Financiers who evaluate only the close entrepreneur

decide how to allocate their capital between the decide how to allocate their capital between the close entrepreneur and risk free technologyclose entrepreneur and risk free technology

Financiers who evaluate both the close and distant Financiers who evaluate both the close and distant entrepreneur decide how to allocate their capital entrepreneur decide how to allocate their capital between the two entrepreneurs and risk free between the two entrepreneurs and risk free technologytechnology

Time 1Time 1 Returns are realized and payoffs are distributedReturns are realized and payoffs are distributed

Benchmark case: Benchmark case: Efficient MarketsEfficient Markets

Information is costless: Information is costless: 0 0 Evaluating all entrepreneurs is optimalEvaluating all entrepreneurs is optimal

Any financier can identify all Any financier can identify all HH--entrepreneursentrepreneurs

Only Only HH entrepreneurs are funded for a entrepreneurs are funded for a return return AAHH if if kIkI > > gg-1-1((AAHH).).

Financiers are promised return Financiers are promised return AAHH..

FavoritismFavoritism

Suppose financiers do not invest in Suppose financiers do not invest in information acquisitioninformation acquisition Financiers decide capital allocation Financiers decide capital allocation

between the risk free technology and the between the risk free technology and the close entrepreneur close entrepreneur

Efficient

Increasingly inefficient

Favoritism IIFavoritism II

In comparison to the benchmark caseIn comparison to the benchmark case Financiers face lower return per unit of capital Financiers face lower return per unit of capital

investedinvested Entrepreneurs enjoy a rent per unit of capital Entrepreneurs enjoy a rent per unit of capital

investedinvested All two types of entrepreneurs are (weakly) better All two types of entrepreneurs are (weakly) better

off with favoritismoff with favoritism Payoffs of type Payoffs of type HH entrepreneurs are higher: entrepreneurs are higher: AAHH – – AALL..

IntuitionIntuition Financiers lack alternative investment Financiers lack alternative investment

opportunities and entrepreneurs are able to opportunities and entrepreneurs are able to keep a rentkeep a rent

Costly information Costly information acquisitionacquisition

Assume that acquiring information on a Assume that acquiring information on a distant entrepreneur involves a cost distant entrepreneur involves a cost

When information acquisition is costly, When information acquisition is costly, there are three types of equilibriathere are three types of equilibria Financiers acquire information and fund Financiers acquire information and fund HH

entrepreneurs only (entrepreneurs only (inefficientinefficient marketsmarkets)) Financiers acquire information and fund Financiers acquire information and fund HH

and and L L entrepreneurs (entrepreneurs (“more”“more” inefficient inefficient marketsmarkets))

Financiers choose not to acquire information Financiers choose not to acquire information and fund only the close entrepreneur and fund only the close entrepreneur ((favoritismfavoritism))

When do “markets” When do “markets” thrive?thrive?

Incentives to acquire information are strong Incentives to acquire information are strong enough,enough,

then markets can improve the capital allocation then markets can improve the capital allocation

Good equilibrium:Markets emerge only at late stage of development and the foster economic performance

FavoritismInefficient Markets2nd Best

“Very” InefficientMarkets

Inefficient markets: Inefficient markets: ImplicationsImplications

In comparison to the equilibrium of no In comparison to the equilibrium of no information acquisition, funding only information acquisition, funding only H H entrepreneurs leads toentrepreneurs leads to A (more) efficient capital allocationA (more) efficient capital allocation Higher returns for financiersHigher returns for financiers Lower rents for all entrepreneursLower rents for all entrepreneurs

Entrepreneurs’ welfareEntrepreneurs’ welfare HH entrepreneurs face a trade-off between entrepreneurs face a trade-off between

attracting more capital and preserving their attracting more capital and preserving their rents (offering lower returns to financiers)rents (offering lower returns to financiers)

When do “markets” fail?When do “markets” fail?

If If markets emerge only at late stage of markets emerge only at late stage of

development and fail to significantly development and fail to significantly improve capital allocationimprove capital allocationFavoritism

“Very” Inefficient markets

Do entrepreneurs want Do entrepreneurs want markets to thrive?markets to thrive?

Do H entrepreneurs favor information Do H entrepreneurs favor information acquisition?acquisition? (Tentative) answer depends on kI(Tentative) answer depends on kI

If kI is small, entrepreneurs prefer to enjoy high rents If kI is small, entrepreneurs prefer to enjoy high rents as information acquisition does not allow to expand as information acquisition does not allow to expand investment to a sufficiently large extentinvestment to a sufficiently large extent

For large kI, entrepreneurs may prefer inefficient For large kI, entrepreneurs may prefer inefficient markets to favoritismmarkets to favoritism

Entrepreneurs prefer to have a lot of L Entrepreneurs prefer to have a lot of L entrepreneurs aroundentrepreneurs around As information acquisition is less likely to As information acquisition is less likely to

emerge as an equilibrium outcome.emerge as an equilibrium outcome. (even more tentative…) they enjoy a larger rent (even more tentative…) they enjoy a larger rent

per unit of capital invested if financiers acquire per unit of capital invested if financiers acquire informationinformation

Empirical implicationsEmpirical implications Allocation of capital based on personal Allocation of capital based on personal

connections is efficient at early stages of connections is efficient at early stages of developmentdevelopment

It becomes inefficient as the economy It becomes inefficient as the economy becomes capital rich becomes capital rich Lamoreaux (1996), Khanna and Yafeh (2006)Lamoreaux (1996), Khanna and Yafeh (2006) East Asian economies experience East Asian economies experience

Transparency and investor protection Transparency and investor protection spur information production and improve spur information production and improve capital allocationcapital allocation Morck, Yeung and Yu (2000)Morck, Yeung and Yu (2000)

Empirical implications IIEmpirical implications II

Financiers’ expected return is higher Financiers’ expected return is higher when competition for external funds is when competition for external funds is strongeststrongest IPOs during “hot” markets and undepring IPOs during “hot” markets and undepring

(Lowry and Schwert 2002, Benveniste, (Lowry and Schwert 2002, Benveniste, Ljungqvist, Wilhelm and Yu 2003)Ljungqvist, Wilhelm and Yu 2003)

Financial liberalizations are followed by an Financial liberalizations are followed by an improvement in transparencyimprovement in transparency Increases in kI make more likely that Increases in kI make more likely that

entrepreneurs prefer inefficient markets to entrepreneurs prefer inefficient markets to “very” inefficient markets“very” inefficient markets

Empirical implications Empirical implications IIIIII

Exchanges fail to attract entrepreneurs if Exchanges fail to attract entrepreneurs if listing requirements become too demandinglisting requirements become too demanding

After the Sarbanes-Oxley Act, an increasing number of After the Sarbanes-Oxley Act, an increasing number of foreign firms exit the U.S. security market by foreign firms exit the U.S. security market by deregistering (Marosi and Massoud 2006)deregistering (Marosi and Massoud 2006)

Higher disclosure standards by SEC force firms off the Higher disclosure standards by SEC force firms off the OTC (Bushee and Leuz 2005)OTC (Bushee and Leuz 2005)

London Stock Exchange with lower listing stahdards London Stock Exchange with lower listing stahdards has had success in attracting foreign listings has had success in attracting foreign listings (Economist, 2006)(Economist, 2006)

Consistent with the finding that entrepreneurs’ Consistent with the finding that entrepreneurs’ payoff in the equilibrium with information payoff in the equilibrium with information acquisition decreases in acquisition decreases in HH

ConclusionsConclusions At early stages of development, markets are At early stages of development, markets are

unnecessary for reaching an efficient capital unnecessary for reaching an efficient capital allocationallocation

When the economy accumulates enough capital, When the economy accumulates enough capital, information acquisition on distant investment information acquisition on distant investment opportunities becomes crucial for capital allocationopportunities becomes crucial for capital allocation If information is reliable and cheap, financiers If information is reliable and cheap, financiers

financial markets thrivefinancial markets thrive If information is unreliable and costly, favoritism If information is unreliable and costly, favoritism

may persist or markets may remain “very” may persist or markets may remain “very” inefficient.inefficient.

Entrepreneurs may prefer favoritism and put Entrepreneurs may prefer favoritism and put obstacles to changes that foster information obstacles to changes that foster information acquisition.acquisition.