Favoritism or Markets in Capital Allocation?

1. Favoritism or Markets in Capital Allocation? Mariassunta Giannetti Stockholm School of Economics, CEPR and ECGI Xiaoyun Yu Indiana University

2. Background • Capital allocation is often driven by favoritism rather than by markets and information about future expected returns • Financial intermediaries convey funds to their cronies (La Porta, Lopez-de-Silanes and Zamarripa 2003) • Entrepreneurs reinvest funds in their business (Khanna and Yafeh 2006) • Firms do not to list on exchange but raise capital from family and friends (Pagano, Panetta and Zingales 1998)

3. Two regimes for capital allocation • Favoritism • Financiers do not investigate new investment opportunities and fund only entrepreneurs they are familiar with • Inefficiencies may arise if entrepreneurs differ in productivity Entrepreneur Financier Information is freely available Risk free technology Entrepreneur Financier Information is freely available

4. Two regimes for capital allocation II • “Markets”: • Financiers acquire information, identify distant investment opportunities, and possibly fund distant investment opportunities Entrepreneur Financier Information is freely available Risk free technology Entrepreneur Financier Information is freely available t cost of discovering a distant entrepreneur

5. Research questions • When does favoritism (or markets) emerge as an equilibrium out come? • When does favoritism lead to an efficient allocation of capital?

6. Preview of results • Favoritism is an equilibrium outcome if saving is low and/or if information is unreliable and costly • Financiers’ incentive to investigate distant investment opportunities depend on the quality and reliability of information • Favoritism can achieve an efficient allocation when domestic saving is low • Markets become crucial for achieving an efficient allocation of capital as the economy’s saving increases • Favoritism can still be an equilibrium outcome • Market remain imperfect in equilibrium • if it is difficult to identify the highest quality entrepreneurs, low productivity entrepreneurs are funded

7. Preview of results II • Why do not markets triumph? • Entrepreneurs may have no incentive to spur institutional changes that leads to a more efficient allocation of capital • They have to pay higher returns to external financiers • Trade-off between rents per unit of capital invested and level of investment • In equilibrium, even high quality entrepreneurs may prefer that there are many low quality entrepreneurs around

8. A quick glance of related literature • Financial systems and economic development • Allen and Gale (2000) • Winner picking effect and allocation of capital • Stein (1996)

9. The model: Financiers • A continuum I risk neutral financiers • Endowed with an initial capital k > 0 • Total capital available in the economy (the pool of saving): kI • A financier either funds an entrepreneur or invests in a risk free technology Entrepreneur Financier Information is freely available Entrepreneur Financier Information is freely available Risk free technology t cost of discovering a distant entrepreneur

10. The model: Entrepreneurs • A number of N risk neutral entrepreneurs • No capital endowment • Type H and L based on their productivity • Probability of encountering one type of entrepreneur: H, and L. • Each type has the same mass of close financiers • Compete a la Bertrand to attract capital from financiers by offering a return on capital invested • Equivalent to offer a share of company’s future cash flows • They can discriminate across investors depending on their alternative investment opportunities • Empirical evidence on the allocation of IPOs and tranching supports this assumption

11. The model: The technologies • Entrepreneur’s productivity • Constant return to scale technology AH, and AL, the return per unit of capital invested • AH > AL. • Risk free technology • Offers a return g() per unit capital invested • g()/ < 0, g()/ > 0 • g(0) > AH • .

12. Timing of the events • Time 0 • Financiers choose whether to acquire information on a distant entrepreneur • Financiers allocate their capital • Financiers who evaluate only the close entrepreneur decide how to allocate their capital between the close entrepreneur and risk free technology • Financiers who evaluate both the close and distant entrepreneur decide how to allocate their capital between the two entrepreneurs and risk free technology • Time 1 • Returns are realized and payoffs are distributed

13. Benchmark case: Efficient Markets • Information is costless:   0 • Evaluating all entrepreneurs is optimal • Any financier can identify all H-entrepreneurs • Only H entrepreneurs are funded for a return AHif kI > g-1(AH). • Financiers are promised return AH.

14. Favoritism • Suppose financiers do not invest in information acquisition • Financiers decide capital allocation between the risk free technology and the close entrepreneur Efficient Increasingly inefficient

15. Favoritism II • In comparison to the benchmark case • Financiers face lower return per unit of capital invested • Entrepreneurs enjoy a rent per unit of capital invested • All two types of entrepreneurs are (weakly) better off with favoritism • Payoffs of type H entrepreneurs are higher: AH–AL. • Intuition • Financiers lack alternative investment opportunities and entrepreneurs are able to keep a rent

16. Costly information acquisition • Assume that acquiring information on a distant entrepreneur involves a cost  • When information acquisition is costly, there are three types of equilibria • Financiers acquire information and fund H entrepreneurs only (inefficientmarkets) • Financiers acquire information and fund H and L entrepreneurs (“more”inefficient markets) • Financiers choose not to acquire information and fund only the close entrepreneur (favoritism)

17. When do “markets” thrive? • Incentives to acquire information are strong enough, • then markets can improve the capital allocation Good equilibrium: Markets emerge only at late stage of development and the foster economic performance Inefficient Markets 2nd Best Favoritism “Very” Inefficient Markets

18. Inefficient markets: Implications • In comparison to the equilibrium of no information acquisition, funding only H entrepreneurs leads to • A (more) efficient capital allocation • Higher returns for financiers • Lower rents for all entrepreneurs • Entrepreneurs’ welfare • H entrepreneurs face a trade-off between attracting more capital and preserving their rents (offering lower returns to financiers)

19. When do “markets” fail? • If • markets emerge only at late stage of development and fail to significantly improve capital allocation “Very” Inefficient markets Favoritism

20. Do entrepreneurs want markets to thrive? • Do H entrepreneurs favor information acquisition? • (Tentative) answer depends on kI • If kI is small, entrepreneurs prefer to enjoy high rents as information acquisition does not allow to expand investment to a sufficiently large extent • For large kI, entrepreneurs may prefer inefficient markets to favoritism • Entrepreneurs prefer to have a lot of L entrepreneurs around • As information acquisition is less likely to emerge as an equilibrium outcome. • (even more tentative…) they enjoy a larger rent per unit of capital invested if financiers acquire information

21. Empirical implications • Allocation of capital based on personal connections is efficient at early stages of development • It becomes inefficient as the economy becomes capital rich • Lamoreaux (1996), Khanna and Yafeh (2006) • East Asian economies experience • Transparency and investor protection spur information production and improve capital allocation • Morck, Yeung and Yu (2000)

22. Empirical implications II • Financiers’ expected return is higher when competition for external funds is strongest • IPOs during “hot” markets and undepring (Lowry and Schwert 2002, Benveniste, Ljungqvist, Wilhelm and Yu 2003) • Financial liberalizations are followed by an improvement in transparency • Increases in kI make more likely that entrepreneurs prefer inefficient markets to “very” inefficient markets

23. Empirical implications III • Exchanges fail to attract entrepreneurs if listing requirements become too demanding • After the Sarbanes-Oxley Act, an increasing number of foreign firms exit the U.S. security market by deregistering (Marosi and Massoud 2006) • Higher disclosure standards by SEC force firms off the OTC (Bushee and Leuz 2005) • London Stock Exchange with lower listing stahdards has had success in attracting foreign listings (Economist, 2006) • Consistent with the finding that entrepreneurs’ payoff in the equilibrium with information acquisition decreases in H

24. Conclusions • At early stages of development, markets are unnecessary for reaching an efficient capital allocation • When the economy accumulates enough capital, information acquisition on distant investment opportunities becomes crucial for capital allocation • If information is reliable and cheap, financiers financial markets thrive • If information is unreliable and costly, favoritism may persist or markets may remain “very” inefficient. • Entrepreneurs may prefer favoritism and put obstacles to changes that foster information acquisition.