Standing out from the Crowd: The Outlier's Effect on Corporate Governance (with Qianqian Du and Frank Yu)
This paper examines the real effects of outliers’ opinions in the context of extreme analyst optimism and corporate governance. Using earnings forecasts issued by sell-side analysts between 1991 and 2011, we construct a proxy to capture two essential traits of an outlier’s opinion—being markedly distinct from the others and coming from an individual instead of a cohort of agents. We show that when an analyst issues extremely optimistic forecasts that drastically deviate from peer consensus, there is a greater tendency on the part of firms to manage earnings. The arrival of an outlier forecast gives rise to the optimism of peer analysts and generates stronger reactions from investors. Further analyses suggest that private information and conflict of interest are less likely to explain the effect of extreme analyst optimism on earnings management; instead, an analyst’s self-motivated incentives are at play.
Unleashing Innovation (with Yifei Mao and Xuan Tian)
Using a sample of venture capital (VC)-backed initial public offering (IPO) firms, we study the effect of financial intermediaries’ tight leash on entrepreneurs’ innovation productivity. We find that financial intermediaries’ tight leash impedes innovation: IPO firms are significantly less innovative when VCs interfere with their development more frequently through staging—as measured by a larger number of VC financing rounds. To establish causality, we exploit plausibly exogenous variation in the frequency of direct flights between VC domiciles and IPO firm headquarters that are due to airline restructuring. Our identification tests suggest a negative, causal effect of VC staging on firm innovation. Furthermore, staging is more detrimental to innovation when innovation is more difficult to achieve and when VCs are less experienced with the industry in which their entrepreneurial firms operate. By documenting a previously under-recognized adverse consequence of VC stage financing, our evidence suggests that contract mechanisms are at play so that short-termist incentives can be cultivated even in a private equity market populated with long-term, sophisticated investors.
Cultural Proximity and the Processing of Financial Information (with Qianqian Du and Frank Yu)
This paper examines how a shared cultural background between analysts and firms under coverage affects information asymmetry in financial markets. To disentangle cultural proximity from geographic proximity, we extract a sample of firms publicly traded in the U.S. but headquartered in regions sharing Chinese culture (“Chinese firms”), and identify a group of U.S. analysts of Chinese ethnic origin. We find that analysts of Chinese ethnicity issue more accurate forecasts about earnings of Chinese firms. The rise in forecast precision is more pronounced among first-generation Chinese immigrants. Market reaction is stronger if analysts of Chinese ethnicity revise their forecasts upwards or issue favorable recommendations about a Chinese firm. Our results indicate that cultural proximity mitigates information asymmetry that adversely affects foreign firms, especially those from emerging markets.
Disciplining Delegated Monitors: When Venture Capitalists Fail to Prevent Fraud by Their IPO Firms (with Xuan Tian and Greg Udell)
Information-based theories of financial intermediation focus on delegated monitoring. However, there is little evidence on how markets discipline financial intermediaries who fail at this function. This paper exploits the direct link between corporate fraud and monitoring failure and examines how a venture capital (VC) firm’s reputation is affected when it fails to prevent fraud in its portfolio companies. We find that VCs who fail to prevent fraud experience greater difficulty in taking future portfolio companies public, and that the negative effect prevails over ten years after the fraud surfaces. In addition, reputation-damaged VCs interact differently in the future with their limited partners, other VCs in the community, and initial public offering (IPO) underwriters because they are perceived by these groups as inefficient monitors.
The "Real" Value of Conflicted Analyst Coverage (with Stacey Jacobsen and Irina Stefanescu)
Existing literature examines how analysts’ conflicts of interest affect investors. Empirically, however, it has been challenging to isolate the impact of analysts’ conflicts of interest, and there is less evidence on how such conflicts affect the firms under coverage. In this paper we develop a novel approach to identify a sample of firms whose coverage is likely driven exclusively by analysts’ private incentives to generate investment banking revenue. We find that the loss of conflicted analyst coverage has little adverse effect on information efficiency, capital investment, cost of capital, and equity issuance. Since conflicted research provides no real benefit to the firm under coverage, our results suggest that firms attain little benefit when offering investment banking business in exchange for analyst coverage.
Ownership Structure, Liquidity, and Investment Efficiencies
By altering the fraction of shares held by shareholders with significant liquidity needs, a firm's ownership structure affects the degree of informed trading in the firm's stock. Extensive informed trading in the firm's shares increases the losses of shareholders who are subject to liquidity shocks, but it improves the information present in share prices, which in turn may improve the firm's investment decisions. Unless shareholders' liquidity shocks are especially severe, a firm with few growth opportunities may favor a structure that places more shares in the hands of a large shareholder that trades infrequently, whereas a firm with significant growth opportunities will prefer a more diffuse ownership structure that favors increased liquidity trading. When small investors' liquidity shocks are especially severe, this result is reversed. If the large shareholder also has access to information about the firm's growth opportunities, it may be optimal to have the large shareholder hold shares with trading restrictions so as to prevent other informed traders from being crowded out.
In this paper we examine how board structure affects the informativeness of board members by comparing the returns earned by officers and independent directors from purchasing the firm’s stock. We investigate whether an exogenous shock to the board structure – the 2002 Sarbanes-Oxley Act and the related mandates – leads to a shift in information asymmetry between officers and independent directors. We find that improvement in board’s information environment is limited to firms whose boards are previously controlled by outsiders. In contrast, information asymmetry rises among firms whose boards are previously dominated by insiders: An increase in independent directors is followed by a significantly larger difference in buy-and-hold returns between officers and independent directors. In addition, the deterioration in board’s information environment is associated with a poor firm operating performance.
Does Money Follow the Flag? (with Nandini Gupta)
We examine whether bilateral political relations can explain investment and trade flows between the United States and other countries. We treat political relations as endogenous using instrumental variable analysis and investigate whether an exogenous shock to political relations, the 2003 war in Iraq, leads to a shift in economic flows. The results suggest that a deterioration in bilateral relations is followed by a significant decrease in economic flows between the United States and that country. These results are robust to country fixed effects, income, industry growth, financial market development, and risk.
Business Cycles, Firm Size and Market Reaction to News (with Yiming Qian)
We study whether market reactions to earnings news vary over the business cycle. Using a sample of quarterly earnings reports from 1984 through 2003, we find market reactions to earnings news differ between periods of expansion and contraction. The difference depends on firm size - market reactions to small firms' earnings news are stronger during expansions than during contractions, but market reactions to large firms' earnings news are weaker during expansions than during contractions. Further analysis shows that the result is mainly driven by bad earnings news. Our findings cannot be explained by the distinction between value and growth stocks, the entry and exit of new firms in the economy, earnings management, pre-announcements, time-varying earnings persistence, or time-varying investor attention.