A Neoclassical Model of Managed Distribution Plans: Theory and Evidence

Abstract

Jensen (1986) identifies the need to motivate managers to distribute funds that earn a ‘below-market’ rate of return as a major problem in corporate finance. Equity closed-end funds (CEFs) provide an example of how capital markets perform this function. CEFs exist to provide investors with portfolio services that investors cannot easily obtain on their own (e.g., liquidity or superior stock picking ability). When a fund does not convincingly provide these services, it trades at a discount to its net asset value (NAV) because managerial compensation is larger than managerial contribution. A Managed Distribution Plan (MDP), where investments might be partially liquidated to increase investors’ cash flows, lowers the value of the manager’s claim on the assets of the fund. This is a direct transfer of wealth from the manager to the shareholders a la Jensen, and will be adopted by managers who fear an eventual liquidation of the fund via a proxy vote. We model the threat of such liquidation through the intermediation of an activist shareholder. Among other things, our model predicts that MDPs are more likely to be adopted by funds that appear to be less effective in providing portfolio services to their investors and that are relatively easy to liquidate or ‘attack’. We test the model on a panel of 236 CEFs and find good agreement with our model.