Adverse Incentives Research Articles

Fund Managers Under Pressure: Rationale and Determinants of Secondary Buyouts

The fastest growing segment of private equity (PE) deals is secondary buyouts (SBOs)—sales from one PE fund to another. Using a comprehensive sample of leveraged buyouts, we investigate whether SBOs are value-maximizing, or reflect opportunistic behavior. To proxy for adverse incentives, we develop buy and sell pressure indexes based on how close PE funds are to the end of their investment period or lifetime, their unused capital, reputation, deal activity, and fundraising frequency. We report that funds under pressure engage more in SBOs. Pressured buyers pay higher multiples, use less leverage, and syndicate less suggesting that their motive is to spend equity. Pressured sellers exit at lower multiples and have shorter holding periods. When pressured counterparties meet, deal multiples depend on differential bargaining power. Moreover, funds that invested under pressure underperform.

Fund Managers Under Pressure: Rationale and Determinants of Secondary Buyouts

The fastest growing segment of private equity deals are secondary buyouts - sales from one PE fund to another. Using a comprehensive sample of leveraged buyouts we investigate whether SBOs are value-maximizing, or reflect opportunistic behavior. To proxy for adverse incentives, we develop buy and sell pressure indexes based on how close PE funds are to the end of their investment period or lifetime, their unused capital, reputation, deal activity, and fundraising frequency. We report that funds under pressure engage more in SBOs. Pressured buyers pay higher multiples, use less leverage, and syndicate less suggesting that their motive is to spend equity. Pressured sellers exit at lower multiples and have shorter holding periods. When pressured counterparties meet, deal multiples depend on differential bargaining power. Moreover, funds that invested under pressure underperform.

Relative Performance Evaluation and Target Setting

It is well known that compensation contracts can improve risk sharing by incorporating information about peer performance ex post, i.e., once the performance of a unit as well as its peers is observed. In this study, we examine whether peer performance is also used ex ante, i.e., when setting performance targets at the beginning of a period. We analyze data on 2008-2010 performance targets from 354 units of a national agency responsible for reintegration of the long-term unemployed into the labor market. We find evidence that a target for a performance measure is strongly positively associated with past peer performance on the same measure as well as past peer performance on a different measure. Thus, performance targets are lower whenever past peer performance is weak on at least one of its dimensions. We also find that the relative weights on different measures of peer performance are proportional to their capacity to filter out common risks. We conclude that using information about past peer performance improves risk sharing and alleviates adverse incentive effects associated with setting targets based on a unit’s own past performance.

Firms’ Commitment to Mitigate the Ratchet Effect under Annual Bonus Plans with Multiple Performance Measures

Prior literature has documented ratcheting targets and a potential adverse incentive problem it may cause, and, as a remedy to the problem, proposed a firm’s commitment to incomplete use of past performance in setting future targets. In this paper, we examine whether a firm makes such a commitment, whether it behaves differently depending on the past target achievement level, the type of a performance measure, and the importance weight. Using a confidential dataset that consists of 1,208 performance-measure-year observations with the complete set of information including targets, actual performance, and importance weights for all performance measures used in the short-term incentive plan, we find that (1) the firm makes a credible commitment; (2) the firm’s target revision behavior, however, varies with the previous target achievement level — rewarding past good performance, eliminating excess good luck, and compensating for excess bad luck; (3) the firm’s behavior also varies with the type of performance measure — making stronger commitments for good financial and common measures while penalizing bad performance in the measures; and (4) contrary to our prediction, importance weights do not affect the firm’s target revision behavior. Overall, generally consistent with prior literature, our study adds empirical evidence with novel findings, making the best use of the unique dataset.

Стимулирование инновационной деятельности российских производственных компаний: новые возможности и ограничения

Иванов Денис Сергеевич - научный сотрудник, Межведомственный аналитический центр (МАЦ). E-mail: ivanov@iacenter.ruКузык Михаил Георгиевич - руководитель направления, МАЦ. E-mail: kuzyk@iacenter.ruСимачев Юрий Вячеславович - заместитель генерального директора, МАЦ. E-mail: simachev@iacenter.ruАдрес: 121069, а/я 35, г. Москва, ул. Поварская, 31/29, стр. 2.Российская инновационная политика в последние годы заметно активизировалась - повышается восприимчивость лиц, принимающих решения, к инновациям, обсуждаются пути их поддержки, развивается инструментальное, институциональное и ресурсное обеспечение. Тем не менее, пока не найдено эффективных рычагов влияния на бизнес, в котором новаторская активность проявляется локально, что не создает предпосылки для изменения общей макроэкономической ситуации. Опираясь на результаты анкетного опроса руководителей 602 российских промышленных предприятий, проведенного осенью 2011 г.,авторыанализируют влияние стимулирующих механизмов на инновационную деятельность бизнеса, оценивают его «запрос» на содержание государственной политики. Выявлен ряд сдерживающих факторов, препятствующих развитию инноваций в российских компаниях, прежде всего - нестабильный деловой климат и внутренняя бюрократизация бизнес-процессов. Для повышения мотивированности значительным потенциалом обладают усиление конкуренции, совершенствование системы госзакупок, ужесточение технических стандартов.Позитивную роль господдержки отметили руководители более половины предприятий-новаторов. Она в большей степени ориентирована на успешных игроков, нежели на аутсайдеров. Максимальным «охватом» характеризуются налоговые льготы. Применяемые инструменты способствуют преимущественно расширению инновационной деятельности, а не ее «старту». Их результативность в значительной степени ограничивается качеством администрирования.Среди важнейших задач - обеспечение стабильности регулирования, создание инвестиционно привлекательной среды, что позволит расширить круг предприятий-новаторов. Эти меры целесообразно сочетать с поддержкой инновационных проектов, ориентированных на демонстрационные эффекты, и относительно молодых фирм, нуждающихся в распределении рисков.Логичен выбор большинства компаний в пользу политики импортозамещения, так как они еще не обладают достаточным потенциалом для экспорта высокотехнологичной продукции. Подобные механизмы не должны ограничивать конкуренцию с зарубежными игроками: в противном случае резко снижается мотивация отечественных производителей к инновациям и ухудшаются условия для технологических заимствований и адаптаций.

The Impact of Introducing Insurance Guaranty Schemes on Pricing and Capital Structure

AbstractThe introduction of an insurance guaranty scheme can have significant influence on the pricing and capital structures in a competitive market. The aim of this article is to study this effect on competitive equity–premium combinations while considering a framework with policyholders and equity holders where guaranty fund charges are volume‐based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyholders and equity holders are analyzed through a one‐period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence, adverse incentives may arise with regard to the overall security level of the industry.

Willingness of farmers to participate in food traceability systems: improving the level of food safety

In order to solve frequently emerging food safety problems and adapt to the developing trends in the international food safety field, the Chinese government is establishing and developing food traceability systems. Whether or not food traceability systems can guarantee food safety is a problem well worth discussing. Hence, we constructed a theoretical model to explore the effect of incentives in a food traceability system in order to improve food safety levels. The following results were obtained: enhancing the effectiveness of a food traceability system, increasing the payment to farmers who supply safe agricultural products and strengthening the penalty for unsafe food supply actions are necessary conditions to improve the level of food safety. How to encourage farmers to use food traceability systems is another problem explored in our investigation. Based on a field survey on the willingness of vegetable growers to participate using a vegetable traceability system in Beijing, the first city in China to develop such a system, we used a descriptive statistics and a binary logistic regression model to investigate the factors which dominate the decision on the part of farmers to participate in a food safety system. The results indicate that i: younger farmers are more likely to get involved in a food traceability system than older farmers, ii: income from non-agricultural activities decreases the willingness of farmers to participate, iii: the higher the cost-benefit ratio of growing vegetables, the more likely for farmers to engage in a food traceability system, iv: farmers with a great concern for food safety information have a high propensity to participate and v: increased penalties against unsafe food supply actions and high-risk expectation are adverse incentives. In contrast, high-price expectation is a positive incentive for farmers to participate, while agricultural training, government subsidies and being part of an industrial organization will significantly strengthen the confidence of farmers to participate in a food safety system.

Unbounded liabilities, capital reserve requirements and the taxpayer put option

When firms access unbounded liability exposures and are granted limited liability, then an all equity firm holds a call option, whereby it receives a free option to put losses back to the taxpayers. We call this option the taxpayer put, where the strike is the negative of the level of reserve capital at stake in the firm. We contribute by (i) valuing this taxpayer put, and (ii) determining the level for reserve capital without a reference to ratings. Reserve capital levels are designed to mitigate the adverse incentives for unnecessary risk introduced by the taxpayer put at the firm level. In our approach, the level of reserve capital is set to make the aggregate risk of the firm externally acceptable, where the specific form of acceptability employed is positive expectation under a concave distortion of the cash flow distribution. It is observed that, in the presence of the taxpayer put, debt holders may not be relied upon to monitor risk as their interests are partially aligned with equity holders by participating in the taxpayer put. Furthermore, the taxpayer put leads to an equity pricing model associated with a market discipline that punishes perceived cash shortfalls.

Private Valuation and Private Information: Can Mandatory Non-Recourse Mortgage Legislation Restore a Missing Market?

Many US states mandate only non-recourse mortgages for dwellings, thus limiting and raising prices. Given the perceived benefit of such mortgages, it is a puzzling fact that no lenders currently offer them in choice states. We simulate a housing market with a spectrum of borrowers with privately-known income distributions, and show that under plausible conditions mandating non-recourse can remedy a market failure due to asymmetric information. Non-recourse loans provide valuable insurance to borrowers by protecting assets in worst-case outcomes involving loss of both equity and income. But markets in these mortgages may be missing due to a combination of adverse selection (inability to screen out high-risk borrowers) and adverse incentives (higher prices incentivize additional walk-aways), leading to a death spiral of rising rates and shrinking pools. Mandating non-recourse loans obligates the lowest risk borrowers to join the pool, which in our model may increase welfare.

Government interventions in banking crises: effects of alternative schemes on bank lending and risk taking

AbstractWe analyse the effects of policy measures to stop the fall in loan supply following a banking crisis. We apply a dynamic framework in which a debt overhang induces banks to curtail lending or choose a fragile capital structure. Government assistance conditional on new banking activities, like on new lending or on debt and equity issues, allow banks to influence the scale of assistance and externalise risks, implying overinvestment or excessive risk taking or both. Assistance without reference to new activities, like granting lump sum transfers or establishing bad banks, does not generate adverse incentives, but may have higher fiscal costs.

Incorporating stakeholder preferences in the selection of technologies for using invasive alien plants as a bio-energy feedstock: Applying the analytical hierarchy process

Invasive alien plants (IAPs) impose significant social costs on the population of the Agulhas Plain region in South Africa due to their adverse impacts on ecosystem goods and services (decreased water supply and increased fire risk). While the cost of clearing IAPs is considerable, this paper assesses opportunities to reduce some of the social and environmental burdens (e.g. disruptions of ecosystems which have negative impacts on livelihoods) by using IAP biomass to produce bio-energy. However, such an initiative could increase financial dependency on these plants and is thus considered to be a major risk factor which could create adverse incentives to illegally grow these plants. A participatory decision-making process with active stakeholder participation is a key element in managing such an initiative. We used a multi-stakeholder engagement process and the analytical hierarchy process to define and weigh suitable criteria for the assessment of different "IAP biomass to bio-energy" technology scenarios on the Agulhas Plain. Feasible scenarios were constructed by means of an expert panel which were then ranked according to stakeholder preference. The six criteria were: minimising impacts on natural resources; job creation; certainty of benefits to local people in the study area; development of skills for life; technology performance and cost efficiency. This ranking was largely determined by the preference for resource efficiency in terms of minimising impacts on natural ecosystems and the localisation of benefits. The smaller, modular technologies were consequently preferred since these realise direct local benefits while developing local skills and capacity in their manufacture, sales and maintenance. The rankings as obtained in this study are context-bound, which implies that the findings only have limited application to areas with similar biophysical and socio-economic characteristics. However, the method itself is fully generalisable, and the same prioritisation process can be followed in any study area to ensure that a participatory decision-making process fulfils local energy needs and contributes to sustainable development.

Globalization of Water: The Case for Global Water Governance?

Although the traditional approach in water resources management is to address water-related scarcity problems at the local or regional scale, some see water as a global resource with global drivers and impacts, supporting the argument for a global governance of water. If water is not appropriately priced, or if “poor water governance“ creates adverse incentives for resource use in countries that export “virtual water,“ then increased demand from the world market may lead to the overexploitation of water or increasing pollution. Is this reason enough for a global governance of regional water-scarcity problems? On which scale should water-management problems actually be addressed, and can global action compensate for local and regional governance failure? The paper argues that compensating globally for regional governance failure could cause “problems of fit“ and present severe downside risks.

Insurance Guaranty Schemes in a Contingent Claims Setting

The introduction of an insurance guaranty scheme can have significant influence on the pricing and capital structures in a competitive market. This contribution summarizes the major findings of a working paper written by Schmeiser and Wagner (Working Papers on Risk Management and Insurance (IVW-HSG), No. 80, 2010). The effect on competitive equity-premium combinations is studied while considering a framework with policyholders and equity holders where guaranty fund charges are volume-based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyholders and equity holders are analyzed through a one-period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence adverse incentives may arise with regard to the overall security level of the industry.

Free Ride, Take It Easy: An Empirical Analysis of Adverse Incentives Caused by Revenue Sharing

A fundamental belief in professional sport leagues is that competitive balance is needed to maximize demand and revenues; therefore, leagues have created policies attempting to attain proper competitive balance. Further, research posits that objectives of professional sport teams’ owners include some combination of winning and profit maximization. Although the pursuit of wins is a zero sum game, revenue generation and potential profit making is not. This article focuses upon the National Football League’s potential unintended consequences of creating the incentive for some teams to free ride on the rest of the league’s talent and brand. It examines whether an owner’s objectives to generate increased revenues and profits are potentially enhanced by operating as a continual low-cost provider while making money from the shared revenues and brand value of the league. The present evidence indicates that, overall, being a low-cost provider is more profitable than increasing player salaries in an attempt to win additional games.

Affirmative action in contest games

This paper analyzes the incentive effects of affirmative action in competitive environments. Competition is between heterogeneous players in a contest game where heterogeneity might be due to past discrimination. Two policy options are analyzed that tackle the underlying asymmetry: either it is ignored and the contestants are treated equally, or affirmative action is implemented to neutralize the disadvantages of discriminated players. Comparing the induced effort exertion under the two policies reveals that in a two-player contest game the normative neutralization objective of affirmative action coincides with higher effort exertion. However, in the multi-player contest affirmative action might have adverse incentive effects as the participation of additional weak players detrimentally affects effort incentives of other players. These results also obtain under imperfect information of the contest organizer.

Is There a Relationship Benefit in Credit Ratings?*

This paper shows that firms with longer rating agency relationships have better credit ratings, conditional on observables. The paper also finds that (1) controlling for observables, firms with longer relationships, while having higher average ratings, do not have lower default rates, (2) relationship benefits are larger among firms with a greater incentive to game their information supplied to agencies or to pressure agencies into giving higher ratings, and (3) investors demand a (price) discount on bonds sold by relationship firms and the correlation between bond yield spreads and ratings is decreasing with relationship length. In sum, the evidence is inconsistent with first-order credit quality explanations but rather supports a ‘‘learning-to-gaming’’ and an ‘‘adverse incentives’’ story.

The Role of Informal Institutions in Building the Institutional Framework of an African State: The Case of the Kanuri in Nigeria

Most institutional economists agree that Africa’s overall poor economic performance is connected with its weak institutions. Among others, institutional research has highlighted the importance of cultural norms and the colonial past. In this context, colonialism presents a “natural experiment” – a phase in which European institutions were imposed on local and predominantly informal institutions. While the persistence of informal institutions have been highlighted among others by Douglass North and Oliver Williamson, case studies investigating their influence on institutional development are rare. This article aims to contribute to filling this gap. It focuses on the institutional development of the Kanuri, a larger ethnic group in north-eastern Nigeria. It uses a theoretical framework of institutional hierarchy to examine the development of key institutions throughout the pre-colonial, colonial and post-colonial period of the Kanuri. The article argues that informal Kanuri institutions have prevailed throughout colonial times and still present powerful norms today. Wherever Kanuri pre-colonial institutions conflict with modern, formal institutions of the Nigerian federal state, they set adverse incentives for economic behavior. Furthermore, the article’s findings shed light on the hitherto neglected role of informal institutions in the institutional development of former African colonies.

Efeito do Programa Bolsa Família sobre a oferta de trabalho das mães

Este artigo investiga a existência de um possível incentivo adverso à oferta de trabalho (participação no mercado e jornada) das mães beneficiadas pelo Programa Bolsa Família. Utiliza-se o procedimento de propensity score matching para encontrar mães não atendidas pelo programa comparáveis às mães atendidas, a partir de três grupos de controle. Os resultados apontam a existência de um efeito-renda associado ao valor do benefício, uma vez que quanto maior a transferência recebida, menor o engajamento da mãe no mercado de trabalho. Entretanto, o efeito líquido de ser beneficiário do programa é positivo, indicando a existência de um efeito-substituição, provavelmente decorrente da redução da oferta de trabalho dos filhos, da maior disponibilidade de tempo das mães para trabalhar ou mesmo do estigma em participar do programa.

Legitimacy, trustee incentives, and board processes: the case of public and private non‐profit nursing homes

Using a unique data set, this study explores how type of ownership (government/private) is related to processes of governance. The findings suggest that the neo-institutional perspective and the self-interest rationale of the agency perspective are helpful in explaining processes of governance in both government- and privately owned non-profit organizations. Due to adverse incentives and the quest for legitimacy, supervising governance bodies within local government-owned non-profit institutions pay relatively less attention to the development of high quality supervising bodies and delegate little to management. Our findings also indicate that governance processes in private institutions are more aligned with the business model and that this alignment is likely driven by a concern to improve decision making. By contrast, our data also suggest that in local government-owned institutions re-election concerns of politicians-trustees are an important force in the governance processes of these institutions. In view of these adverse incentives - in contrast to the case of private organizations - a governance code is unlikely to entail much improvement in government-owned organizations.

Free Ride, Take It Easy: An Empirical Analysis of Adverse Incentives Caused by Revenue Sharing

A fundamental belief in professional sport leagues is that competitive balance is needed to maximize demand and revenues; therefore, leagues have created policies attempting to attain proper competitive balance. Further, research posits that objectives of professional sport teams’ owners include some combination of winning and profit maximization. Although the pursuit of wins is a zero sum game, revenue generation and potential profit making is not. This article focuses upon the National Football League’s potential unintended consequences of creating the incentive for some teams to free ride on the rest of the league’s talent and brand. It examines whether an owner’s objectives to generate increased revenues and profits are potentially enhanced by operating as a continual low-cost provider while making money from the shared revenues and brand value of the league. The present evidence indicates that, overall, being a low-cost provider is more profitable than increasing player salaries in an attempt to win additional games.