Endogeneity in Corporate Governance Studies

1
Endogeneity in Corporate Governance Studies

• Bhagat-Jefferis (2002)
• An econometric model for investigating, say, the
  impact of takeover defense on takeover activity
  has the following structure
• Separation f1 (Governance, Ownership,
  Performance, Z1, e1)
• Governance f2 (Ownership, Performance, Z2, e2)
• Ownership f3 (Governance, Performance, Z3, e3)
• Performance f4 (Governance, Ownership, Z4, e4)
• Separation takeover, management turnover
• Governance takeover defense, corporate board
  structure, board and management compensation
  structures
• Ownership equity ownership, capital structure

2
Endogeneity in Corporate Governance Studies

• Bhagat-Jefferis (2002)
• Identification requires some combination of
  exclusion restrictions, assumptions about the
  joint distribution of the error terms, and
  restrictions on the functional form of the fi.
• Maddala (1983) discusses restrictions that
  identify the model when the ?i are normally
  distributed.
• Identification in single equation semiparametric
  index models, where the functional form of f1 is
  unknown and the explanatory variables in that
  equation are continuous, known functions of a
  basic parameter vector is discussed by Ichimura
  and Lee (1991).
• Estimation of a system of the form (1)-(4) in the
  absence of strong restrictions on both the fi and
  the joint distribution of error terms is, to the
  best of our knowledge, an unsolved problem.

3
Endogeneity in Corporate Governance Studies

• Bhagat-Jefferis (2002)
• We are unaware of a model of takeover defense
  that implies specific functional forms for the
  fi. If these functions are linear,
  identification may be attained through either
  strong distributional assumptions or exclusion
  restrictions. Maddala (1983) and Amemiya (1985)
  discuss restrictions on the ?i that identify the
  model in the absence of exclusion restrictions.
  But these restrictions are inconsistent with
  incentive-based explanations of takeover defense,
  since unobservable characteristics of managerial
  behavior or type will be reflected in all of the
  ?i. Using panel data and firm-fixed effects it
  would be possible to control for unobservable
  characteristics of managerial behavior or type
  however, a system such as in (1)-(4) would have
  to be specified and estimated. Aside from the
  non-trivial data collection effort required to
  estimate such a system, this system would not be
  identified when Z2 Z3 Z4. Exclusion
  restrictions are therefore the most likely path
  to identification.

4
Endogeneity in Corporate Governance Studies

• Corporate Ownership and Performance
• Diffused share ownership
• Costs Manager-shareholder agency costs
  (separation of ownership and control)
• Benefits Better risk-bearing
• If the costs of diffused share ownership
  dominate
• Greater management ownership should lead to
  better corporate performance.
• However, corporate performance can also have an
  impact on management ownership! Why?
• Management compensation plans Superior corporate
  performance leads to an increase in the value of
  stock options owned by management which, if
  exercised, would increase their share ownership.
• Insider information If there are significant
  divergences between insider expectations and
  market expectations of future firm performance,
  then insiders have an incentive to adjust their
  ownership in relation to the expected future
  performance. Insider trading is legal subsequent
  to earnings/corporate announcements and with
  appropriate disclosure.

5
Endogeneity in Corporate Governance Studies

• Corporate Ownership and Performance
• What determines the firms ownership structure?
  Ownership may be endogenously determined by the
  firms contracting/investment environment. If the
  scope for perquisite consumption is low in a
  firm, then a low level of management ownership
  may be the optimal incentive contract. For firms
  with significant growth opportunities, greater
  management ownership may be appropriate.
• Ownership has an impact on corporate performance.
  Also, corporate performance has an impact on
  management ownership.
• Ownership f3 (Governance, Performance)
• Performance f4 (Governance, Ownership)

6
Endogeneity in Corporate Governance Studies

• Measurement of Corporate Performance
• Market-based measures of performance.
• Industry- and size-adjusted stock returns.
• Anticipation problem.
• Tobins Q (Current market value of the
  company/Replacement cost)
• Denominator does not reflect cost of intangible
  assets.
• Numerator includes value of market power.
• Accounting-based measures of performance.
• Return on invested capital. Return on sales.
• Avoids anticipation problem.
• Avoids anticipation problem no credit given for
  future sales/growth opportunities.
• Some managerial discretion.