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 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) 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) 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) 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 Favoritism Financiers do not investigate new investment opportunities and fund only entrepreneurs they are familiar with Financiers do not investigate new investment opportunities and fund only entrepreneurs they are familiar with Inefficiencies may arise if entrepreneurs differ in productivity 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”: “Markets”: Financiers acquire information, identify distant investment opportunities, and possibly fund distant investment opportunities 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  cost of discovering a distant entrepreneur

5. Research questions When does favoritism (or markets) emerge as an equilibrium out come? When does favoritism (or markets) emerge as an equilibrium out come? When does favoritism lead to an efficient allocation of capital? 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 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 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 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 Markets become crucial for achieving an efficient allocation of capital as the economy’s saving increases Favoritism can still be an equilibrium outcome Favoritism can still be an equilibrium outcome Market remain imperfect in equilibrium Market remain imperfect in equilibrium if it is difficult to identify the highest quality entrepreneurs, low productivity entrepreneurs are funded 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? Why do not markets triumph? Entrepreneurs may have no incentive to spur institutional changes that leads to a more efficient allocation of capital 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 They have to pay higher returns to external financiers Trade-off between rents per unit of capital invested and level of investment 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 In equilibrium, even high quality entrepreneurs may prefer that there are many low quality entrepreneurs around

8. Outline A brief literature review A brief literature review The model The model The agents – financiers and entrepreneurs The agents – financiers and entrepreneurs The technologies The technologies The timing of the events The timing of the events Results Results Benchmark: costless information Benchmark: costless information Information asymmetry Information asymmetry Empirical implications Empirical implications Conclusion Conclusion

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

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

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

12. The model: The technologies Entrepreneur’s productivity Entrepreneur’s productivity Constant return to scale technology A H, and A L, the return per unit of capital invested Constant return to scale technology A H, and A L, the return per unit of capital invested A H > A L. A H > A L. Risk free technology Risk free technology Offers a return g(  ) per unit capital invested Offers a return g(  ) per unit capital invested  g(  )/  0  g(  )/  0 g(0) > A H g(0) > A H.

13. Timing of the events Time 0 Time 0 Financiers choose whether to acquire information on a distant entrepreneur Financiers choose whether to acquire information on a distant entrepreneur Financiers allocate their capital 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 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 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 Time 1 Returns are realized and payoffs are distributed Returns are realized and payoffs are distributed

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

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

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

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

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

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

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

21. Do entrepreneurs want markets to thrive? Do H entrepreneurs favor information acquisition? Do H entrepreneurs favor information acquisition? (Tentative) answer depends on kI (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 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 For large kI, entrepreneurs may prefer inefficient markets to favoritism Entrepreneurs prefer to have a lot of L entrepreneurs around Entrepreneurs prefer to have a lot of L entrepreneurs around As information acquisition is less likely to emerge as an equilibrium outcome. 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 (even more tentative…) they enjoy a larger rent per unit of capital invested if financiers acquire information

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

23. Empirical implications II Financiers’ expected return is higher when competition for external funds is strongest 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) 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 Financial liberalizations are followed by an improvement in transparency Increases in kI make more likely that entrepreneurs prefer inefficient markets to “very” inefficient markets Increases in kI make more likely that entrepreneurs prefer inefficient markets to “very” inefficient markets

24. Empirical implications III Exchanges fail to attract entrepreneurs if listing requirements become too demanding 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) 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) 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) 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 Consistent with the finding that entrepreneurs’ payoff in the equilibrium with information acquisition decreases in  H

25. Conclusions At early stages of development, markets are unnecessary for reaching an efficient capital allocation 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 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 reliable and cheap, financiers financial markets thrive If information is unreliable and costly, favoritism may persist or markets may remain “very” inefficient. 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. Entrepreneurs may prefer favoritism and put obstacles to changes that foster information acquisition.