by Dr Shiqi Chen, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
Unlike what is often assumed in the standard corporate finance literature that firms are often governed by a single representative agent on behalf of the principal, in reality, many corporate decisions are indeed determined by a group of agents or investors, who are heterogeneous in many dimensions (eg beliefs, risk preferences, investment horizons, capital contributions, etc). Group decision making is very prevalent in finance, for example, board meetings, partnerships, team-managed mutual funds, or general management teams within firms. All these mean that ignoring such heterogeneity and interactions within the decision coalition will miss out on an essential ingredient of the corporate decision-making process and lead to inconclusive results.
Existing experimental studies have shown that group behaviour is very different from individual behaviour. The literature offers two competing hypotheses for group decisions. The group shift hypothesis (eg Moscovici and Zavalloni, 1969; Kerr, 1992) suggests that group decisions often shift toward one of the dominant individuals in a team, and this person usually has a prevalence preference. As a result, the team eventually gravitates toward extremes and makes more polarised decisions than its members. The diversification hypothesis (eg Sah and Stiglitz, 1986 and 1988) suggests that the extreme preferences or opinions are averaged out, and teams make less extreme decisions than individual members. Although so far, the diversification hypothesis receives more empirical support (Bär, Kempf and Ruenzi, 2011), it struggles to explain the puzzling observation that the average group is more (less) risk-averse than the average individual in high (low) risk situations (Shupp and Williams, 2008). The working paper by Chen and Lambrecht (2021) reconciles the two hypotheses by examining a private firm’s financial decision from the lenses of group decision making.
Compared to public firms, there are two distinct characteristics of private firms that are currently underexplored. First, the stakes are not traded on a public market, meaning that shares in private firms are highly illiquid, and investors cannot withdraw from the firm easily. Second, unlike public firms that are often run by management and owned by dispersed investors, private firms are often owned and run by a small group of investors, all of which are actively involved in the day-to-day running of the business. Taking into account these two properties, this paper studies a private firm founded and run by a group of investors with heterogeneous capital contributions and risk preferences, who cannot trade their claims on the firm. They group together because one of the investors (the entrepreneur) has a superior investment opportunity but not enough capital, while other co-investors have the required capital but no access to the investment opportunity, which incentivises all the investors to join the firm. However, they have to jointly agree on the firm’s investment, financing and payout decisions, as well as the internal governance structure.
Ideally, each investor prefers policies that maximise their own lifetime utility. Nevertheless, such policies cannot sustain because of the heterogeneity in preferences. This paper shows that the firm’s optimal investment and financing policies are not merely a weighted of the investors’ optimal policies. Interesting, these weights are time-varying, with more weight shifting toward the less (more) risk-averse investors in good (bad) times. This means that the firm will act more aggressively (conservatively) in good (bad) times by taking on more (less) debt and investing more (less) in the risky project. The resultant leverage is procyclical as the firm dynamically rebalances its assets and liabilities in response to income shocks. Even though all investors have constant levels of risk aversion and their compositions within the firm are fixed, the implied coefficient of relative risk aversion for the group is time-varying and spikes (declines) in bad (good) times.
Heterogenous preferences also give rise to a capital structure that consists of safe debt, equity, and preferred equities. The claim for the least risk-averse investor is convex in the firm’s total net worth, similar to an equity contract. The claims for the most risk-averse investor is concave, while for investors with intermediate levels of risk aversion, the claims are S-shaped, resembling preferred equities with different levels of seniority and payout caps. Such a finding helps explain the mixture of contracts adopted in private firms such as venture capitals.
The paper further reveals that the internal governance structure depends not only on the initial capital contribution but also on the heterogeneity in risk preferences and the investors’ outside options. The internal governance weights (which resemble ownership shares) are fixed at the startup. In the equilibrium, a co-investor’s weight shrinks toward zero as her capital contribution vanishes. In contrast, the entrepreneur retains a positive weight even without any capital contribution, reflecting the synergies she generates from her human capital! Meanwhile, the entrepreneurs’ net worth stake in the firm is greater than the capital she contributes. This means the entrepreneur is buying her share at a discount, and the co-investors are paying a premium to access a better investment opportunity.
The paper demonstrates that the dynamics in the firm’s financial policies and the diversity in equity claims resolve the divergence in preferences and compensate for the inability to trade. The paper also highlights the importance to take into account such ‘group’ elements in the analysis of corporate financial behaviour. Indeed, dynamic models of group decision making in corporate finance are very rare (see Garlappi, Giammarino and Lazrak, 2017 and 2021). Nevertheless, we hope that the work we are currently working on can provide some insights into how firms make their decisions and serve as the first step for many more to come.
Bär, M., A. Kempf, and S. Ruenzi (2011) “Is a team different from the sum of its parts? Evidence from mutual fund managers,” Review of Finance, 15(2), 359–396.
Garlappi, L., R. Giammarino, and A. Lazrak (2017) “Ambiguity and the corporation: Group disagreement and underinvestment,” Journal of Financial Economics, 125(3), 417– 433.
Garlappi, L., R. Giammarino, and A. Lazrak (2021) “Group-managed real options,” Review of Financial Studies, forthcoming, hhab100.
Kerr, N. L. (1992) “Group decision making at a multialternative task: Extremity, interfaction distance, pluralities, and issue importance,” Organizational Behavior and Human Decision Processes, 52(1), 64–95.
Moscovici, S., and M. Zavalloni (1969) “The group as a polarizer of attitudes,” Journal of Personality and Social Psychology, 12(2), 125–135.
Sah, R. K., and J. E. Stiglitz (1986) “The architecture of economic systems: Hierarchies and polyarchies,” The American Economic Review, 76(4), 716–727.
Sah, R. K., and J. E. Stiglitz (1988) “Committees, hierarchies and polyarchies,” The Economic Journal, 98(391), 451–470.
Shupp, R. S., and A. W. Williams (2008) “Risk preference differentials of small groups and individuals,” The Economic Journal, 118(525), 258–283.