My research interests mainly focus on investigating how financial frictions and constraints affect financial policy and real outcomes. My research is mainly in empirical corporate finance, although I also do work in applied corporate finance theory.
Abstract: Financial institutions are financed by both investors and customers. Investors expect an appropriate risk-adjusted return for providing financing and risk bearing. Customers, in contrast, provide financing in exchange for specific services, and want the service fulfillment to be free of the intermediary’s credit risk. We develop a framework that defines the roles of customers and investors in intermediaries, and use it to build an economic theory that has the following main findings. First, with positive net social surplus in the intermediary-customer relationship, the efficient (first best) contract completely insulates the customer from the intermediary’s credit risk, thereby exposing the customer only to the risk inherent in the contract terms. Second, when intermediaries face financing frictions, the second-best contract may expose the customer to some intermediary credit risk, generating “customer contract fulfillment” costs. Third, the efficiency loss associated with these costs in the second best rationalizes government guarantees like deposit insurance even when there is no threat of bank runs. We further discuss the implications of this customer-investor nexus for numerous issues related to the design of contracts between financial intermediaries and their customers, the sharing of risks between them, ex ante efficient institutional design, regulatory practices, and the evolving boundaries between banks and financial markets.
Abstract: Uncertainty surrounding the risk and reward of investments in biopharmaceutical companies poses a challenge to those interested in funding such enterprises. Using data on publicly traded stocks, we track the performance of 1,066 biopharmaceutical companies from 1930 to 2015—the most comprehensive financial analysis of this sector to date. Our systematic exploration of methods for distinguishing biotech and pharmaceutical companies yields a dynamic, more accurate classification method. We find that the performance of the biotech sector is exquisitely sensitive to the presence of a few outlier companies, and confirm that nearly all biotech companies are loss-making enterprises, exhibiting high stock volatility. In contrast, since 2000, pharmaceutical companies have become increasingly profitable, with risk-adjusted returns consistently outperforming the market. The performance of all biopharmaceutical companies is subject not only to factors arising from their drug pipelines (idiosyncratic risk), but also from general economic conditions (systematic risk). The risk associated with returns has profound implications both for patterns of investment and for funding innovation in biomedical R&D.
1) "The Effect of Cash Injections: Evidence from the 1980s Farm Debt Crisis" (with Nittai Bergman and Rajkamal Iyer). NBER Working Paper No. 23546. Revise and resubmit, The Review of Financial Studies
Abstract: What is the effect of cash injections during financial crises? Exploiting county-level variation arising from random weather shocks during the 1980s Farm Debt Crisis, we analyze and measure the effect of local cash flow shocks on the real and financial sector. We show that such cash flow shocks have significant impact on a host of economic outcomes, including land values, loan delinquency rates, and the probability of bank failure. Further, we measure how cash injections affect local labor markets, analyzing the impact on employment and wages both within and outside of the sector receiving a positive cash flow shock. Estimates of the effect of local cash flow shocks on county income levels during the financial crisis yield a multiplier of 1.63.
2) "Liquidity Windfalls and Reallocation: Evidence from Farming and Fracking"
Abstract: Financing frictions may create a misallocation of assets in a market, thus depressing output, productivity, and asset values. This paper empirically explores how liquidity shocks generate a reallocation effect that diminishes this misallocation. Using a unique dataset of agricultural outcomes, I explore how farmers respond to a relaxation of financial constraints through a liquidity shock unrelated to farming fundamentals, namely exogenous cash inflows caused by an expansion of hydraulic fracturing (fracking) leases. Farmers who receive positive cash flow shocks increase their land purchases, which results in a reallocation effect. Examining cross-county purchases, I find that farmers in high-productivity counties who receive cash flow shocks buy farmland in low-productivity counties. In contrast, farmers in low-productivity counties who receive positive cash flow shocks do not engage in similar behavior. Moreover, farmers increase their purchases of vacant (undeveloped) land. Average output, productivity, equipment investment, and profits all increase substantially following these positive cash flow shocks. Farmland prices also rise significantly, consistent with a cash-in-the-market pricing effect. These effects are consistent with an efficient reallocation of land towards more productive users.
Abstract: We develop a theory of optimal financing for R&D-intensive firms that uses their unique features—large capital outlays, long gestation periods, high upside, and low probabilities of R&D success—that explains three prominent stylized facts about these firms: their relatively low use of debt, large cash balances, and underinvestment in R&D. The model relies on the interaction of the unique features of R&D-intensive firms with three key frictions: adverse selection about R&D viability, asymmetric information about the upside potential of R&D, and moral hazard from risk shifting. We establish the optimal pecking order of securities with direct market financing. Using a tradeoff between tax benefits and the costs of risk shifting for debt, we establish conditions under which the firm uses an all-equity capital structure and firms raise enough financing to carry excess cash. A firm may use a limited amount of debt if it has pledgeable assets in place. However, market financing still leaves potentially valuable R&D investments unfunded. We then use a mechanism design approach to explore the potential of intermediated financing, with a binding precommitment by firm insiders to make costly ex post payouts. A mechanism consisting of put options can be used in combination with equity to eliminate underinvestment in R&D relative to the direct market financing outcome. This optimal intermediary-assisted mechanism consists of bilateral “insurance” contracts, with investors offering firms insurance against R&D failure and firms offering investors insurance against very high R&D payoffs not being realized.
Abstract: The high cost of capital for firms conducting medical research and development (R&D) has been partly attributed to the government risk facing investors in medical innovation. This risk slows down medical innovation because investors must be compensated for it. We propose new and simple financial instruments, Food and Drug Administration (FDA) hedges, to allow medical R&D investors to better share the pipeline risk associated with FDA approval with broader capital markets. Using historical FDA approval data, we discuss the pricing of FDA hedges and mechanisms under which they can be traded and estimate issuer returns from offering them. Using various unique data sources, we find that FDA approval risk has a low correlation across drug classes as well as with other assets and the overall market. We argue that this zero-beta property of scientific FDA risk could be a main source of gains from trade between issuers of FDA hedges looking for diversified investments and developers looking to offload the FDA approval risk. We offer proof of concept of the feasibility of trading this type of pipeline risk by examining related securities issued around mergers and acquisitions activity in the drug industry. Overall, our argument is that, by allowing better risk sharing between those investing in medical innovation and capital markets more generally, FDA hedges could ultimately spur medical innovation and improve the health of patients.
8) Find and Replace: R&D Investment Following Public Health Advisories (with Joshua L. Krieger and Xuelin Li)
Published Non-Academic Articles
1) "Clarifying the Roles of Customers and Investors in Financial Institutions” (with Robert C. Merton). See Far Executive Summaries, Spring 2018. The Wells Fargo Advisors Center for Finance and Accounting Research, Washington University in St. Louis, Olin School of Business.
2) "A Theory of Efficient Short-termism". Harvard Law School Forum on Corporate Governance and Financial Regulation, September 17, 2016.
3) "A Framework for Understanding Financial Institutions" (with Robert C. Merton). Harvard Law School Forum on Corporate Governance and Financial Regulation, August 11, 2015.
4) "Customers and investors: A framework for financial institutions" (with Robert C. Merton). VoxEU: CEPR's Policy Portal, August 1, 2015.
5) "Competition and R&D: Evidence from biopharma" (with Andrew W. Lo). VoxEU: CEPR's Policy Portal, March 24, 2015.