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: 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 that is unrelated to farming fundamentals, namely exogenous cash inflows that are caused by an expansion of hydraulic fracturing (fracking) leases. Farmers who receive positive cash flow shocks increase their purchases of land, 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, when farmers in low-productivity counties receive positive cash flow shocks, they do not engage in similar behavior. Moreover, farmers increase their purchases of vacant (undeveloped) land. Average output, productivity, and profits all increase following these positive cash flow shocks, and farmland prices rise significantly. These effects are consistent with an efficient reallocation of land towards more productive users.
Abstract: This paper develops a theory in which the shareholders pursue short-termism in project choice to limit managerial rent-seeking behavior. Unlike in previous theories, a short-term bias in investment horizons maximizes firm value in the second-best case, whereas managers themselves prefer long-horizon projects. Short-termism benefits the firm because it limits managerial rent extraction by preventing investments in long-term bad projects that produce managerial private benefits but delay information revelation about project quality and managerial ability, thereby obstructing more efficient subsequent decisions. This result does not depend on any stock mispricing or managerial desire to manipulate stock prices. The likelihood of short-termism is higher when corporate governance is stronger, and at lower levels of the corporate hierarchy, and it may affect maturity transformation in banks. Numerous testable predictions of the analysis are discussed.
3) "The Effect of Cash Injections: Evidence from the 1980s Farm Debt Crisis" (with Nittai Bergman and Rajkamal Iyer). NBER Working Paper No. 23546
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.
4) "Competition and R&D Financing Decisions: Evidence from the Biopharmaceutical Industry" (with Andrew W. Lo). NBER Working Paper No. 20903
Abstract: How does competition affect innovation and how it is financed in R&D-intensive firms? We study the interaction between competition, R&D investments, and the financing choices of such firms using data on biopharmaceutical firms. Motivated by existing theories, we develop empirical hypotheses. The key predictions are that, as competition increases, R&D-intensive firms will: (1) increase R&D investment relative to investment in assets-in-place that support existing products; (2) carry more cash and maintain less net debt; and (3) experience declining betas but greater total stock return volatility due to higher idiosyncratic risk. We first establish stylized facts using time-series evidence that are consistent with these predictions. In order to deal with the endogeneity issue introduced by the fact that a firm's R&D investments and the product-market competition it faces influence each other, we then provide further evidence through a differences-in-differences analysis.
5) "Financial Risk and Return in the Biotech and Pharmaceutical Industries from 1930 to 2015" (with Nicholas Anaya, Yuwei Zhang, Christian Vilanilam, and Andrew W. Lo). (Note: Due to journal restrictions, manuscript cannot be posted online. Draft is available upon request.)
Abstract: Uncertainty surrounding the risk and reward of financial investments in biotechnology and pharmaceutical companies poses substantial challenges to funding biomedical R&D. To address this uncertainty, we document the financial risks and returns of publicly traded stocks of biopharma companies using data from January 1930 to December 2015. While the healthcare sector has yielded attractive risk-adjusted returns on average, there is considerable variation in both risk and return over time. Contrary to the popular misconception that drug companies generate exorbitant profits with little risk, the empirical evidence shows substantial risks in both biotech and pharma companies, with extended periods of industry-wide underperformance. Biopharma companies also exhibit substantial systematic risk—risk that cannot be eliminated through diversification—which is greater on average for biotech companies, implying lower investment in such assets for a given level of expected return. We describe methods for reducing such risks and increasing the capital efficiency of biopharma investments.
Abstract: We develop a theory of optimal financing of R&D-intensive firms that uses their unique features—large capital outlays, long gestation periods, high upside, and low probabilities of R&D success—to explain three prominent stylized facts about these firms: their relatively low use of debt, large cash balances, and underinvestment in R&D. This model relies on three key frictions: adverse selection, upside uncertainty, and moral hazard from risk shifting. We establish the optimal pecking order of securities with direct market financing. Using the familiar debt tradeoff between tax benefits and the costs of risk shifting, as well as a novel risk-shifting technology, we establish the 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. We show that a mechanism consisting of put options can be used in combination with equity to eliminate underinvestment in R&D and improve welfare 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.
7) "Customers and Investors: A Framework for Understanding Financial Institutions" (with Robert C. Merton). NBER Working Paper No. 21258
Abstract: Financial institutions are financed by both investors and customers. Investors, such as shareholders and bondholders or private/public-sector guarantors of institutions, expect an appropriate risk-adjusted return in exchange for providing financing and risk bearing. Customers, in contrast, provide financing in exchange for specific services, and want the fulfillment of these services to be free of the intermediary’s credit risk, even when these customers are not small, uninformed agents lacking in sophistication. This paper develops a framework that defines the roles of customers and investors in intermediaries, and uses the framework to develop a theory that provides an economic foundation for the aversion of customers to intermediary credit risk. We have the following main results. First, with positive net social surplus in the bank-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, we provide a formal analysis of insurance contracting as a specific illustration of our theory. Fourth, we propose that 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 a host of issues related to how contracts between financial intermediaries and their customers are structured and how risks are shared between them, ex ante efficient institutional design, and regulatory practices.
8) "Sharing R&D Risk in Healthcare via FDA Hedges" (with Adam Jorring, Andrew W. Lo, Tomas J. Philipson, and Manita Singh). NBER Working Paper No. 23344
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.
Published Non-Academic Articles
1) "A Theory of Efficient Short-termism". Harvard Law School Forum on Corporate Governance and Financial Regulation, September 17, 2016.
2) "A Framework for Understanding Financial Institutions" (with Robert C. Merton). Harvard Law School Forum on Corporate Governance and Financial Regulation, August 11, 2015.
3) "Customers and investors: A framework for financial institutions" (with Robert C. Merton). VoxEU: CEPR's Policy Portal, August 1, 2015.
4) "Competition and R&D: Evidence from biopharma" (with Andrew W. Lo). VoxEU: CEPR's Policy Portal, March 24, 2015.