Cfa Level Iii - Study Session 12

Front 1

Equity Portfolio Management

Corporate Governance - Moral Hazard
(SS12)

Back 1

1. Insufficient effort - to oversight of their subordinates
2. Extravagant investments - empire building
3. Entrenchment strategies - managers do this to keep their positions. Make themselves indispensable.
4. Self-dealing - private jets, art and entertainment

Front 2

Equity Portfolio Management

Dysfunctional Corporate Governance
(SS12)

Back 2

Managerial misbehavior
1. Lack of transparency - people don't know how much top management is getting paid.
2. Level - of total comp.
3. Tenuous links between performance and compensation - maintain high pay even after bad performance. May also try and 'get out in time' before stock tanks.
i. to get around this make them vest their shares
4. Accounting Manipulations - to keep bank covenants, their jobs etc.

Front 3

Equity Portfolio Management

Managerial Incentives - Who monitors?
(SS12)

Back 3

Who monitors the managers?
1. Large institutional investor (pension fund, mutual fund, bank)
2. A venture capitalist
3. Large private owner

All of these restrict managerial control and alleviate the agency problem.

Front 4

Equity Portfolio Management

Monetary Incentives for Mangers
(SS12)

Back 4

1. The compensation package - makes it difficult for managers to undo their position in the firm through open or secret trading.
Managers can dodge public selling by using equity swaps and collars.
2. Bonuses and shareholdings - substitutes or complements?
Balance between short term and long term incentives.
3. The compensation base - shouldn't be based on things outside the control of the manager.
Don't compensate just for luck.
4. Straight shares or stock options - careful her because if managers stock options are 'out of the money' it may encourage them to take crazy risks to bring them back into the money.
i. to overcome this, reprice them or lapse out the old ones and issue new ones.
5. The executive compensation controversy - there has been a trend to higher comp. as well as stronger performance linkages.
History has shown that there is a low sensitivity of CEO's comp. to firm performance.

Front 5

Equity Portfolio Management

Implicit Incentives
(SS12)

Back 5

1. Threat of bankruptcy - 52% get management change, 19% for poorly performing co.

Front 6

Corporate Governance

How do you classify monitoring?
(SS12)

Back 6

1. Active (forward looking)
i. interfere with management in order to increase the value of the investors' claims.
ii. If the firm doesn't want to sell to an acquirer it investigates to see if this is the right decision.
iii. only cares about the future and the degree to which things can be chaged.
2. Speculative (backward looking)
i. Take a picture, take stock of managers achievements to date e.g. a stock market analyst is a speculative monitor.
ii. doesn't try to increase firm value, but rather to measure value.
iii. based on the past, they decide 'to stay or should i go now'
iv. speculative monitoring also includes legal suits by shareholders against directors, to sanction past underperformance.
3. Competition is also a good monitor, but it no substitute for a proper governance structure.

Also, who monitors the monitor? Are THEY even acting in the best interest of the beneficiaries?

Front 7

Corporate Governance

How good are board of directors at monitoring?
(SS12)

Back 7

Board of Directors
1. Are they independent?
2. Able to pay attention to the firm - are they overcommitted elsewhere?
3. Are their incentives on the mark? Do they get paid enough to sit up and take notice.
4. Make sure there are no conflicts? Are the directors friends with management - can they fire them?
They have to get along to work together, but when it comes to the crunch can they fire them?

Front 8

Corporate Governance

Drawbacks of whistleblowing
(SS12)

Back 8

Disadvantages of whistleblowing
1. Firm only chooses loyal employees, ie those that won't whistleblow
2. Company's reduce information flow to stop anyone who might find them out.
3. If you whistleblow, you'll get fired and people will know you're a WB and not hire you elsewhere.

Front 9

Corporate Governance

What is the advantage of having the Cadbury code of good governance
(SS12)

Back 9

Advantages of the code
1. It educates the general public
2. Everyone/ company is on the same page so any major differences in practise are easier to see
i. questions can be asked of any differences
ii. comply or explain

Front 10

Corporate Governance

Takeover Bids and Defenses
(SS12)

Back 10

Targets are:
i. Likely to have a low "Tobin's Q"
Market Value of securities
--------------------------------------
Accounting Value of assets

1. Corporate charter defenses - technically difficult to get control
i. Staggered board - only a certain % of board is up for reelection each year
ii. Supermajority - 80 or 90% instead of 50% for simple majority
iii. Delaware Defense - tougher anti-takeover laws than normal
2. Dilution Defenses
i. Scorched Earth - co. sells assets at a lower price than normal so raider can't get their hands on them.
ii. Litigation against the raide
3. Poison Pills
i. special rights to target's shareholders to buy additional shares at low price
ii. these rights act lice calls and puts for the target sh that have value in the event of a takeover.
4. Friendlies
i. White Knights
ii. Greenmail - target company purchases at a premium the raider's stake of the targets stock to effectively get rid of them.
BAD because greenmail is seen as collusion between managers and raider at the expense of the other shareholders. Profits go to the raider.

Front 11

Corporate Governance

Leveraged Buyouts
(SS12)

Back 11

Advantages of being LBOed for the firm
1. Strong money incentives for firms managers relative to a public co.
2. Active monitoring because general manager is closer, more invested and has the means to monitor
3. High leverage, big incentives to improve efficiency

i. Timeline is 5-10 yrs before exiting.
ii. Each LBO is left separate and they are not mixed with each other at the LBO firm.

Front 12

Corporate Governance

Debt as a Governance Mechanism
(SS12)

Back 12

Debt is a discipline if its maturity is short because you need to be able to roll it over.
i. GOOD taking cash out of the firm prevents managers from 'consuming' it
ii. GOOD the threat of illiquidity from not paying debt keeps managers disciplined.
iii. GOOD Creditors are in the drivers seat with debt and they can gain control of the firm that way, thus avoiding the need to formally acquire these rights.
iv. BAD cost of illiquidity if managers have no cash to invest in new projects
v. BAD because of bankruptcy costs from having too much debt
vi. BAD transaction costs of having to work it out among so many different senior and junior creditors
vii. BAD direct costs of bankruptcy like legal and accounting
viii. BAD indirect costs of management gambling towards the end.

Front 13

Corporate Governance

Objections to the Stakeholder Society
(SS12)

Back 13

People who hate Stakeholder Society
1. Giving control rights to non-investors may discourage financing in the first place
2. Inefficient decision making if you share TOO MUCH with stake-holders
3. Manager can't manage socially responsible things to well defined measures COMPARED to max. shareholder value (in a non-stakeholder society). Too big a task for one person to make the world a better place.
4. Directors aren't the best people in the planet to make the world socially responsible.

Front 14

Corporate Governance

Costs and Benefits from Shared Control - Three types
(SS12)

Back 14

1. Structural Separation - controlled by players that are independent from the users
2. Vertical Integration - controlled by one of the users who then sells it to the other users (eg. electrical transmission network controlled by a distribution company)
3. Association or Joint Venture -
Jointly controlled by users. Sometimes bad things happen here when fights break out and efficiency if impacted.

Front 15

International Equity Benchmarks

What was the original purpose of indexes?
(SS12)

Back 15

1. To help investors measure active performance
2. Investors should invest internationally for many reasons (diversification and industrial mix is different) but capturing a risk premium IS NOT one of them.
3. Remember to float adjust your index.
i. If you don't cross-holdings lead to double counting for the index.
ii. free float also means that so many of the shares may not even be available to the public to invest in.
4. If a benchmark is very easy or very difficult for a large proportion of the investment managers to beat, something is probably wrong with the benchmark

Front 16

International Equity Benchmarks

What is the trade-off in making an International Index?
(SS12)

Back 16

1. Breadth versus investability - breadth is number of stocks, investability is the ability to buy them.
You want LESS breadth if you have troubles with investability.
2. Liquidity versus reconstitution effects - program trades with baskets of securities.
Reconstruction is the inclusion/deletion effect of adding a stock or taking it out of the index.
3. Precise float adjustment versus transaction costs from rebalancing. - Float bands reduce the need to trade to the penny and therefore reduce transaction costs.
4. Objectivity and transparency versus judgment.

If a country is classified as developing (instead of emerging) more people will invest in it.
Korea wants to be a small weight of developing, than a large weight of emerging because there is more access to capital for developing.

Front 17

Emerging Markets Finance

Financial Liberalization
(SS12)

Back 17

As a market moves from segmented to integrated: (even though the move to integrated will never be perfect)
1. Impact of Pricing
i. HIGHER prices
ii. depends on credibility of the governments announcement to liberalise (credibility evolves over time)
ii. and the diversification benefits gained from integrating the market.
2. Expected Returns
i. should decrease, because a closed country is much more volatile. When integrated the volatility is lower and therefore the expected returns are too.
ii. covariances with the rest of the world increase because it is more open
iii. cost of capital decreases (same as expected return going down) and there might be more IPOs.
3. Liquidity will increase as foreigners gain access to the local market.
4. Trading volume goes up as foreigners gain access to the local market.

Front 18

Emerging Markets Finance

What happens to an emerging economy after financial liberalization?
(SS12)

Back 18

The theory says that there is a positive average effect for equity market liberalizations.
Liberalization is defined as
i. First ADR date
ii. First country fund launch
iii. Official liberalization date given by that co's government.
1. Economic growth - conditional convergence. Poor grows faster than rich.
If additional investment is efficient, the growth should INCREASE.
If is is wasted then there is no impact.
2. Real exchange rates - should go up, but then this adversely affects the competitive position of the country.
3. Income in/equality - should trend towards equal
4. Volatility of market - in the long run it should reduce. It make be higher/lower as country is opened and adjusts.

Front 19

Emerging Markets Finance

What is the downfall of emerging markets?
(SS12)

Back 19

1. Excess correlations in times of crisis (contagion isn't just normal increase in correlations from crisis, it's the excess i.e. the correlation of residuals) - You seem to be able to predict a crisis from the economic data, but spread of panic.
First real ER goes up, then competitiveness goes down, then reduced growth and lower income levels after a crisis reduce the demand of goods from other countries.
2. Corporate Governance - in emerging markets insiders have control rights way above their ownership rights and this gives rise to extreme managerial agency problems.
i. explanation for this is the large gov holdings.
3. Price discovery - faster
4. Liquidity - higher

Front 20

Emerging Markets Finance

Emerging Market Bonds
(SS12)

Back 20

1. Emerging market bonds
i. behave like equity
ii. correlation between emerging market bonds and equity are high because essentially they are the same thing.
2. Sovereign debt
i. if you can 'go-after' the foreign borrower then the spread is lower (therefore less risk)
ii. population growth is negatively related to rating
i.e big pop growth leads to lower ratings

Front 21

Emerging Markets Finance

Market Microstructure
(SS12)

Back 21

After reforms?
i. increase turnover
ii. increased liquidity in Moroccan market but trading costs got WORSE because the exchange was illiquid both before AND after liberalization.
2. In US fall in trading costs contributed to a decline in the equity premium of 1%

Front 22

Emerging Markets Finance

Conclusion of Market Liberalization
(SS12)

Back 22

Liberalization has lead to
i. a very small increase in correlations with the world market
ii. a very small decrease in dividend yields (could be a decrease in cost of capital or decrease in div yields)
iii. economic growth increases by about 1% a year on average over a 5 year period.
iv. more people invest (providing one channel for increased growth)
v. it DOES NOT drive up real investment rates
vi. it DOES NOT increase in variability