Tag: Radhakrishnan Gopalan



A member of a corporation’s board of directors may exert a similar amount of influence on a business’ outcome as its CEO.

Particularly if that board member has endured a bankruptcy at another company where they serve as a director.

So finds a new study from Olin researchers, plus a former Olin PhD at Indiana University, forthcoming in the Journal of Financial Economics.

In fact, Olin’s Radhakrishnan Gopalan and Todd Gormley, along with Indiana’s Ankit Kalda, learned that firms take more risks after a member of their board of directors undergoes a bankruptcy at another firm where they serve as a director. The co-authors discovered such risk-taking usually occurs when this particular director (a) experienced a quick, less-costly bankruptcy elsewhere and (b) serves in a position of greater influence.

Their findings suggest that these firsthand bankruptcies provide board directors with a learning experience that causes them to lower their estimate of distress cost—expenses faced by firms in financial distress beyond the cost of doing business.

Gopalan

“This is one of the first studies to highlight how a director’s later-life experience influences their attitudes about risk and risk-taking,” said Gopalan, professor of finance. “Our study highlights the importance of learning and understanding the director’s life experience when making hiring decisions.“

There are two extreme parts of the bankruptcy spectrum, the co-authors noted. A director could’ve seen a contentious process that ends in liquidation, emboldening a perspective that bankruptcy is costly. Or a director could’ve experienced a tidy, pre-packaged bankruptcy that ends in a successful return to operation, causing the director to infer that bankruptcy, and hence risk-taking in general, need not be as costly as they originally assumed.

To research a set of such corporate directors from the period 1994-2013, the co-authors used the Lopucki Bankruptcy Research Database, a US Securities and Exchange Commission database (Electronic Data Gathering, Analysis and Retrieval, or EDGAR), BoardEx, data from proxy statements and more. That enabled them to identify 718 firms sharing a director with 261 firms that filed for bankruptcy at some point in the study’s roughly 20-year window.

Next, they stacked these firms and a control group (lacking any bankruptcy-veteran directors) against three sets of risk measures: corporate financial policies such as net leverage, cash holdings and equity issuance; corporate risk such as cashflow volatility, stock volatility and distress; and measures of acquisition activity. Why acquisition activity? Because prior evidence showed firms engage in diversifying their acquisitions to reduce their risk.

On average, the data showed, firms increased their risk taking and moved closer to bankruptcy, following a director’s previous experience with it.

On average, the data showed, firms increased their risk taking and moved closer to bankruptcy, following a director’s previous experience with it.

The firms with bankruptcy veterans on their boards saw their net leverage increase after their own bankruptcies, as well as seeing increases in cash flow volatility (by 0.9 percentage points), stock volatility (by 0.2 percentage points) and distress events. Similarly, those businesses’ diversifying acquisitions (by 2.9 percentage points) decrease and their likelihood of default increases.

These weren’t new or even newly bankruptcy-scarred directors, either. On average, they were sitting on these boards for more than six years prior to a bankruptcy filing.

To try to ensure that there weren’t any crossover issues in their findings, the co-authors analyzed for any possibility of common shocks and industry-wide issues in a shared business silo. They conducted what they called placebo tests, identifying multiple firms that previously shared a director with a corporation that filed for bankruptcy but didn’t share one at the time of that corporation’s bankruptcy.  They found no evidence of a shift in behavior in this placebo test. Nor did they observe a change in risk-taking when a director experiencing bankruptcy elsewhere exits that board soon after.

The co-authors also analyzed how risk-taking differed based on how costly the previous bankruptcy was.

It didn’t surprise them to find more risk-tasking by businesses with directors who experienced lower-cost, pain-free bankruptcies, and less risk-taking by firms with directors who endured protracted, costly ones.

What did surprise them: The aftershocks to that particular director’s career. The data showed that a person’s number of board memberships declined in the years following a bankruptcy, but this only occurred among directors who led their firms through protracted, costly bankruptcies.

Gormley

“Directors serve two main roles,” said Gormley, assistant professor of finance. “One, monitor the manager to make sure they act in shareholders’ best interests. Two, advise the manager on important decisions.

“Typically, independent directors — those with no prior connection to the firm or CEO — are thought to serve more of a monitoring role. Non-independent directors are thought to provide more of an advisory role. We find our results are concentrated among non-independent directors, suggesting the change toward risk-taking is driven by a change in the advice directors provide rather than a change in their monitoring.”

Moreover, in parsing the influence of board members who aren’t on the management team but have some connection or advisory role, the co-authors found that many of them had backgrounds in private equity (13.1%), manufacturing (10.3%), venture capital (8.6%) and consulting (7.5%). Such portfolios might explain why CEOs and other directors might more highly regard, and abide by, their views when making decisions over finance and risk.

“It’s well known that CEOs and their experience matter,” Gormley said. “But here, we are seeing that individual directors also matter. This is different than what most investors typically focus on, which are the board-level characteristics like what fraction of directors are independent.

“These findings suggest that it’s important for firms to hire individual directors with the experience set they consider most important for improving the quality of the advice they will provide the manager.”




At a time when evictions and mortgage defaults have been likened to an oncoming tsunami across America, a big-data study of loan-to-value ratios in the wake of the 2007-08 recession carries a cautionary forecast for vexing economic weather ahead:

The higher a worker’s outstanding mortgage relative to their home value, the worse their future income growth and job mobility.

Those were the key findings when four researchers, including two from Washington University in St. Louis’ Olin Business School, delved into the wage data and credit profiles encompassing 30 million Americans across 5,000 companies. They found a negative relationship between workers’ income and their home loan-to-value (LTV) ratio, especially when the home was underwater (higher principal owed than value).

For example, the scientists discovered that people with underwater mortgages earned $352 — or 5% — less monthly than workers with less mortgage debt relative to home values.

Compounded by credit and liquidity issues, these workers are virtually stuck, unable to move to a job with a better income or a new area, the researchers wrote in their study forthcoming in The Review of Financial Studies.

And it could well translate to the COVID-19 economic effects today.

Radha Gopalan

“The impact of the current crisis on local economies varies widely across the U.S.,” said Radhakrishnan Gopalan, professor of finance at Olin and study co-author. “Our study highlights the difficulties someone in a worse-affected area may face in trying to pack up and move to a less-affected region. Furthermore, our study also highlights an important cost of homeownership: For instance, buying a home will constrain your labor mobility, and in the long run that may adversely affect your labor income.”

“This is one of the first studies to tie detailed credit histories to information on worker mobility and pay increases,” added co-author Barton Hamilton, the Robert Brookings Smith Distinguished Professor of Economics, Management & Entrepreneurship and director of the Koch Center for Family Business at Washington University. “Prior work has analyzed these factors in isolation and has not made the connection between the two.”

Bart Hamilton
Bart Hamilton

Seeking ways to scrutinize the effect of home equity and labor income, in addition to the mechanisms intertwined, the researchers used Equifax information and Corelogic house-price indices to drill down to study a random sample of 300,000 workers with an active mortgage over a 72-month period earlier in this decade.

They measured home equity as LTV — the unpaid mortgage vs. the market value — on the workers’ primary residence. They additionally accounted for home-value increases/decreases using ZIP-code level price fluctuations and controlled for local economic conditions. Moreover, they contrasted the income path of homeowners versus renters who worked at the same firm, were of a similar age and job tenure, and held a similar level of income and non-mortgage debt.

What the data essentially showed: Homeowners facing high LTVs were less likely to change homes, but more likely to change jobs, if they could. And renters working at the same companies and with similar job tenure faced no such issues. Additionally, homeowners with high LTVs faced slower income growth while renters faced no such penalties.

It wasn’t as cut and dried as a rent-vs.-own debate, though. Income and mobility for homeowners could vary. A worker could face relatively smaller income declines or find greater employment opportunities if they lived in a metropolitan area with more jobs — for instance, an IT worker in San Francisco/Silicon Valley — or a state with softer non-compete laws limiting movement within an industry.

Housing prices and wages

Still, they found that declines in housing prices as a result of that 2007-08 recession suggested a 2.3% reduction in monthly wages economy-wide due to constrained mobility.

“If the adverse effects of the current pandemic on local economic conditions also spill over to house prices, then we will find ourselves with a number of underwater homeowners,” Gopalan said. “In that scenario, the effects we document will be very relevant.”

Gopalan and Hamilton were joined in the research by two former Olin PhDs, Ankit Kalda and David Sovich, who work at Indiana University and the University of Kentucky, respectively.

They wrote that a homeowner with an underwater mortgage were to face a new job offer in a different area, they were confronted with three (unappealing) prospects:

  1. Sell and swallow the shortfall — meaning they still must require some access to liquidity, despite being credit constrained.
  2. Retain the home and rent it out — meaning there will be no or negligible down payment on a new home in the new area.
  3. Walk away and default on the mortgage — meaning deeper credit issues.

In short, their mobility was as hampered as their current job situation, the co-authors said. A worker may not seek out better opportunities in the first place and, consequently, feel adverse effects on income because of an undermined bargaining power at the current workplace.

For the record, the median individual in their study group was 41 years old with an annual $41,015 salary; comparatively, the median person in the U.S. workforce overall in that time window was 41.9 with an annual $41,392 income, the co-authors wrote. The median loan: $192,400.

“Our study highlights an important cost of home ownership,” Gopalan said. “While the ‘American dream’ is usually defined in terms of building wealth through home ownership, the financial crisis has revealed a few glaring holes in this story. Our study formally quantifies one important cost of following the ‘American Dream.’ A relatively safe way to own a house is to make sure one has sufficient down payment or home equity so that even if house prices fall, one is not stuck with an underwater mortgage. To this extent, our study recommends caution in pushing mortgages with less down payment.”

Hamilton added: “Our study highlights that policies affecting financial markets can directly impact the labor market as well. Businesses also need to be aware of the indirect costs that credit markets and home ownership may impose on mobility and the optimal allocation of their workforces.”




2016 Olin Award (165x178)Todd Milbourn, the Hubert C. and Dorothy R. Moog Professor of Finance and Radhakrishnan “Radha” Gopalan, associate professor of finance, presented their findings on performance-based pay to the largest group yet at the 9th Annual Olin Award Winner’s Luncheon.

A write-up of the findings, a video, and the paper can be found here.

Guests at the luncheon included several CEOs and CFOs asking questions about company approaches to performance-based pay.