European Finance Association Meeting 2007

A Theory of Preemptive Entrenchment Dalida Kadyrzhanova Paper Discussion Andrea Vedolin University of St. Gallen [email protected]

24th August 2007

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 Purpose of the Paper Summary Key Ideas Comments Overall Assessment

Purpose of the Paper

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Summary Purpose of the Paper Summary



Key Ideas Comments Overall Assessment

The Model: The paper studies an industry equilibrium model of optimal entrenchment where 

a risk-neutral manager has empire-building preferences and



shareholders can monitor managers’ product market decisions.

Hypotheses: 

Industry leaders have higher levels of entrenchment.



A negative impact of entrenchment on firm value is smaller for industry leaders.



The link between industry leadership and the valuation effect of entrenchment is more pronounced in industries that are more concentrated, relatively less heterogeneous, and less subject to foreign competition.

 These hypotheses are assessed and confirmed empirically.

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Purpose of the Paper

 Key Ideas Model Comments

Overall Assessment

Key Ideas

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Key Ideas of the Paper 

Empire-building managers with superior information about product market conditions.



Shareholders delegate product market decisions to managers. They can hire auditors (governance choice).



The marginal benefits of governance are

Purpose of the Paper Key Ideas Model



Comments Overall Assessment

1. Higher monitoring intensity allows to cut on wasteful over-production 2. Efficiency gains, however, are traded off against endogenous −i product market costs of governance ( ∂q ∂αi > 0). ⇒ Stronger governance weakens firms in the product markets! 

The interaction of imperfect product markets is key to deliver the dependence of equilibrium governance choices on industry structure. Through entrenchment, the leader gains a strategic advantage over its rivals in the form of a more aggressive manager.



Entrenchment leads to concentrated product markets with sizeable adverse consequences for consumer welfare. EFA 2007 – 5

Key Ideas of the Paper cont’d Purpose of the Paper



Principals optimally entrench mangers more the higher is demand and the larger is their cost advantage with respect to the rivals. ⇒ Industry leaders face a lower opportunity cost of entrenchment .



Same intuition also applies to the valuation effect of entrenchment.



Industry leaders have a less negative impact of entrenchment than laggards.



Incorporating entry and exit into the model allows to study the effect of entrenchment on the competitive position.

Key Ideas Model



Comments Overall Assessment

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Purpose of the Paper Key Ideas

 Comments Tech. Comments Empirical Comments Other Comments Minor Comments Overall Assessment

Comments

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Technical Comments Purpose of the Paper Key Ideas Comments Tech. Comments Empirical Comments Other Comments Minor Comments



Overall Assessment

The choice of the parameter values is not well motivated. For instance, an annual interest rate of 4% is quite high compared to Mehra (2003) who finds an average annual interest rate of 1%. Using this value and simulating 10,000 periods (694 secs on a Core 2 Quad processor), I confirm the high concentration of one firm active, however, the number of entry and exit is much higher , the mean lifespan is much lower, the average length of runs is different, and mean p-c margin is double. ⇒ Results seem to be quite sensitive to different initial values. While one parametrization is sufficient to demonstrate that something can happen in equilibrium, it is insufficient to explore dynamic properties of the equilibrium. Estimation and calibration of these models is highly computational inefficient. ⇒ Continuous-time stochastic games (see Doraszelski and Judd, 2007).

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Empirical Comments Purpose of the Paper Key Ideas Comments Tech. Comments Empirical Comments Other Comments Minor Comments



Overall Assessment

Valuation Effect of Managers: Proposition 2 says that for leaders, entrenchment should have a less negative impact on firm value than for laggards. (Who does managerial entrenchment hurt the most?, p. 11) In your empirical analysis, you find, however, that the effect of entrenchment is positive on firm value for industry leaders. ⇒ This is not what your model is saying! The negative sign is inline with Bebchuk, Cohen, and Ferrell (2005). Some inconsistence between internal and external measures of corporate governance: While for external governance measures the sign is positive for industry leaders, for internal governance measures, two out of four signs are negative. Do you have any explanation for this? Endogeneity: Signs are positive / negative and significance is much lower, although R2 are very high. What about the other determinants? You do not use data before 1990, what is the point to control for simultaneity in the first half of 1980?

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Other Comments Purpose of the Paper Key Ideas Comments Tech. Comments Empirical Comments Other Comments Minor Comments



Overall Assessment

Few economic intuition provided for certain propositions, which are themselves often stated in very technical terms. Graphical illustration of impact of entrenchment on market concentration is nice but what is the intuition behind it? Why does entrenchment has a negative effect on consumer welfare? Are there any stylized facts so that the model is consistent with these? Some theorems seem tangential to the main message of the paper and are not discussed in the text e.g. Theorem 1: Existence of MPE and conditions to ensure existence. Suggestions  

See if the paper can be simplified, and if not, explain to the reader why all the technical machinery is needed. Provide economic intuition for each proposition and theorem.

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Minor comments Purpose of the Paper Key Ideas Comments Tech. Comments Empirical Comments Other Comments Minor Comments

Clearly delineate which results are new and which have been encountered before and provide a discussion of marginal contribution of the paper and why this particular modeling approach is needed to generate that marginal contribution. I.e. valuation effect of entrenchment.



There are some proofs missing. E.g. Proof of Prop. 2 is not in Appendix A.

Overall Assessment

The tables and figures should be self-explaining. Axis description and caption is sometimes missing. There are tables and figures in the paper which are never explained. Figure 1 (time line) and Tables 3 and 4. Numerous variables that are not always defined when they should. Also for example it is never defined what an “industry leader” is, only when reading the table caption I found the definition. Since your results hinge on this assumption is it also robust towards other definitions of leadership? In particular, your state variable is not a function quantity. Sometimes there is a mixing up between sub-indices and super-indices. Update references. EFA 2007 – 11

Purpose of the Paper Key Ideas Comments

 Overall Assessment Assessment

Overall Assessment

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Overall Assessment Purpose of the Paper Key Ideas

Praise of the paper 

The paper is well written and interesting both from a theoretical and empirical point of view.



Modeling of endogenous product market costs of governance implies rich implications for cross-sectional differences among firms. The paper actually determines under which conditions governance creates values. This is interesting also from a public finance view.

Comments Overall Assessment Assessment





However ... 

Check the robustness of your empirical results with the theoretical hypotheses from your model.



Need to focus more on exposition, economic intuition, and delineation of incremental contribution relative to existing literature.



Estimation (calibration) of model parameters would make results more robust towards critique of arbitrarily chosen parameters. ⇒ Continuous-time Markov model would simplify computations enormously, while leaving the main model twists as they are. EFA 2007 – 13