Matching Capital and Labor

46 Pages·2016·0.44 MB·English

Matching Capital and Labor∗
Jonathan B. Berk
Stanford University and NBER
Jules H. van Binsbergen
University of Pennsylvania and NBER
Binying Liu
Northwestern University
September 26, 2016
Abstract
We establish an important role for the firm by studying capital reallocation
decisions of mutual fund firms. The firm’s decision to reallocate capital amongst its
mutualfundmanagersaddsatleast$474,000amonth,whichamountsto30%ofthe
total value added of the industry. We provide evidence that this additional value
added results from the firm’s private information about the skill of its managers.
Investors reward the firm following a capital reallocation decision by allocating
additional capital to the firm’s funds.
JEL classification: G30, J24, D22
∗We thank Anat Admati, Peter DeMarzo, Daniel Ferreira, Francisco Perez-Gonzalez, Paul Pfleiderer,
Anamaria Pieschacon, Jonathan Reuter, Michael Roberts, Paulo Volpin, and seminar participants at
GeorgiaStateUniversity,theUniversityofChicago,StanfordUniversity,UCLA,theUniversityofMary-
land,Wharton,UniversityofNewSouthWales,UniversityofSydney,UniversityofMelbourne,theAdam
Smith Workshop, the SFS Cavalcade, and the NBER Corporate Finance Meetings, for helpful comments
and suggestions.
We demonstrate that an important role of a firm in the mutual fund sector is to effi-
ciently match capital to skill. In a world with perfectly rational players, no information
asymmetries and no other frictions, the role of a mutual fund firm would be irrelevant be-
cause investors themselves would efficiently allocate their own capital amongst managers.
In reality, what we find, is that mutual fund executives play a very important role in
capital allocation. A decision to increase a portfolio manager’s assets under management
(AUM) leads to an increase in the manager’s productivity as measured by value added.
Similarly, we find that decisions to reduce managers’ responsibilities by taking away assets
also lead to increases in subsequent value added. We find that at a minimum, the decision
to reallocate capital to a manager adds, on average, $474,000 per manager per month,
implying that the firm is responsible for at least 30% of the total value added of the
average manager. Mutual fund firms appear to add substantial value by intermediating
between investors and managers and thereby efficiently matching capital to skill.
We further demonstate that investors are unable to match the firm’s capital realloca-
tion decision themselves. We hypothesize that the reason why derives from the significant
informational advantage mutual fund executives have relative to investors. For example,
firm executives know every trade a manager makes, and in addition, trades that the man-
ager chooses not to make. Executives use this information to direct capital away from
overfunded managers towards underfunded managers.
We provide supporting evidence in favor of the informational advantage hypothesis:
(1) external hires that involve a change in AUM do not lead to a detectable change in
future value added, (2) while past performance does explain investor flows, it does not
have much power to explain firm capital reallocation decisions and (3) investors respond
to these capital reallocation decisions by investing additional capital in the firm’s funds.
We also find that the capital reallocation decision adds more value for young managers,
supporting the hypothesis that the firm’s advantage derives from its access to better
information about managerial ability. These facts are consistent with the hypothesis,
first theorized by Alchian and Demsetz (1972), that firm executives use factors that are
noteasilyobservabletopeopleoutsidethefirmtomakepersonneldecisions. Theyarealso
consistent with the hypothesis in Gennaioli, Shleifer, and Vishny (2015) that investors
trust mutual fund firms to make sound financial decisions on their behalf, and so when
they see these firms making a managerial change they respond by investing additional
capital.
Although there is a large body of evidence demonstrating the importance of the firm’s
1
informational advantage in assigning workers to jobs and thereby determining compensa-
tion, there is little evidence demonstrating that firms also use this knowledge to determine
the job scope of the employee. Our results imply that by correctly determining how much
responsibility to give an employee in a particular job, firms add considerable value. Con-
sequently, the documented wage gains that result from internal job assignments likely not
only result from the productivity gains from correctly matching jobs to workers, but also
from correctly assigning worker responsibility within a job.
Many of the questions pertaining to the economics of organizations are difficult to
study because it is often hard to measure employee output directly. An advantage of our
study is that because the performance of a mutual fund is public information, employee
output is directly observable. That is, a mutual fund manager has one task — to invest
capital on behalf of investors. The return he generates, as well as the amount of capital
invested, is public information. The investor’s next best alternative investment opportu-
nity, an investment in passively managed index funds, is also observable. By comparing
the manager’s performance against this alternative, we can directly calculate an individ-
ual manager’s productivity, that is, the value she adds. A second advantage of our study
is that mutual fund firms own little physical capital.1 Consequently, ownership rights to
capital cannot play an important role in why mutual fund companies exist or are valuable.
What our results imply is that other factors, such as the informational role of the firm,
are also important.
Although we do not find strong evidence for a behavioral explanation of our findings,
we cannot definitively rule out the possibility that at least part of our results derive
from suboptimal investor behavior. For example, part of the value the firm adds could
potentially result from investor inattention. Firms add value by paying attention on
investors’ behalf. We leave it to future research to determine the possible importance of
this explanation for our results.
In the next section we describe how our paper fits into the existing literature. We
develop a simple model that formalizes our hypothesis for why firms add value in Section
2. In Section 3 we define the value added of firms, funds and managers. The data set is
described in Section 4 and provides summary statistics. In Section 5 we show that we can
reject our Null hypothesis that firm capital reallocation decisions do not add value and,
more importantly, provide a lower bound estimate of the value firms add. In the following
1Although the industry is capital intensive, firms do not own their own capital. Instead, the firms
manage capital on behalf of outside investors. That is, capital providers retain full ownership rights to
their capital and can call it back at any time.
2
section, Section 6, we show that investors respond to these capital allocation decisions by
investing additional capital with the firm, indicating that investors are aware of the value
these decisions add. In Section 7 we present a body of evidence that is consistent with
the hypothesis that the value the firm adds by reallocating capital derives from the firm’s
informational advantage from observing the quality of its own employees.
1 Background
The literature on the economics of organizations has raised several important questions
related to the role of firms. What makes a firm successful? Is it a characteristic of the
firm itself, or is it simply that a successful firm is a collection of particularly talented
employees? Why do people choose to work for firms rather than for themselves? Do
personnel decisions within the firm add to overall firm value?
There is now a large theoretical literature designed to answer these questions (see Hart
and Moore (1990), Holmstrom and Tirole (1989), Hart (1995) and Rajan and Zingales
(1998)). A key aspect of modern theories of the firm is the concept of ownership. In a
world with incomplete contracting, incomplete information and bounded rationality, ex
post bargaining power is affected by ownership. Asset owners, because they retain the
rights of control, have inherently more bargaining power. An important insight of this
literature is that firms exist to ensure that ex ante ownership is concentrated to allow for
efficient ex post outcomes. Although these theories undoubtedly explain an important
component of why modern firms exist, they cannot explain a particular, and increasingly
important, type of firm — a firm that consists almost exclusively of human capital. These
firms have little physical capital other than perhaps some intangible capital such as the
firm’s brand name. Hence, a primary reason for the existence of these types of firms
cannot be the assignment of ex post bargaining rights through asset ownership.
Ourpaperrelatestoanexpandingliterature,pioneeredbyBertrandandSchoar(2003),
that seeks to isolate the productive role of the worker (manager) from that of the firm.
Bertrand and Schoar (2003) demonstrate the importance of firm managers by studying
CEOs. More recently, Ewens and Rhodes-Kropf (2013) separate the value added in ven-
ture capital projects into a manager component and a firm component and argue that
human capital, rather than organizational capital, accounts for most of the skill in the
venture capital world. This research relies on the fact that workers move between firms to
identify the separate roles of workers and firms. However, because switching firms is an
3
endogenous decision, this methodology is generally unable to put a quantitative estimate
on the contribution of the firm nor is it informative on what precisely the firm does to
add value. Instead of focusing on external moves as the identification strategy, we rely
on the firm’s internal decision to promote and demote its workers and thus we are able
to both identify the source of the firm’s value added and derive a quantitative bound on
the firm’s contribution to productivity.
Our paper also relates to the labor literature studying personnel economics and the
internal labor market of the firm pioneered by Doeringer and Piore (1971).2 That lit-
erature focuses on how firms establish and end employment relationships and how firms
provide incentives to workers through the wage contract. Our focus is different. We do
not observe employee wages, but instead observe employee productivity (value added).
That allows us to study how firm decisions regarding the scope of the managers’ job (the
size of their AUM) affects their productivity rather than their wages. We argue that the
firm uses its private information about employee skill to efficiently allocate capital and
thereby determine the scope of responsibility of the employee.
Finally,ourpaperisalsopartoftheliteraturethatstudieshowtheintra-firmallocation
of capital and labor affects productivity and drives heterogeneity in the quality of firms.
Gertner, Scharfstein, and Stein (1994) model the costs and benefits of internal capital
allocation versus external capital allocation in the form of bank lending. Stein (1994)
studies the comparative advantages of decentralized versus hierarchical firms in efficiently
allocating capital to projects. Tate and Yang (2014) show that diversified firms have
higher labor productivity and actively redeploy their human capital to business areas with
better prospects. Giroud and Mueller (2014) find that firms take resources away from less
productive plants and reallocate them to plants with better investment opportunities.
Resource allocation (or misallocation) across firms and across industries has also been
identified as a major determinant of economic productivity at the macroeconomic level.3
A key determinant of a firm’s productivity is its management. Bloom, Sadun, and
van Reenen (2013) find significant differences in management quality across firms both
in the U.S. and abroad. Bloom, Eifert, Mahajan, McKenzie, and Roberts (2013) show,
2In more recent work, Abowd, Kramarz, and Margolis (1999) find worker fixed effects to be more
importantthanfirmfixedeffectsindrivingheterogeneityinworkers’wages. Graham,Li,andQiu(2011)
decomposevariationinCEOcompensationandshowthatmostofthisdifferenceisexplainedbymanager
heterogeneity rather than firm heterogeneity. Oyer and Schaefer (2011) and Waldman (2013) are recent
surveys of this literature.
3For example, see Hsieh and Klenow (2009), Alfaro, Charlton, and Kanczuk (2009) and Bartelsman,
Haltiwanger, and Scarpetta (2013).
4
based on randomized experiments in India, that management practices have a significant
impact on firm productivity. Lazear, Shaw, and Stanton (2014) find that hiring better
supervisors make workers more productive. Finally, most mutual funds are owned and
marketed as part of a fund family, so a number of studies have looked into how the family
structure affects the mutual fund industry.4
2 Theory
Our underlying hypothesis in this paper is that internal firm decisions about how to
allocate capital amongst employees add value, and that this value derives from the fact
that firms have better information about their employees’ abilities than outside investors
in the firm. With that in mind, in this section we will develop a simple model that
formalizes this hypothesis.
We assume that there are three types of agents. Outside investors, employees and a
firm executive. Both employees and the firm executive have a skill in short supply and
receive all the rents for this skill. A firm consists of an executive and I employees. The
net present value (NPV) of the value created by each employee, i, using capital q is,
i
V ≡ q ψ (q ),
i i i i
where ψ (q) is the average excess return on capital employee i generates when given
i
responsibility for the amount of capital q. In the mutual fund literature, ψ (q) is referred
i
to as the gross alpha and V corresponds to what Berk and van Binsbergen (2015) refer
i
to as value added. We will maintain the realistic assumption throughout the paper that
ψ(cid:48)(q) < 0. In words, there are decreasing returns to scale so that the excess return on
i
capital decreases in the amount of responsibility an employee is assigned.5 Employee i
receives a wage (compensation) W . The firm executive determines the amount of capital
i
employees are given responsibility for.
4Massa (2003) argues that having fund families reduces investors’ cost of switching between funds.
Gaspar,Massa,andMatos(2006)andBhattacharya,Lee,andPool(2013)findevidencethatmutualfund
families transfer performance from one group of funds to another group of funds through coordinated
trades. Kempf and Ruenzi (2008) show that intra-firm competition has important effects on managers’
appetite for risk. Chen, Hong, Jiang, and Kubik (2013) find that funds outsourced to advisory firms
underperform funds managed in-house. Fang, Kempf, and Trapp (2014) show that a firm allocates its
skilled managers to funds targeting inefficient markets.
5There is a growing body of empirical evidence documenting decreasing returns to scale in the mu-
tual fund industry, see Chen, Hong, Huang, and Kubik (2004), Pollet and Wilson (2011), and Pastor,
Stambaugh, and Taylor (2015).
5
2.1 Coasian Benchmark
First we derive the equilibrium level of capital in a frictionless market with no asymmetric
information (the null hypothesis in this paper). In such a world, there is no role for a
firm executive because the executive does not add any value over the value added of
individuals working for themselves. To see this formally, consider the case where each
employee works for herself but needs to raise money from outside investors. The outside
investors maximize the NPV of their investment, subject to the condition that the NPV
is not negative:
max[q ψ (q )−W , 0]. (1)
i i i i
qi
The solution to this problem for each employee i = 1,...,I, is
ψ (q∗)+q∗ψ(cid:48)(q∗) = 0. (2)
i i i i i
Each employee chooses his wage by maximizing his compensation taking into account the
outside investor’s participation constraint, implying
W = q∗ψ (q∗). (3)
i i i i
Now assume employees work for a firm. In this case the firm executive’s maximization
problem, taking employees’ wages as given, is
(cid:34) (cid:35)
I
(cid:88)
max q ψ (q )−W , 0 . (4)
i i i i
{qi}
i=1
The solution to this problem, {q∗,...,q∗}, uniquely satisfies the following I first order
1 I
conditions:
ψ (q∗)+q∗ψ(cid:48)(q∗) = 0, i = 1,...,I, (5)
i i i i i
which is identical to (2). The employees can always choose to work for themselves, which
implies that, in equilibrium, the firm must pay at least (3). The investor participation
constraint implies the firm cannot pay more, so we have
W = q∗ψ (q∗). (6)
i i i i
At this wage the NPV of investing in the firm is zero, so we can assume that outside
investors will be willing to provide capital (cid:80)I q∗ and so the two equilibria are identical.
i=1 i
6
2.2 Asymmetric Information
The alternative hypothesis in this paper is that the firm executive can better observe
the quality of her employees than the providers of capital. We assume that employees
cannot credibly communicate their ability and so the providers of capital cannot differen-
tiate between employees.6 This model is observationally equivalent to a model in which
investors can observe employee ability but nevertheless choose to ignore this information
for behavioral reasons. Under these assumptions the providers of capital believe employee
excess return on capital is
ψ(q) ≡ E[ψ (q)]. (7)
i
If the employees work for themselves, the outside investors maximize the NPV of their
investment subject to their participation constraint:
max[E[V ]−W , 0] = max[q ψ(q )−W , 0], (8)
i i i i i
qi qi
where we are assuming that employee productivity risk is idiosyncratic and so does not
command a risk premium. The first order condition is:
ψ(qˆ)+q ψ(cid:48)(qˆ) = 0, i = 1,...,I. (9)
i
As before, each employee maximizes his wage subject to the participation constraint:
¯
W = qˆψ(qˆ). (10)
The solution does not depend on i and so all employees manage the same amount of
¯
capital, qˆ, and earn the same wage, W. The total amount of capital invested is therefore:
¯
Q ≡ Iqˆ.
Next we turn to the firm’s optimization problem. The firm executive has a competitive
advantage because she has private information that allows her to allocate capital better.
6That is, for ease of exposition, we normalize the information set of outside investors by assuming
that the publicly available information for all employees is the same. This model is easily generalizable
to the case where outside investors can partially differentiate between employees and we thus we allow
outside investors to partially differentiate in the empirical work that follows.
7
For a given level of capital invested by outside investors, Q, they add value by efficiently
allocating capital, and because this skill is in short supply, they are able to capture this
value, ∆V. That is, the NPV of the additional value added by the firm is the solution to
I I
(cid:88) (cid:88)
¯
∆V = max q ψ (q )−IW s.t. q = Q. (11)
i i i i
{qi}
i=1 i=1
The employee wage is set subject to the constraint that employees can choose to work
¯
for themselves, implying that each employee earns W, and so total wage expenses are
¯
IW. As before, in equilibrium, the NPV of outside investors’ investment is zero, implying
that they are indifferent to the choice of Q, so the firm executive can assume that outside
investors will provide the level of Q that maximizes her value added, that is,
I I
(cid:88) (cid:88)
¯
∆V = max q ψ (q )−IW s.t. q = Q. (12)
i i i i
{qi,Q}
i=1 i=1
˜
At the optimal allocation of capital, {q˜ ,...,q˜ ,Q},
1 I
I
(cid:88)
¯
∆V = q˜ψ (q˜)−IW ≥ 0, (13)
i i i
i=1
¯
where the inequality follows because q = qˆ∀i and Q = Q is feasible.
i
For most firms neither q nor ψ (q ) are directly observable and so measuring ∆V is
i i i
challenging. The mutual fund industry is exceptional because both quantities are directly
observable at the employee level. In the next subsection we illustrate this explicitly in the
context of a simple example.
2.3 A Simple Mutual Fund Example
Our objective is to measure the contribution of mutual fund firms, ∆V. In this regard,
we are departing from the conventional approach in the mutual fund literature. In that
literature researchers have used ψ, that is, alpha, to measure skill. Consequently, some
readers have questioned our approach arguing that to correctly measure the contribution
of the firm, we should be measuring ∆ψ rather than ∆V. For that reason, we will
illustrate, in the context of a simple example, why ∆ψ does not measure the contribution
8
0.12
Gross Alpha ψ(·)
V
V*= a2/40b.1
ΔV
VI = 3a2/160.0b8
0.06
Promotion
0.04
ψ(0) = a
0.02
ψ(qI) = 3a/4
ψ(q*) = a/2 -b
0
0161116212631364146qI51 =56a/614b667176818691q96*=01a06/211b16212631364146515661667176818691q=96a01/b
111111111111111111112
Figure 1: Value Added and Gross Alpha: The blue (solid) line plots gross alpha as a function of
thesizeofthefund: ψ(q)=a−bq. Thegreen(dashed)curveisthevalueaddedofthefundasafunction
of fund size, q ψ(q).
of the firm.7 Suppose
ψ(q) = a−bq,
that is, a fund manager’s excess return on capital (gross alpha) on the first dollar she
manages is a and it decreases at a rate b, plotted in blue in Figure 1. Assume that the
parameters a and b are both known to firm executives. The optimal amount the manager
shouldbemanagingisfoundbymaximizingthetotalvalueaddedoverq (thegreendashed
line in the figure):
maxqψ(q) = q(a−bq).
q
7Berk and van Binsbergen (2015) prove (based on the arguments in Berk and Green (2004)), in a
world that features competitive capital markets, that alpha measures do not measure skill.
9