Lecture 2

Question 1

moral hazard

Answer 1

A situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.

Question 2

4 criterions on information asymmetry in agent theory

Answer 2

Hidden characteristics, hidden information, hidden action, hidden intention

Question 3

Hold up problem

Answer 3

The hold-up problem is a situation where two parties may be able to work most efficiently by cooperating but refrain from doing so because of concerns that they may give the other party increased bargaining power and thus reduce their own profits.

Question 4

What did Jensen (1989) say?

Answer 4

LBO is better adapt to deal with agency problems than listed firm. He says that a listed firm has problems with the payout of free cash flow. This is overcome through the LBO governance model.

Question 5

Three typical moral hazard situations in financing companies

Answer 5

• consumption on the job (misdeployment of assets)
• being one’s own boss (misguided effort)
• establishing a track record (misguided effort)

Question 6

Characteristics of public corporations concerning governance

Answer 6

• Dispersed public ownership
• Managers without substantial equity shareholdings
• Board of Directors dominated by outsiders

Question 7

Pros and cons of public corporation structure

Answer 7

Advantage: risk diversification across households and institutional investors through public stock markets
Disadvantage: conflicts of interest between risk bearers and decision-makers

Question 8

Jensen’s 4 forces that should control management to act in the investor’s interest

Answer 8

• product markets (competition)
• internal control systems (supervisory boards)
• legal/political/regulatory system
• capital markets (investors)

Question 9

When are Jensen’s four forces effective and when not?

Answer 9

Agent principal alignment in high-growth industries as there are more positive NPV investment opportunities than free cash flow internally

Misalignment in low-growth or declining sectors as managers often waste cash flow through organizational slack or investments in negative NPV projects.

Question 10

Free cash flow

Answer 10

Cash flow in excess of that required to fund all positive NPV projects. So you first finance your positive NPV projects and if cash is left that is called free cash flow.

Question 11

What do efficient and shareholder value-maximizing companies do with the free cash flow?

Answer 11

Distribute free cash flow to investors (pay out as dividends)

Question 12

Why are managers incentivizes to retain cash and engage in empire building?

Answer 12

• increases autonomy vis-á-vis the capital markets (for future financing needs)
• increases firm size, even beyond optimal size. Size enhances social prominence, public prestige and political power. Management income is often related to increases in company size rather than value.

Question 13

Examples of the disciplining effect of debt

Answer 13

• increases the debt-to-equity ratio –> solves free cash flow problem
• financing through debt introduces the legal obligation to meet periodic payments
• managerial discretion is reduced and managers are forced to skip negative NPV investments
• violation of debt covenants creates board-level crisis and urges to review management and strategy

Question 14

Role of PE firm in LBO

Answer 14

sponsors transactions, counsels and monitors managment

Question 15

Role of company management in LBO

Answer 15

holds substantial equity stakes and stay in buyout company

Question 16

Role of institutional investors

Answer 16

fund the limited partnership funds and provide equity part of buyout transactions

Question 17

Differences of LBO to public corporations

Answer 17

1. Management incentives are built around a strong relationship between pay and performance
2. PE structure is more decentralized than publicly held conglomerates
3. PE relies heavily on leverage.
4. LBO structures imply well-defined obligations to creditors and residual claimants

Question 18

carried interest

Answer 18

performance-dependent gains of PE managers

Question 19

4 Characteristics of LBO firms

Answer 19

1. Management Incentives
2. Decentralization
3. High leverage
4. Well-defined obligations (PE managers cannot transfer capital from one buyout company to another. Returns must be distributed to limited partners)

Question 20

blockholder

Answer 20

A blockholder refers to an individual or organization which owns a substantial amount of a company’s shares or debt

Question 21

financial intermediary

Answer 21

entity that brings together (intermediates between) providers and users of financial capital

Question 22

3 Factors of contribution to a better market outcome by financial intermediaries

Answer 22

1. Transaction costs
2. Minimum investment volume
3. Risk management

Question 23

Which transaction costs can PE firms reduce?

Answer 23

Initial costs, information costs, control costs, contracting costs, adjusting costs, and execution costs.