Paper Spotlight: Optimal Capital Structure with Imperfect Competition

Alexei Zhdanov

Egor Matveyev

Why do firms in the same industry often have different leverage levels? In their paper “Optimal Capital Structure with Imperfect Competition,” Egor Matveyev and Alexei Zhdanov show that strategic interaction alone can generate this difference. The authors first exhibit a theoretical model in which two ex ante identical firms are deciding when to enter an industry and also how much debt to issue. The product price depends both on the aggregate quantity and on a stochastic shock to the demand curve. In the overall equilibrium of the model, one firm (which becomes an incumbent) enters in a relatively low demand state with a correspondingly low amount of debt. The second firm, the new entrant, enters the industry in a high demand state, and with more debt than the incumbent. Thus, not only do ex ante identical firms in the industry have different leverage levels, but a sharper prediction emerges: Younger firms are more levered than older ones. As a result, younger firms are more likely to fall into financial distress. Further, the dispersion in leverage naturally relates to industry features such as cash flow volatility, tax rate, and bankruptcy costs. The authors then test these predictions on U.S. public firms. Indeed, as predicted by the model, leverage is negatively correlated with firm age, and firms that go bankrupt tend to be younger. To study leverage dispersion, they construct pairs of firms that are close rivals within each industry, and find that leverage dispersion is positively related to cash flow volatility, and negatively to tax rates and asset tangibility. Overall, the empirical results support the idea that strategic interaction is an important driver of differences in leverage.

Spotlight by Uday Rajan
Photos courtesy of Egor Matveyev and Alexei Zhdanov
First published February 4, 2022

Tiered Submission Fees

As part of our continued effort to increase access for authors worldwide, the SFS is implementing tiered submission fees for our journals. Authors who reside in middle-income economies will be eligible to pay a reduced submission fee and authors who reside in low-income economies will be eligible for a fee waiver. While our journals have always offered some waivers for economic hardship, we have now formally defined the waiver options to increase transparency.

Paper Spotlight: Sharing R&D Risk in Healthcare via FDA Hedges

Adam Jørring

Andrew W. Lo

Tomas J. Philipson

Manita Singh

Richard T. Thakor














Recent estimates suggest that the cost of developing a single new drug in the biopharmaceutical sector is $2.6 billion, confirming the very large amounts of money that medical companies invest to develop a new treatment. Biomedical companies also face the risk of very low rates of success, not only due to the inherent scientific risk of developing new drugs, but also due to the risk of the Food and Drug Administration’s (FDA) regulatory approval process. The question that ought to be asked is what financial markets can do to promote more efficient risk sharing in the healthcare and drug development areas from which our societies can benefit. This is the question investigated by Adam Jørring, Andrew Lo, Tomas Philipson, Manita Singh, and Richard Thakor in their paper “Sharing R&D Risk in Healthcare via FDA Hedges.” They address the problem highlighted by many in the medical fields that investors are unwilling to provide financing due to these risks, resulting in a “funding gap” and underinvestment in biomedical R&D that causes many potentially valuable drugs either not being realized or not pursued beyond a certain stage. The authors propose a new form of financial instrument, FDA hedges, which allow biomedical R&D investors to share the pipeline risk associated with the FDA approval process with capital markets. Such instruments are shown to avoid the market failure that leads to an R&D “funding gap.” Using FDA approval data, the authors discuss the pricing of FDA hedges and mechanisms by which they can be traded and use novel panel dataset of FDA approval probabilities to explore the risks inherent in these contracts. The paper finds evidence that the risk associated with FDA hedges is mostly idiosyncratic, and argue that these instruments are appealing to both investors and issuers. Ultimately, FDA hedges should accelerate the development of new biomedical products by providing the necessary funding to support such risky projects, and will undoubtedly improve the health of countless patients. The significant social welfare implications are very clear for all of us.

Spotlight by Andrew Ellul
Photos courtesy of Adam Jørring, Andrew W. Lo, Tomas J. Philipson, Manita Singh, and Richard T. Thakor
First published December 10, 2021

Paper Spotlight: Private Equity and the Resolution of Financial Distress

Edith S. Hotchkiss

David C. Smith

Per Strömberg








Leveraged buyouts by private equity funds have been a constant, and growing, phenomenon in corporate finance over the last two decades and their importance is likely to increase in the post-COVID world. Empirical literature on this subject has explored various angles, but one unanswered question is whether the high leverage used in private equity (PE) buyout transactions contributes to the disproportionately high default rates among buyout targets. In the paper “Private Equity and the Resolution of Financial Distress,” Edith S. Hotchkiss, Per Strömberg and David C. Smith investigate how PE ownership correlates with the probability of default and resolution of financial distress, a relationship that is, theoretically speaking, unclear. One can argue that actions that boost the short-term returns to PE owners, increasing leverage to pay large dividends as an example, could drain liquidity and put PE-owned firms at higher default risk. But there is an opposite argument to be made as well: PE sponsors could help avoid defaults or resolve financial distress, thus preserving firm value, because of their expertise and skill. The authors find a series of interesting results that will help the literature understand better this relationship. First, they find that PE-backed firms have higher leverage and default at higher rates than other companies borrowing in leverage loan markets. This said, conditional on contemporaneous leverage, default rates are not significantly higher for PE-owned firms. These results suggest that it is leverage, rather than PE-backing specifically, that could be the key driver of default probabilities. Second, among leveraged borrowers that experience a default, PE-backed firms restructure more quickly and are less likely to be liquidated. Third, PE owners are more likely to retain control post-restructuring than other pre-default owners, often by infusing capital as firms approach distress. Overall these results suggest a very nuanced view of PE investors and their potential impact on subsequent target firms’ default: while PE investors contribute to more defaults due to the high leverage they put on companies’ balance sheets, such cost is reduced by the PE investors’ intrinsic abilities and skills in dealing with and managing financial distress.

Spotlight by Andrew Ellul
Photos courtesy of Edith S. Hotchkiss, David C. Smith, and Per Strömberg
First published October 5, 2021

Paper Spotlight: The Wisdom of Crowds in FinTech: Evidence from Initial Coin Offerings

Jongsub Lee

Tao Li

Donghwa Shin








Initial coin offerings are fast becoming a new type of crowdfunding for blockchain-related startups. In this type of offerings, an entrepreneur raises capital through the creation and selling of virtual currencies or “tokens,” which themselves give rights to their holders (for example, access to a platform). As is to be expected, there are severe problems of information asymmetry associated with these instruments and capital raising mechanisms, especially due to the lack of the traditional underwriting process. These challenges could lead to failures of these crowdfunding exercises. In the paper “The Wisdom of Crowds in FinTech: Evidence from Initial Coin Offerings,” Jongsub Lee, Tao Li, and Donghwa Shin investigate whether the void created by the absence of an underwriter can be filled by the “wisdom of crowds” instead, defined as the collective opinion of a group of individuals rather than that of a single expert. The authors use the weighted average of ratings issued by analysts active on a prominent rating platform to capture the wisdom of the crowds. The paper finds that favorable ratings issued by analysts with diverse backgrounds are associated with fundraising success, aggressive initial token subscriptions, and long-run returns. Interestingly, analyst ratings predict potential fraud and token-price volatility, areas of considerable interest of regulators and market participants. Put together, these results point to an important role played by online analysts to deal with information problems in blockchain-related startups. These results have implications that go beyond the initial coin offerings, since the wisdom of crowds phenomenon is becoming more pervasive among FinTech platforms.

Spotlight by Andrew Ellul
Photos courtesy of Jongsub Lee, Tao Li, Donghwa Shin
First published September 2, 2021

Paper Spotlight: Investor Rewards to Climate Responsibility: Stock-Price Responses to the Opposite Shocks of the 2016 and 2020 U.S. Elections

Stefano Ramelli

Alexander F. Wagner

Alexandre Ziegler

Richard J. Zeckhauser








Recent survey evidence shows that the list of institutional investors paying close attention to environmental issues, with a consequent impact on their investment decisions, is increasing. A central factor that ought to be considered is the role of government regulation, especially the uncertainty surrounding it, and subsequent response of firms to those regulations against the background of a worsening environmental scenario. This is the dimension that Stefano Ramelli, Alexander F. Wagner, Alexandre Ziegler, and Richard J. Zeckhauser, investigate in their paper Investor Rewards to Climate Responsibility: Stock-Price Responses to the Opposite Shocks of the 2016 and 2020 U.S. Elections. The authors argue that analysis of firms’ climate-related performance so far ignore the fact that firms differ with respect to both current environmental footprint and to climate responsibility. The latter, which includes firms’ future-oriented strategies and voluntary initiatives on the road to transitioning to a low-carbon economy, is the dimension mostly overlooked so far and the paper’s major contribution. The authors treat these two dimensions of the challenge separately and do so by exploiting stock price reactions to the shock to climate policy following the 2016 U.S. election, and the opposite shock from the 2020 election. These two political shocks provide a good laboratory to analyze the interconnections between climate regulation, firms’ climate-related performance, and firm value. The authors find that, while investors reacted to the 2016 election by rewarding carbon-intensive firms, investors also rewarded companies that showed stronger commitment to the environmental transition and climate strategies. How should one interpret these findings? The authors provide what they call the “boomerang hypothesis” as an explanation, where long-term investors expected the roll-back of climate regulation over the Trump administration to be transitory in nature and a blip against a backdrop of tightening environmental regulations as the corporate world grapples with how to achieve more ambitious greenhouse gas emissions. The evidence is consistent with the view that the Trump Administration’s expected environmental hostility may have led to higher, not lower, demand for climate-responsible firms by long-term investors.

Spotlight by Andrew Ellul
Photos courtesy of Stefano Ramelli, Alexander F. Wagner, Alexandre Ziegler, and Richard J. Zeckhauser
First published August 17, 2021

Paper Spotlight: Efficient Programs to Support Businesses During and After Lockdowns

Thomas Philippon

The scale and scope of various government interventions around the globe in the aftermath of the COVID-19 outbreak have been nothing short of staggering. Programs have come in different forms: guaranteed loans, equity injections, bank loans to SMEs that can be transformed into government-financed grants, etc. The actions taken in the initial stages of the outbreak, necessary to fight the economic fallout, are bound to generate major spillovers going forward. Very high firm indebtedness is likely to be a major concern. One reason is likely to be the large number of insolvencies, thus raising a major question that policymakers will have to grapple with: will there be excessive liquidations from a social point of view? It is time to start asking these questions to prepare for this eventuality that can bring havoc to societies. In the paper “Efficient Programs to Support Businesses During and After Lockdowns,” Thomas Philippon makes the point that firm failures in times of high unemployment and when wages are downward rigid, such as the present environment, are likely to be inefficiently high and an optimal mitigation policy is required. Thomas theoretically shows how it is optimal for the government to offer a premium for the continuation of a firm (in the form of an extra haircut the government accepts) in order to induce efficient restructurings, liquidations, and continuation of otherwise viable firms. From a social welfare point of view, governments will not want to prevent all liquidations, but rather to nudge private incentives toward continuation when a firm is viable once the pandemic is over. The most important challenge:  how to carry out optimal interventions when we know that governments have limited information about the quality of firms. The paper suggest that the government can use the behavior of private creditors to reach the efficient outcome.

Spotlight by Andrew Ellul
Photo courtesy of Thomas Philippon
First published January 14, 2021

Paper Spotlight: Resiliency of Environmental and Social Stocks: An Analysis of the Exogenous COVID-19 Market Crash

Rui Albuquerque

Yrjo Koskinen

Shuai Yang

Chendi Zhang








The COVID-19 pandemic, with its heavy toll on human lives, unemployment, and financial distress, should be considered as an important acid test for firms’ professed investments in their responsibility toward society. It is during such times that we can better understand how to interpret the Environmental, Social, and Governance (ESG) scores, standard proxies for firms’ corporate social responsibility, and what is really driving them. The paper “Resiliency of Environmental and Social Stocks: An Analysis of the Exogenous COVID-19 Market Crash,” by Rui Albuquerque, Yrjo Koskinen, Shuai Yang, and Chendi Zhang, has this objective. The authors show that U.S. firms with higher Environmental and Social (ES) scores were more resilient during the COVID-19 induced stock market crash: these stocks suffered lower stock price declines and lower volatility compared to other firms. The authors then investigate how ES policies build resiliency and look at theories of customer and investor loyalty. Firms with high customer and investor loyalty experienced the strongest stock price performance. Customer loyalty translated into higher operating profit margins of firms with high ES scores, even at a time when the economy as a whole was suffering through the first stages of a contraction. Overall, the results in the paper lend support to the view that consumer and investor loyalty play important roles in making high ES firms more resilient during stressful times.

Spotlight by Andrew Ellul
Photos courtesy of Rui Albuquerque, Yrjo Koskinen, Shuai Yang, and Chendi Zhang
First published August 3, 2020