In Search of a Unicorn: Dynamic Agency with Endogenous Investment Opportunities

with Felix Feng and Beatrice Michaeli

Journal of Accounting and Economics, 2024

We study the optimal dynamic contract that provides incentives for an agent (e.g., SPAC sponsor, VC general partner, CTO) to exploit investment opportunities/targets that arrive randomly over time via a costly search process. The agent is privy to the arrival as well as to the quality of the target and can take advantage of this for rent extraction during the search process and the ensuing production. The optimal contract provides the agent with incentives for timely and truthful reporting via a time-varying threshold for investment and an internal charge for the time spent on search. In the equilibrium, as time elapses, the charge becomes progressively higher while the investment threshold is progressively lower, resulting in overinvestment at a time-varying degree. Our model generates empirically testable predictions regarding investments (such as M&As, hedge fund activism, VC investing, SPACs, and internal innovations), linking the degree of overinvestment to observable firm and industry characteristics.

Markups and Misallocation in Banking

Solo-authored · Preliminary draft available upon request

We study how uneven bank pricing power distorts the joint allocation of deposits and loans across banks. We develop a structural model tailored to the two-sided environment and show that the welfare loss from misallocation can be summarized by the weighted dispersion of deposit and loan markups across banks, together with a third component that captures how the two sides interact. Applying the framework to U.S. banking data, we find that markup-driven misallocation reduced welfare by about 0.2 to 0.6 percent of total assets per year in the 1980s and 1990s, but declined sharply in recent years. The deposit side accounts for most of the measured loss, and markup dispersions on the deposit and loan sides generally reinforce each other in generating welfare loss. We then use the framework to study bank mergers and find that mergers on average increase the acquirers' contribution to misallocation, especially for deals in the 1990s. Finally, we construct an ex ante measure of predicted welfare loss from misallocation for each deal based on an ownership counterfactual, and confirm that deals with larger predicted welfare losses ex ante are associated with larger ex post increases in misallocation.

The Optimal Schedules of Incentives and Cash Flows

with Felix Feng and Mark Westerfield

We model delegated management when the agent can either invest in durable asset quality or raise instantaneous cash flow. Both actions add value, but the principal can only observe aggregate output, not inputs or asset quality, so a schedule of incentives for investment in durable quality also raises instantaneous cash flows. The schedule's flexibility makes long-term incentives relatively cheap, until the contract becomes constrained after a sufficiently long history of negative cash flow surprises. Optimal contracts begin with weak, long-term-focused incentives, and alternate between those and stronger, present-focused incentives. All contracts induce short-term thinking as part of the equilibrium path.