UC Berkeley

In this dissertation, I analyze behavior of two types of financial intermediaries that play critical roles in capital allocation: ratings agencies and merger advisors. Each type of intermediary survives due to (assumed) informational advantages relative to firms and investors. In the following chapters, I analyze how differences in information between market participants and intermediaries lead to signaling behavior related to privately-observed quality. My results explain some seemingly-anomalous aspects of financial markets, and provide a framework for assessing the impact intermediaries can have on efficient capital allocation.

In the first chapter, I examine whether rating agencies strategically manipulate the informativeness of bond ratings in response to competition from private lenders. I model a monopolistic rating agency that caters to a low-quality marginal customer with uninformative ratings. High-quality customers prefer informative ratings but are captive customers of the rating agency in the absence of competition from private lenders. With competition from private lenders, the rating agency uses informative ratings to keep high-quality customers in public markets. The model also suggests that the ratings sector dampens the impact of capital supply shocks, and offers a strategic pricing rationale for the controversial practice of issuing unsolicited credit ratings.

In the second chapter, I test predictions of the model using a measure of informativeness based on the impact of unexpected ratings on a debt issuer's borrowing cost. I analyze two events that increased the relative supply of private vs.\ public lending: the temporary shutdown of the high-yield market in 1989 and legislation in 1994 that reduced barriers to interstate bank lending. After each event, I find that the informativeness of ratings increased for issuers whose relative supply of private vs.\ public capital increased most.

In the third chapter, I analyze how acquiring firms select and pay advisors. I present a model in which an advisor with privately known quality screens targets (due diligence) and improves negotiation outcomes (bidding). When a transaction involves only bidding, advisors pool by offering fees contingent on a completed transaction. By contrast, a transaction involving due diligence can lead to a separating equilibrium and fixed fees. The model predicts that acquirers use advisor market share instead of stock return-based measures to select advisors when synergies are not observable, and that acquirers with better information about advisor quality pay higher fees. I argue that investors in leveraged buyouts are skilled in acquisitions, and find that they pay higher fees for both mergers and tender offers, controlling for assignment and deal characteristics. They are also less likely to include contingent fees than other acquirers. Results suggest skilled investors use private information about advisor ability to hire advisors, and do so primarily to screen targets rather than to improve negotiation outcomes.