Working Paper: CEPR ID: DP10400
Authors: David L. Dicks; Paolo Fulghieri
Abstract: We present a novel source of disagreement grounded in decision theory: ambiguity aversion. We show that ambiguity aversion generates endogenous disagreement between a firm's insider and outside shareholders, creating a new rationale for corporate governance systems. In our paper, optimal corporate governance depends on both firm characteristics and the composition of the outsiders' overall portfolio. A strong governance system is desirable when the value of the firm's assets in place, relative to the growth opportunity, is sufficiently small or is sufficiently large, suggesting a corporate governance life cycle. In addition, more diversified outsiders (such as generalist mutual funds) prefer stronger governance, while outsiders with a portfolio heavily invested in the same asset class as the firm (such as venture capitalists or private equity investors) are more willing to tolerate a weak governance system, where the portfolio companies' insiders have more leeway in determining corporate policies. Finally, we find that ambiguity aversion introduces a direct link between the strength of the corporate governance system and firm transparency, whereby firms with weaker governance should also optimally be more opaque.
Keywords: ambiguity aversion; corporate governance; disagreement
JEL Codes: G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| ambiguity aversion (D81) | endogenous disagreement between insiders and outsiders (D80) |
| endogenous disagreement between insiders and outsiders (D80) | implications for corporate governance systems (G38) |
| ambiguity aversion (D81) | strength of corporate governance (G38) |
| strength of corporate governance (G38) | firm transparency (G38) |
| firm characteristics and composition of outside shareholders' portfolios (G34) | governance structures (G38) |