Topics on intermediaries, reorganization and empirical asset pricing

Lewis, R (2016) Topics on intermediaries, reorganization and empirical asset pricing. Doctoral thesis, University of London: London Business School.

Abstract

My thesis is composed of three articles that examine the behavior of both financial and legal institutions and, in some cases, their relationship with asset prices. In the first article, "Corporate Debt Markets and Recovery Rates with Vulture Investors", I examine the endogenous role of intermediaries in the market for defaulted bonds where classic frictions from agency theory motivate concentrated asset ownership. When the private decisions of individual creditors do not maximize recoveries to their creditor class, ex-post consolidation of defaulted securities by activist vulture funds can improve emergence recovery rates. As long as barriers prevent rapid capital reallocation, the ratio of activist wealth to the amount of defaulted debt in the economy emerges as the key state variable that determines prices, returns and eventual recovery rates on defaulted bonds. In empirical tests, my model explains 82% of the time series variation in aggregate post-default trading prices based on this one state variable. Moreover, this ratio is a significant determinant of risk-adjusted returns to defaulted bonds. As the model predicts, the relationship between the activists wealth ratio and returns is strongest in firms with assets that are difficult to monetize and for fulcrum classes where the creditors are likely to emerge from bankruptcy holding the newly issued equity. In "Finding Fund Scale", I aid in describing scale effects in the mutual fund industry by developing a simple proxy to capture fund level constraints: the average shares owned by a firm scaled by the total float. I document that "Constrained" managers diversify more in response to inflows, tend to pick stocks whose returns mimic that of their benchmark and, when returns are measured over longer horizons, I observe that a 10% capital inflow today reduces market adjusted returns by 60-80bps per year over next two years for the most constrained funds. Finally, in "Do Market Prices Improve the Accuracy of Court Valuations in Chapter 11?", coauthored work with Cem Demiroglu and Julian Franks, we explore the extent to which publicly verifiable information about the price of a firms defaulted bonds effects the ability of the bankruptcy process to determine the fair value of a firm. We find the disclosure of trade information through the TRACE program decreases the valuation errors by more than 50% and does so mostly when the firm suffers from a weak information environment. These results have important implications for the distributions to pre-default creditors and therefore the pricing of non- defaulted bonds.