Study: Corporate/Government Cronyism Does Create Alpha

revolvingdoorThree scholars, two affiliated with Oxford University, the other with the University of Connecticut, have brought statistical rigor to prove what seems intuitively plausible: firms on the private side of the public/private revolving door benefit from that situation. Their coziness with officialdom produces significant alpha for their investors.

A simple example of the sort of public/private interaction that these three scholars have in mind arose out of the career of Darleen Druyun. Druyun, who at the turn of the millennium was the principal deputy undersecretary of the U.S. Air Force for acquisition, was involved in a decision to lease refueling craft, KC-767 tankers, from Boeing. The leasing meant that the U.S. spent more money per plane than it would have if it had purchased the planes outright. The decision created a public furor in 2003, when Druyun left the Air Force and took a job with … Boeing. Investigation showed she had actually been negotiating the terms of her contract with Boeing while she was dealing with the issue of the KC-767 lease.

Former regulators are in their way as useful for private companies as are former procurement officials, but the latter are the primary focus of this study.

Excluding Reverse Causality

Such coziness led Barack Obama, as a candidate for president in 2007, to declare that he as chief executive would “make it absolutely clear that working in the Obama administration is not about serving your former employer, your future employer, or your bank account. It’s about serving your country, and that’s what comes first.”

The new report, by Mehmet I. Canayaz, Jose V. Martinez, and Hans N. Ozsoylev, finds that firms where current public officials are destined to become employees outperform other private firms by 7.43% per year, on an equally-weighted basis, during the three year period before the officials/employees pass from one post to the other. The outperformance is highest in the year immediately before the switch, and “diminishes and eventually vanishes as we move further away from the hiring date.”

Canayaz et al. use the four-factor model of alpha in their assessment of performance. That is, outperformance has to be judged against the market portfolio (CAPM), plus the premium for small caps, plus the premium for low P/B stocks, plus the momentum factor. They draw upon data from the Center for Responsive Politics, which maintains a Revolving Door Database.

Focus on the outperformance of firms that have yet to hire certain individuals raises the issue of causation in rather stark form. After all, most people would probably agree to exclude “reverse causality” as a hypothesis. Someone who has joined a firm in year 5 does not, by virtue of his/her wonderful performance on the job in year 6, account for that company’s positive four-factor alpha in years 3 or 4. So it isn’t a big leap to surmise that the revolvers caused that performance of firms they had not yet joined by actions favoring their future employer while the People of the United States were still their employers.

The abnormal returns do shrink a bit if the firms involved are treated on a value-weighted rather than an equal-weighted basis. But the difference between the firms that hire the “revolving” government employees and those that don’t remains highly significant at 6.10% a year.

After All Screenings

Another important consideration: the higher the number of revolvers relative to the size of the firm, the more marked the alpha generation. In what they call the “top tercile of revolver intensity” the equally-weighted four-factor alpha involved is 12.26% per year – again, drawing upon the three year period prior to the hiring.

A skeptic about the causative claim, though, could suggest that revolvers are well positioned to learn what firms in their field of expertise are doing well, and are more likely to look for performance at those firms than at others. Or, relatedly, firms that are doing well may simply have the cash available to hire away newly available government employees knowledgeable in the field. The alpha would create the hiring pattern, then. The hiring would not necessarily be a reward for any alpha-creating decisions made by those in their final year or years of government employ.

The authors employ various tests to screen out such possibilities. They conclude that after all possible screening, a residuum remains that suggests blatant-quid-pro-quo, contracts awarded to private companies because the officials making the decision want employment there, and employment contracts extended because those lucrative contracts were awarded.

It hardly warms the heart of the citizen of a republic, but it does suggest an investment strategy.

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