Monday, May 25, 2015

Hanergy gambling? When people and firms take risks

Li Hejun is the tycoon who owns more than 70 percent of Hanergy Thin Film Group, a solar energy firm that became famous after its shares dropped by 47 percent on May 20. The price drop was remarkable for the total stock value loss and the fact that it made him lose his position as the richest man in China; it is also remarkable for having happened in a fraction of a second thanks to computer trading driving share prices down.

There is now a great deal of uncertainty around Hanergy and the events of the stock value fall, so what I am writing in this paragraph could become outdated quickly. First, it is alleged that Mr. Li was behind a large stock sale that triggered the crash.* (Of course, it was also important that there weren’t enough buyers for that sale and additional sale attempts by others afterwards.) Second, Mr. Li both owned stock (80 percent at the latest filing) and had “short” stock (opposite of owning, 7.7 percent). Third, the company (not him) had pledged stock as collateral for a series of loans, with the latest loan being USD 200 million. Finally, Hanergy sales of equipment to its mother company were an important part of its business, but the sustainability of that business model was questioned by some.

Confused by this information? It is chaotic, but for an investor it is easy to add up: This is a company with so many question marks that an investment would be risk at the level of pure speculation. Interestingly, the actions leading to this risk were fully under the control of the investor who lost the most from them: Mr. Li. Of course, we are familiar with firm owners and top managers who take risks that look excessive to others, so the Hanergy events are not new except for the scale of risks and losses. They do however raise the question of what makes individuals and firms take risk.

There has been much research on individuals taking risks when facing losses guided by prospect theory, which is based on how people evaluate gains and losses differently, and take high risks to escape losses. There has been much research on organizations making changes when facing low performance guided by performance feedback theory, which is based on how organizations discover and seek to solve problems following disappointing performance, but are less eager to find opportunities. A recent paper by Kacperczyk, Beckman,and Moliterno in Administrative Science Quarterly sheds new light on risk taking and changing by asking whether the drivers of change and risk in organizations are the same.

The study findings speak to both theories. Organizational change happens the way performance feedback theory specifies, both for risky change and less risky change. But an important component of performance feedback theory is what level of performance is seen as disappointing, and there the results are different. Organizational change of the less risky kind is driven by comparing the performance against that of other organizations, so competitors in the market. Risky organizational change is driven by comparing the performance against that of other units in the same organization. Why are they different? Well, the internal comparison is not against market competitors – it is against nearby managers and career rivals. That’s personal, and when losses are personal people take risks. So, risky organizational change is a blend of performance feedback and prospect theory.

What do these findings say about Hanergy? Well, so far we do not have information of any fraud in the Hanergy case, so it looks like a big bet gone wrong. And the bet is interesting because it is made by an individual who controls the firm so closely that there is little difference between him and the firm. In such a case, any comparison of performance gets personal because the firm falling behind means that he falls behind, so high risk taking would be a natural response. It is a very good demonstration of how closely held firms can go wrong.

Kacperczyk, Aleksandra, Christine M. Beckman, and Thomas P.Moliterno. 2015. "Disentangling Risk and Change: Internal and External Social Comparison in the Mutual Fund Industry." Administrative Science Quarterly 60(2):228-62.

*I knew I would end up correcting this paragraph. The initial report was incorrect; he actually bought shares just before the crash. I have not seen news yet on who made the fateful sale that started the price drop.