Valuation and the Volatility of Financing and Investment∗

The use of valuation has an externality: it creates information on which adverse selection can occur. We study a market in which investors provide external financing for real investment projects. A subset of investors, sophisticated investors, can buy a technology to value a given number of projects, and reject those with low payoffs, Because rejected projects can seek funding from other investors, there are strategic complementarities in the capacity for valuation, the private benefits to valuation exceed its social benefits, and the market can exhibit multiple equilibria. In one equilibrium, sophisticated investors do valuation, only sophisticated investors invest, and only good projects are funded; in another, sophisticated investors do not do valuation, and all projects are funded. In the region of multiplicity, the move from a pooling (socially efficient) equilibrium to a valuation (socially inefficient) equilibrium involves many features of a financial crisis: prices decline (interest spreads rise); real investment declines; unsophisticated investors leave the market (flight to quality) and sophisticated investors make profits; trust declines and due diligence increases. ∗For helpful comments, we thank Andrea Eisfeldt, V.V. Chari, Igal Hendel, Alessandro Lizzeri, Andrew Winton and seminar participants at Kellogg and the Minnesota Corporate Finance Conference 2010, although we remain responsible for any errors, omissions, or typos. Luis Bryce provided excellent research assistance. †Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, IL 60208-2001, e-mail: [email protected], www.kellogg.northwestern.edu/faculty/bio/Fishman.htm ‡Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, IL 60208-2001, e-mail: [email protected], www.kellogg.northwestern.edu/faculty/parker/htm