Download Essay on Agent-Principal Conflicts in Corporations

Essay on Agent-Principal Conflicts in Corporations1
John Byrd
March 2005
1. Why do agency conflicts exist?
Modern corporations combine capital from many shareholders with the operational
skills of a professional management team. This structure allows corporations to pursue
business activities beyond the scale or expertise of sole proprietorships or all but a very few
family operated businesses or partnerships. However, the separation of ownership from
decision-making results in a classic principal-agent relationship. Managers, as the agents of
shareholders, are charged with making decisions that enhance the wealth of shareholders, the
principals. Shareholders have capital at risk but almost no influence over the corporation’s
activities, nor can they effectively monitor the decisions of their agents. When the goals of
principals and agents differ, managers may use their corporate decision-making authority to
pursue self-serving activities at the expense of shareholders. Such behavior reduces the value
of the firm below its value if managers had the same incentives as shareholders. Economists
label the value the conflicts arising in such a principal-agent relationship as “agency
problems” and denote the value lost because of such problems as “agency costs.”
Principal-agent conflicts arise because managers and shareholders view the role of the
corporation differently. Investors see corporations as investment vehicles. Shareholders
want corporate managers to work diligently and efficiently toward the simple goal of
maximizing the value of their ownership stake.
Unlike shareholders, managers rarely see the companies that employ them solely as
investment vehicles. While they usually own some of their company’s stock, this represents
just one facet of their relationship with the firm. In addition to being a financial investment,
managers see the company as a source of salary, perquisites, self-esteem or recognition, and
as a means of creating value from their human capital. To protect and enhance these multiple
sources of benefits, only one of which is share value, managers will sometimes make
1
This essay draws extensively on the article by John Byrd, Robert Parrino and Gunnar
Pritsch, “Stockholder-Manager Conflicts and Firm Value,” Financial Analysts Journal,
54 (3 May/June, 1998) 14-30.
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decisions that are personally beneficial, but sub-optimal in terms of creating shareholder
value.
2. Types of manager-shareholder conflicts
This section describes six different types of agency conflicts. Managers do not
always have incentives to make the same type of sub-optimal decision. For example, in
some instances managers have incentives to invest too much, while in other situations underinvestment is a problem.
The Effort Problem: As managerial ownership falls from 100% the incentives that managers
have to shirk (or exert less than full effort creating value for shareholders) increases. As the
fraction of the firm owned by a manager decreases, he or she captures a decreasing fraction
of the value that is created through his or her efforts, yet receives 100% of the value of the
leisure obtained by shirking. Alternatively, the manager bears the entire cost of his or her
efforts to increase shareholder wealth, but captures only a fraction of the benefits.
For example, the typical CEO of a large public corporation owns 0.14% of the firm
(Jensen and Murphy; 1990) so it costs the CEO only $1,400 (0.14% of $1 million) to reduce
his or her effort to the extent that the value of the firm’s equity is worth $1 million less than it
would otherwise have been. Conversely, the typical CEO receives only 0.14 cents ($0.0014)
for every dollar that the value of the firm increases. Compare the incentives of the typical
CEO to those of a CEO who owns 10% of the firm. Holding 10% of the company’s stock
means that the CEO receives 10 cents for every dollar that the value of the firm increases,
and shirking behavior that reduces the value of the firm’s equity by $1 million costs the
executive $100,000.
Of course, executives must not reduce their effort so much that they put their jobs,
salaries, or promotion opportunities at risk. But the implication is clear -- the smaller a
manager's ownership stake in a firm, the lower his or her incentives to work as hard as the
shareholders would like.
Shirking does not necessarily imply that managers are basking on white sand beaches
or pursuing other types of recreation. Managers my elect to pursue business related activities
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that give them satisfaction (or supplemental income), but do not further the causes of the
corporation. For example, executives sitting on the boards of other companies receive
income and prestige, but the time demands may interfere with their principal managerial
duties. For some firms, the opportunity cost of board membership can outweigh the value of
the additional knowledge and contacts that managers obtain through these positions.
Similarly, high profile positions as trustees of charitable or philanthropic organizations, while
possibly creating goodwill for the company, may interfere with an executive’s productivity.
The Time Horizon Problem: Executives have different time horizons than shareholders.
Corporations essentially have an infinite life, so shareholders are concerned with the value of
an infinite series of future cash flows.2 In contrast, an executive's concerns are largely
limited to his or her tenure with the corporation. Managers place a lower value than
shareholders on cash flows that occur after they are likely to leave the firm. This difference
in time horizons becomes particularly important as executives approach retirement,
especially if their compensation is not strongly tied to firm value. Executives nearing
retirement may chose less profitable investments which will produce results more quickly
rather than potentially more valuable investments that reach maturity only after the executive
retires. For example, consider research and development (R&D) expenditures. Investments
in R&D reduce income in the near term, so they may reduce a manager’s compensation. If
the manager continues working at the company for an extended period into the future, R&D
investments will often generate benefits. However, a manager close to retirement may suffer
the costs of the R&D investment, but never reap the benefits, creating incentives to pursue
self-serving ‘end game’ investment strategies.
Different Risk Preferences: Portfolio theory tells us that diversification eliminates industryor firm-specific risk, but cannot reduce the effect of ‘systematic’ or ‘economy-wide’
fluctuations on a firm’s stock returns. A well-diversified investor is primarily concerned
with systematic risk and values a firm by discounting the expected future cash flows using a
2
A particular investor will not own a company's shares forever, but the price of the
shares when that person sells them is based on other investors' estimates of the
company's anticipated future cash flows, so share value extends beyond an individual
owners actual holding period.
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rate that reflects the stock’s marginal contribution to the systematic risk of his or her
portfolio. This systematic component of risk usually comprises only a small portion of a
company’s total risk as measured by the total variability of returns or cash flows.
Unlike investors, managers are not well-diversified because a very large portion of
their wealth is tied to the success of the firms that they work for. Their current and future
employment income, the value of their stock and options, and the value of some of their
experience and training, all depend on the survival of the corporation. Any event or
fluctuation that threatens the survival of the company can be devastating for managers,
whether it stems from firm-specific or economy-wide factors. Thus, managers are concerned
with the company’s total risk, not just its systematic risk, and have incentives to make
decisions that reduce total risk.
When managerial compensation is comprised largely of salary and managers have a
significant investment in company-specific human capital (so transferring their skills to
another firm is difficult), then they have a risk perspective similar to that of bondholders.
They want to assure that corporate cash flows are above some threshold level and that the
risk of default or bankruptcy is minimized. Thus, managers, like bondholders, prefer lower
risk investments than shareholders. Risky projects increase the likelihood of default, but
provide fixed claimants -- bondholders and salaried managers -- little or no additional payoff
if successful.
As with fixed claimants, financial distress or bankruptcy can greatly reduce a
manager’s net worth, especially if you consider the present value of his or her future
earnings. Financial distress increases the likelihood that a senior manager is fired and it
negatively affects his or her reputation in the labor market. On the other hand, when a firm
performs well, the compensation packages received by many managers provide only limited
upside benefits. Bonus plans are typically capped at some specific percentage of salary or at
a fixed dollar amount. Furthermore, the small fraction of equity owned by the typical CEO
of a public firm provides only very limited potential for wealth gains.
With limited upside potential but considerable downside risk, managers (like lenders
or bondholders) tend to prefer low risk investment projects, even if the project’s expected
return is lower than that of more risky projects. Managers can reduce the total risk of a
firm’s assets, and thereby the risk they bear personally, through the company’s investment
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and financing policies. One way in which this can be accomplished is by selecting low risk
investment projects. Rather than betting the entire company on a new product, technology,
or market, a manager may to prefer to expand existing product lines using known
technologies and selling in known markets. Better still if the strategy requires a relatively
small initial investment. While such a strategy will almost certainly never produce a
meteoric winner, the chance of a firm-threatening failure is much smaller than with a bigwinner strategy. Managers willingly forfeit the chance of extremely high shareholder returns
to avoid the possibility of total ruination. Forgoing risky projects reduces the expected
wealth of shareholders but enhances the expected wealth of managers.
With pay, stock and options and human capital tied to the company, executives have
limited opportunities to diversify. Managers can diversify (and thereby reduce their risk
exposure) by making diversifying acquisitions. Broadening the firm’s product lines or
expanding into other industries enables them to diversify their exposure to industry- or
market-specific risk. Poor performance in one division or subsidiary will often be
counterbalanced to some degree by superior performance elsewhere in a diversified
company. These offsetting effects reduce the company’s cash flow variability, and so the
likelihood of job loss. Shareholders can easily and at low cost diversify their own portfolios,
so have little need for such costly corporate diversification. Not only may shareholders not
benefit from corporate diversification, they may suffer value losses. If executives do not
have sufficient skill or experience managing companies in the new markets the company is
entering, value can be lost. In takeovers, as in many types of auctions, the winner is often the
bidder who most over-optimistically estimates the value of the target. This 'winner's curse'
implies the bidder pays too much for the target.
Finally, managers can use financial policy to influence the variability of a firm’s cash
flows and the likelihood of financial distress. Debt financing (or leverage or gearing)
magnifies the effect of fluctuations in operating performance and thereby the anxiety of
managers. Consequently, managers prefer less leverage than shareholders. Shareholders
benefit from leverage through the interest tax shields and because debt can be less expensive
than equity financing (both in terms of issuance costs and the effect on a firm’s stock price).
Managers of profitable mature firms can set a company’s dividend policy in a way
that allows the company to finance growth with internally generated funds. Using internally
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generated funds not only enables the firm to reduce its borrowing, but also helps managers
avoid the scrutiny associated with the security issuance process: due diligence, rating
agencies, protective covenants, prospectuses, and so on. When a company obtains external
funds, new security holders will want their questions answered before committing money.
This process creates an additional layer of monitoring that managers must satisfy. For some
managers, the fewer questions asked the better. Over-retention reduces the situations in
which managers must face their inquisitors.
Excess Perquisite Consumption: Agency costs can also arise from the misuse of corporate
assets. Excess perquisite consumption is an example of this type of cost. Perquisites such as
a company car, club memberships, or a plush working environment supplement the monetary
compensation of many executives, and thereby help firms attract and retain talented
managers. Up to some level, investments in perquisites improve managerial quality and
productivity. However, beyond this point, the marginal benefits of expenditures on
perquisites no longer exceed their costs to shareholders. Since the typical manager bears
only a fraction of the cost of such expenditures but reaps all of the benefits, he or she has an
incentive to spend more on perquisites than shareholders would like.
The Overinvestment Problem: The overinvestment problem refers to managers investing in
negative net present value (NPV) projects or products. This occurs when managers purchase
assets that expand the size of the firm without creating value for shareholders. Some
commentators argue that executives gain prestige the larger the firm they operate. In the
past, some compensation contracts explicitly rewarded managers based on asset levels,
creating another incentive to expand the firm.
According to Jensen (1986) the potential for overinvestment becomes particularly
acute when managers have access to free cash flow, which he defines as cash flow in excess
of that needed to fund all of the company’s available net present value projects.3 Free cash
flow can occur in industries with high profits but limited growth opportunities. Examples of
3
Jensen, Michael C., 1986, Agency costs of free cash flow, corporate finance, and
takeovers, American Economic Review 76, 323-329.
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such industries are the tobacco industry and the oil industry during the late-1980s. While
managers should distribute excess cash to shareholders, the temptation is to invest it. By
definition, such investments erode, rather than create, shareholder value. Companies in the
oil industry spent billions of dollars on diversifying acquisitions that failed. Rather than
paying higher dividends with their excess cash, Exxon put together an office products
subsidiary and Mobil bought the Montgomery Ward retail store chain. These excursions into
non-oil markets were failures that cost shareholders hundreds of millions of dollars.
The Underinvestment Problem: The underinvestment problem is related to the risk
preference problem discussed above. Managers choose to forgo making some positive NPV
investments to either increase the company's cash holdings, avoid outside financing or
because the benefits of the investment will not accrue to shareholders. Creating a larger cash
buffer within the company reduces the risk of future cash shortfalls and thereby bankruptcy.
As already discussed, outside financing requires the firm to undergo additional monitoring
that managers may prefer to avoid. Also, if the financing is debt, the increased leverage can
increase the company's risk.
If a company is close to bankruptcy the value of its debt usually decreases. Suppose
the company has a good (i.e., a positive NPV) investment opportunity. Depending on how
large the NPV is, most of the gain could go to bondholders. If the company makes the
investment it will use cash that could have been distributed to shareholders to improve the lot
of bondholders. Sometimes managers will choose not to invest because shareholders
(including managers) will not benefit sufficiently, although investing would increase total
firm value.
Misrepresenting Financial Results: A special set of problems arises when the stock market
overvalues a company's stock.4 First, managers have no incentive to try and correct such
pricing errors. Doing so would appear to be destroying shareholder value rather than
creating it. No sane manager would even think about reducing share price.
4
This section is based on Michael Jensen's "The Agency Cost of Overvalued Equity and the Current State
of Corporate Finance" European Financial Management, Vol. 10, No. 4, pp. 549-565,
2004. A pre-publication version is available at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=480421.
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The problems become much worse if managers have been compensated with lots of
stock and/or options. Reducing share price to an appropriate level then not only affects
whether they keep their job but also how much the equity portion of their pay is worth. With
their job and personal wealth at risk, managers in this situation try to anything with in their
power to maintain those unsustainable market valuations. Depending on a person's moral
strength this can include fraudulently misrepresenting the company's financial position or
performance. This certainly describes the Enron situation very well.
3. How can manager-shareholder conflicts be resolved?
Within the firm there are three common ways that companies try to reduce the agentprincipal problem between managers and shareholders: contracting, incentives and
monitoring. As the brief discussion will make clear none of these methods can eliminate
agency problems.
Contracting: The nature of business leadership is identifying potentially profitable markets
or products then managing the enterprise so entering those markets results in a profit. It is
impossible to write a contract that so completely defines this activity that the agent is unable
to make any decisions but those than enhance shareholder value. If such a contract could be
written then there would be no need for a manager: lower-level employees following the
contracts instructions could carry out all activities. The reason managers are given discretion
over decisions is so that they can creatively respond to opportunities that arise or crises that
occur. When executives must deal with uncertainty and make decisions about the future
direction of the company, contracting will rarely be an effective method for reducing agency
costs.
A contract might be written that defines the executive's assignment as identifying and
pursuing those opportunities that will increase firm value the most. But such a contract
would be difficult to enforce. The executive knows much more than shareholders about the
range of products and markets the company is capable of producing or entering. Without
such information it would be very difficult for an outsider to evaluate whether the manager
made the right decisions. Being unable to verify the agent's actions implies that such a
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vaguely worded contract would be difficult to enforce. The problem of asymmetric
information pops up often in business dealings.
Incentives: More promising than contracting for reducing agency problems is the use of
incentives. The agent-principal conflict arises because the two parties have different
incentives or different perspectives about what the company is to them. Incentives such as
stock or option compensation can shift the incentives of managers toward those of
shareholders. By making managers more like shareholders, managers' incentives change. As
mentioned in the section on types of agency conflicts, too much equity-based compensation
combined with over-valued equity can create more problems than it resolves.
Monitoring: The corporate structure - a board of directors overseeing managers on behalf of
shareholders - is designed to monitor managers. Monitoring can be effective in limiting
excess perquisite consumption, the poor use of corporate assets and the time horizon
problem. It is less effective in dealing with the shirking or effort problem, since directors
have insufficient information about market opportunities to verify that a manager was
making an honest effort to create shareholder value.
Whether monitoring is effective depends on whether the monitors have the incentives
and knowledge to monitor the manager. Recent calls for more independent directors are a
response to directors being mediocre monitors. We will discuss this topic at some length.
Shareholders can also be effective monitors. Some institutional investors, such as
pension funds, actively identify and critique managers of companies with poor performance.
Investors cannot become too involved with the management of a company or risk losing their
limited liability status. But they can express concern over poor performance and ask
managers to explain their plans for improvement. Monitoring by shareholders suffers from a
free-rider problem, so there is always too little. A shareholder with even a fairly large stake
in a company, say 5% of outstanding stock, will incur all the cost of monitoring but receive
only 5% of any benefits from the activity. For most investors an investment in monitoring
makes no sense; the costs far exceed any possible benefits. Most investors will choose to
wait and let others monitor, even if delaying means forgoing benefits.
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Outside forces can also limit agency costs. If poor decision-making results in
inferior, expensive or otherwise uncompetitive products, customers will switch to other
providers, sales will drop and the share price will fall. Companies in this situation will not be
able to raise capital and may see their debt credit ratings drop. If share price falls enough it
may attract bids from other companies. The low share price lets the bidder pay a premium to
acquire the company, make necessary management changes and, once share price reflects the
value of these changes, earn a profit on the investment. Takeovers are an expensive and
disruptive way to address agency problems, so tend to occur only as a last resort after internal
systems have proved inadequate to solve the problem.
A variant of the takeover - the leveraged buyout (LBO) or management buyout
(MBO) - has been a very successful vehicle for restructuring companies to be more efficient.
In the 1980s in the US and UK there were many LBO transactions. Today, private equity
firms are completing similar deals worldwide.
4. Summary
Agent-principal conflicts are inherent in the structure of the modern corporation:
Highly dispersed ownership and delegation of decision authority to professional managers.
Shareholders and managers differ in how they see the company, so also differ on the types of
decisions they would prefer. Corporate governance is about trying to mitigate or reduce the
value loss shareholders suffer because of these differing perspectives about company
operations. To understand corporate governance, it is important to understand why
corporations need governance and the types of problems that governance systems need to
address.