Reading: Lesson 5 - Agency Conflicts

10.5.A - Agency Conflicts

1. Agency Conflicts

1. There is no conflict at a one-person company—the owner makes all the decisions, does all the work, reaps all the rewards, and suffers all the losses. This situation changes as the owner begins hiring employees because the employees don’t fully share in the owner’s rewards and losses. The situation becomes more complicated if the owner sells some shares of the company to an outsider, and even more complicated if the owner hires someone else to run the company. In this situation, there are many potential conflicts between owners, managers, employees, and creditors. These agency conflicts occur whenever owners authorize someone else to act on their behalf as their agents. The degree to which agency problems are minimized often depends on a company’s corporate governance, which is the set of laws, rules, and procedures that influence the company’s operations and the decisions its managers make. This chapter addresses these topics, beginning with agency conflicts.
   
2. An agency relationship arises whenever someone, called a principal, hires someone else, called an agent, to perform some service, and the principal delegates decision-making authority to the agent. In companies, the primary agency relationships are between (1) stockholders and creditors, (2) inside owner/managers (managers who own a controlling interest in the company) and outside owners (who have no control), and (3) outside stockholders and hired managers. These conflicts lead to agency costs, which are the reductions in a company’s value due to agency conflicts. The following sections describe the agency conflicts, the costs, and methods to minimize the costs.
   

1. Creditors have a claim on the firm’s earnings stream, and they have a claim on its assets in the event of bankruptcy. However, stockholders have control (through the managers) of decisions that affect the firm’s riskiness. Therefore, creditors allocate decision-making authority to someone else, creating a potential agency conflict.
   
2. Creditors lend funds at rates based on the firm’s perceived risk at the time the credit is extended, which in turn is based on (1) the risk of the firm’s existing assets, (2) expectations concerning the risk of future asset additions, (3) the existing capital structure, and (4) expectations concerning future capital structure changes. These are the primary determinants of the risk of the firm’s cash flows, hence the safety of its debt.
   
3. Suppose the firm borrows money, then sells its relatively safe assets and invests the proceeds in assets for a large new project that is far riskier. The new project might be extremely profitable, but it also might lead to bankruptcy. If the risky project is successful, most of the benefits go to the stockholders, because creditors’ returns are fixed at the original low-risk rate. However, if the project is unsuccessful, the bondholders take a loss. From the stockholders’ point of view, this amounts to a game of “heads, I win; tails, you lose,” which obviously is not good for the creditors. Thus, the increased risk due to the asset change will cause the required rate of return on the debt to increase, which in turn will cause the value of the outstanding debt to fall. This is called asset switching or “bait- and-switch.”
   
4. A similar situation can occur if a company borrows and then issues additional debt, using the proceeds to repurchase some of its outstanding stock, thus increasing its financial leverage. If things go well, the stockholders will gain from the increased leverage. However, the value of the debt will probably decrease, because now there will be a larger amount of debt backed by the same amount of assets. In both the asset switch and the increased leverage situations, stockholders have the potential for gaining, but such gains are made at the expense of creditors.
   
5. There are two ways that lenders address the potential of asset switching or subsequent increases in leverage. First, creditors may charge a higher rate to protect themselves in case the company engages in activities which increase risk. However, if the company doesn’t increase risk, then its weighted average cost of capital (WACC) will be higher than is justified by the company’s risk. This higher WACC will reduce the company’s intrinsic value (recall that intrinsic value is the present value of free cash flows discounted at the WACC). In addition, the company will reject projects that it otherwise would have accepted at the lower cost of capital. Therefore, this potential agency conflict has a cost, which is called an agency cost.
   
6. The second way that lenders address the potential agency problems is by writing detailed debt covenants specifying what actions the company can and cannot take. Many debt covenants have provisions that (1) prevent the company from increasing its debt ratios beyond a specified level, (2) prevent the company from repurchasing stock or paying dividends unless profits and retained earnings are above a certain level, and (3) require the company to maintain liquidity ratios above a specified level. These covenants can cause agency costs if they restrict a company from value-adding activities. For example, a company may not be able to accept an unexpected but particularly good investment opportunity if it requires temporarily adding debt above the level specified in the bond covenant. In addition, the costs incurred to write the covenant and monitor the company to verify compliance also are agency costs.
   

3. Conflicts between Inside Owner/Managers and Outside Owners

1. If a company’s owner also runs the company, the owner/manager will presumably operate it so as to maximize his or her own welfare. This welfare obviously includes the increased wealth due to increasing the value of the company, but it also includes perquisites (or “perks”) such as more leisure time, luxurious offices, executive assistants, expense accounts, limousines, corporate jets, and generous retirement plans. However, if the owner/manager incorporates the business and then sells some of the stock to outsiders, a potential conflict of interest immediately arises. Notice that the value of the perquisites still accrues to the owner/manager, but the cost of the perquisites is now partially born by the outsiders. This might even induce the owner/manager to increase consumption of the perquisites.
   
2. This agency problem causes outsiders to pay less for a share of the company and require a higher rate of return. This is exactly why dual class stock (see Chapter 1) that doesn’t have voting rights has a lower price per share than voting stock.
   
   

4. Conflicts between Managers and Shareholders

1. Shareholders want companies to hire managers who are able and willing to take legal and ethical actions to maximize intrinsic stock prices. This obviously requires managers with technical competence, but it also requires managers who are willing to put forth the extra effort necessary to identify and implement value-adding activities. However, managers are people, and people have both personal and corporate goals. Logically, therefore, managers can be expected to act in their own self-interests, and if their self-interests are not aligned with those of stockholders, then corporate value will not be maximized. There are six ways in which a manager’s behavior might harm a firm’s intrinsic value.
   
   1. Managers might not expend the time and effort required to maximize firm value. Rather than focusing on corporate tasks, they might spend too much time on external activities, such as serving on boards of other companies, or on nonproductive activities, such as golf, gourmet meals, and travel.
   
   2. Managers might use corporate resources on activities that benefit themselves rather than shareholders. For example, they might spend company money on such perquisites as lavish offices, memberships at country clubs, museum-quality art for corporate apartments, large personal staffs, and corporate jets. Because these perks are not actually cash payments to the managers, they are called non-pecuniary benefits.
   
   3. Managers might avoid making difficult but value-enhancing decisions that harm friends in the company. For example, a manager might not close a plant or terminate a project if the manager has personal relationships with those who are adversely affected by such decisions, even if termination is the economically sound action.
   
   4. Managers might take on too much risk or they might not take on enough risk. For example, a company might have the opportunity to undertake a risky project with a positive NPV. If the project turns out badly, then the manager’s reputation will be harmed and the manager might even be fired. Thus, a manager might choose to avoid risky projects even if they are desirable from a shareholder’s point of view. On the other hand, a manager might take on projects with too much risk. Consider a project that is not living up to expectations. A manager might be tempted to invest even more money in the project rather than admit that the project is a failure. Or a manager might be willing to take on a second project with a negative NPV if it has even a slight chance of a very positive outcome, because hitting a home run with this second project might cover up the first project’s poor performance. In other words, the manager might throw good money after bad.
   
   5. If a company is generating positive free cash flow, a manager might “stockpile” it in the form of marketable securities instead of returning FCF to investors. This potentially harms investors because it prevents them from allocating these funds to other companies with good growth opportunities. Even worse, positive FCF often tempts a manager into paying too much for the acquisition of another company. In fact, most mergers and acquisitions end up as break-even deals, at best, for the acquiring company because the premiums paid for the targets are often very large. Why would a manager be reluctant to return cash to investors? First, extra cash on hand reduces the company’s risk, which appeals to many managers. Second, a large distribution of cash to investors is an admission that the company doesn’t have enough good investment opportunities. Slow growth is normal for a maturing company, but this isn’t very exciting for a manager to admit. Third, there is a lot of glamour associated with making a large acquisition, and this can provide a large boost to a manager’s ego. Fourth, compensation usually is higher for executives at larger companies; cash distributions to investors make a company smaller, not larger.
   
   6. Managers might not release all the information that investors desire. Sometimes, they might withhold information to prevent competitors from gaining an advantage. Other times, they might try to avoid releasing bad news. For example, they might “massage” the data or “manage the earnings” so that the news doesn’t look so bad. If investors are unsure about the quality of information managers provide, they tend to discount the company’s expected free cash flows at a higher cost of capital, which reduces the company’s intrinsic value.
2. If senior managers believe there is little chance they will be removed, we say that they are entrenched. Such a company faces a high risk of being poorly run, because entrenched managers are able to act in their own interests rather than in the interests of shareholders.