The CEO, CFO, and other managers cannot be perfect agents of their shareholders. The managers are human beings who cannot completely set aside their own interests and concerns. It’s naive to think that they will find and invest in all and only positive-NPV investments. Agency costs are incurred when they don’t.
Agency costs of investment can’t be eliminated, but they can be mitigated. Managers are monitored by shareholders, banks, and other financial institutions, which push back against inefficient investment and waste. Compensation and other incentives can be designed so that managers are rewarded appropriately when they generate value for the firm. Managers are also constrained by law and regulation from taking actions that damage the shareholders. A good combination of monitoring, incentives, and constraints adds up to good corporate governance.
There will be more on monitoring and management compensation later in this chapter and on corporate governance later in the book. We start here by listing several specific agency problems that can interfere with value-maximizing investment.
- Reduced effort. Finding and implementing positive-NPV projects can be a high-effort, high-pressure activity. Managers may be drawn to slack off.
- Perks. Managers are tempted to spend wastefully on upscale office accommodations, meetings scheduled at luxury resorts, private jets, and so on. Economists refer to these nonpecuniary rewards as private benefits. Ordinary people refer to them as perks.1
- Empire building. Other things equal, managers prefer to run large businesses rather than small ones. Getting from small to large may not be a positive-NPV undertaking.
- Entrenching investment. Suppose manager Q considers two expansion plans. One plan will require a manager with special skills that manager Q just happens to have. The other plan requires only a general-purpose manager. Guess which plan Q will favor? Projects designed to require or reward the skills of existing managers are called entrenching investments.2
- Overinvestment. Entrenching investments and empire building are typical symptoms of overinvestment—that is, investing beyond the point where NPV falls to zero. The temptation to overinvest is highest when the firm has plenty of cash but limited investment opportunities. Michael Jensen called this the free-cash-flow problem.3
- Insufficient disinvestment. There is also a reluctance to disinvest, especially when jobs are at stake. Sometimes value is added by selling off a factory or product line or closing down a loss-making business. The reluctance to disinvest amounts to overinvestment on the downside.
1. Agency Problems Don’t Stop at the Top
The CEO, CFO, and other top managers are agents for shareholders as principals. But the top managers must also supervise and set incentives for middle managers. In this case, the top managers are principals and the middle managers agents.
Getting incentives right throughout a large corporation is difficult. So why not bypass these difficulties and let the CFO and his or her immediate staff make the important i nvestment decisions?
The bypass won’t work, for at least four reasons. First, top management would have to analyze thousands of projects every year. There’s no way to know enough about each one to make intelligent choices. Top management must rely on analysis done at lower levels.
Second, the design of a capital investment project involves investment decisions that top managers do not see. Think of a proposal to build a new factory. The managers who developed the plan for the factory had to decide its location. Suppose they chose a more expensive site to get closer to a pool of skilled workers. That’s an investment decision: additional investment to generate extra cash flow from access to these workers’ skills. (Outlays for training could be lower, for example.) Does the additional investment generate additional NPV, compared with building the factory at a cheaper but more remote site? How is the CFO to know? He or she can’t afford the time or the technical knowledge to investigate every alternative that was considered but rejected by the project’s sponsors.
Third, many capital investments don’t appear in the capital budget. These include research and development, worker training, and marketing outlays designed to expand a market or lock in satisfied customers.
Fourth, small decisions add up. Operating managers make investment decisions every day. They may carry extra inventories of raw materials so they won’t have to worry about being caught short. Managers at the confabulator plant in Quayle City, Kansas, may decide they need one more forklift. They may hold on to an idle machine tool or an empty warehouse that could have been sold. These are not big decisions ($25,000 here, $50,000 there), but thousands of such decisions add up to real money.
2. Risk Taking
Because managers cannot diversify their risks as readily as the shareholders, one might expect them to be too risk-averse. Indeed, evidence suggests that managers seek a “quiet life” when the pressure to perform is relaxed.[1] But there are plenty of exceptions.
First, the managers who reach the top ranks of a large corporation must have taken some risks along the way. Managers who seek only the quiet life don’t get noticed and don’t get promoted rapidly.
Second, managers who are compensated with stock options have an incentive to take more risk. As we explain in Chapters 20 and 21, the value of an option increases when the risk of the firm increases.[2]
Third, managers sometimes have nothing to lose by taking on risks. Suppose that a regional office suffers large, unexpected losses. The regional manager’s job is on the line, and in response, he or she tries a risky strategy that offers a small probability of a big, quick payoff. If the strategy pays off, the losses are covered and the manager’s job may be saved. If it fails, nothing is lost, because the manager would have been fired anyway. This behavior is called gambling for redemption.[3]
Fourth, organizations often hesitate to curtail risky activities that are delivering—at least temporarily—rich profits. The financial crisis of 2007-2009 provides sobering examples. Charles Prince, the pre-crisis CEO of Citigroup, was asked why that bank’s leveraged lending business was expanding so rapidly. Prince quipped, “When the music stops . . . things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Citi later took a $1.5 billion loss on this line of business.
Example: Agency Costs and Subprime Mortgages “Subprime” refers to mortgage loans made to home buyers with weak credit. Some of these loans were made to naive buyers who then struggled to keep up with interest and principal payments. Some were made to opportunistic buyers who were willing to bet that real estate prices would keep improving so that they could “flip” their houses at a profit. But prices fell sharply in 2007 and 2008, and many buyers were forced to default.
Why did so many banks and mortgage companies make these loans in the first place? One reason is that they could repackage the loans as mortgage-backed securities and sell them at a profit to other banks and institutional investors. It’s clear with hindsight that many buyers of these mortgage-backed securities were, in turn, naive and paid too much. When housing prices fell and defaults increased, the prices of these securities fell drastically. For example, Merrill Lynch wrote off $50 billion of losses and was sold under duress to Bank of America.
Although there’s plenty of blame to pass around for the subprime crisis, some of it must go to the managers who promoted and sold the subprime mortgages. Were they acting in shareholders’ interests or their own interests? We doubt that their shareholders would have endorsed the managers’ tactics if the shareholders could have seen what was really going on. We think that the managers would have been much more cautious if they had not had the chance for another fat bonus before their game ended. If so, the financial crisis was partly an agency problem, not value maximization run amok.
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