Agency Problems and Corporate Governance

• Assumptions

  • Self-interest

  • Risk-aversion

• Problems

  • Information asymmetry -> Goals conflict and Principal cannot verify the work of the agent

  • Risk sharing -> Principal and agent have different attitudes towards risk

Banks cannot know if the firm, who is asking for a loan, is a good or bad firm (Pooled Market). If loans are to expensive, good firms will leave the market. The fraction of bad firms in the credit markt increases and with them the interest rate. Even more good firms will leave the market due to the rise of interest rate. In the end only bad firms remain in the credit market.

Shareholder cannot differ between good and bad shares (Pooled Market). Therefore shares of good firms are undervalued and the manager wont issue new equity to the market, because this implies to transfer the wealth of old shareholders to new shareholders.

Shares of bad firms are overvalued and the manager uses the capital market for his own good and will issue even more new equity. As a result, the market can collapse becues only overvalued stocks are offered

• Self selection

• Signaling

• Screening

  
  

Managers are not 100% owner of the firm. Therefore they deviate from the Shareholder value principal and Managers pursuit their own interset, but does not bear the full costs of their behavior. (Financial and non financial benefits)

• Shareholder -> maximize shareholder value

• Bondholder -> invest in safe project

After the debt has been granted, the shareholder wants to invest in riskier projects. Downside risk is borne by Bondholder. Upside potential is only a benefit for the shareholder.

-> Risk shifting/Asset substition

• Monitoring

  • Principals controls the agent

    • Example: Use Bank loans instead of Bonds, financial analysts

    • But: Produce monitoring Costs

• Bonding

  • Contractual clauses

    • Example: Use of secured debt, bond covenants

    • But: Produces bonding costs

• Incentives

  • clauses to align the interes of principal and agent for example with stock options

• Financial intermediaries

  • Banks reduce information asymmetries

  • Banks produces information

  • Banks monitors and control the borrowers

  • Indirect financing is more important than direct financing. Only large established firms have access to capital markets

• Collateral and equity

  • Reduce the risk for lenders

  • Reduce the incentives for borrowers to take large risks

  • Collateral is included in standrad loan

• Managers have more information than investor

• Its not possible to make complete contracts where all rules of the game are determined, therefore shareholder have to gather information and control the manager.

• With diversified shareholder, a free rider problems accour the incentives to monitor the manager are low because the costs are not justifying their own benefit.

It is a set of Method to ensure that investors get a return of their money. It is a straighfoward agency perspective that is referred to as separation of ownership and Conrtol

• Tirole, 2001

  • Design institutions to make mangers internalize the welfare of stakeholders

• Schmalenbach, 1925

  • Not focusin on the interests of the provider of capital, but rather on how firms establish their social productivity

Jensens (2001) proposes an elightened stakeholder approach

• Maximization of shareholder Value = Maximazation of overall welfare. But Stakeholders interests are inclueded through binding covenants

• Board of directors

• Monetary incetives

• Financial leverage

• Accounting standards and auditing

• Employee representation on the board

• Bank-Based Europe

  • Ownership is concentrated -> large Shareholders and cannot easily sell

• Market-Based Countires

  • Firm is widely dispersed or in hand of financial intermediareis

In concentrated markets, firms prefer bank loans instead of bonds

• German Bank

  • House Banks or relationship banking

• US Bank

  • Transaction based bank, each loan is a single deal (Portfolio oriented)

The problem is not the separation of control and ownership, but the expropriation of minority interest by large shareholders.

Investment companies are often holding a large stake of the firm. Large stakes are difficult to sale on the market, therefore the goal of the stake is a high peformance of the firm. To Monitor the firm peformance, a large stake is needed.

The supervisory board is divided by inside vs outside. There is a formal separation of responsibilites. But often the separation is bypassed

• Board Size

• Independence of Board

• Director experience

The Stock Price reflects his efforts

• Problems

  • External Crashes

  • Windfall profits

  • Over compensation

  • Share repruchase

  • possibile price manipulations

• Possible Solutions

  • Measure the peformance relative ot a benchmark

  • Construct long-term options

Principle confronts the Agent with a decision and he can infer the qualities from his choice.

• Secured Loans for example

Agent reveals his qualites by sending a signal. But that singal is only trustworthy if its costly.

Exapmle: Funds from VC

Indirect financing is important because only large and established firms have access to capital markets

Principal is aquiering information from the agent. For example through rating agencies oder analysts.

Managers with high leveraged firms tend to not invest in profitable projects beacause most of the cash would flow to the debtholder.

Borrowers tend to take to too high risks

• Monitoring or restrictive covenants

• Financial Intermediares have advantages in monitoring

Results

• Stocks are not most import source to finance a company

• Bonds are not most import to source debt

• Indirect finance is more important thand direct finance

• Banks are the best external source of financing

100% Owner Manager will make decision to maximize his utlity. His utilty is not only financial driven but also non financial.

He also bears all the costs of Consumption from non financial benefits, which will decrease the Values Firm.

It is Possible, that the Benefits from Consumption exceed the loss of Valuation

The 100% Manager-Owner wants to sell a percentge of his share, without voting rights. He now only bears the const of consumption (1-a). Due to the Reason he can get benefits for teh price of 1-a instead of 1, he will consume more. As a result the Firm Value will decrease and the Naiive Investore paid a higher price.

A Rational investor is anticipating such a behaivior and is decreasing the price to purchase a % percantage of the share.

Agency Costs are the loss of Utility for the Manager Owner. They are caused by the seperation of ownership and control of the firm.

• Constrains, so the manager owner is limited in consumpiton

• Monitoring Costs, because both of them have to bear them.

• Agency Costs because if the owner sells a portion of his ownership, he is not fully bearing the costs for his action.

• Manager do benefit also with non financial benefits, if they pursuit their own interest. A conflict of interst could arise

• Decreasing Mangerial Ownership (Jensen and Meckling, 1967)

• Decreasing Ownership Concentration (Stiglitz, 1985)

Shareholder elect directors and have to tely on them. It is a one-tier board structure with managing and non managing directors.

• Pro

  • Flow of Information is decision is faster and more efficient.

• Cons

  • Mgmt. determines who becomes nominated for the board, therefore it is doubtful that the board is independent

A Purchase of shares by the management through leverage, could lead to direct the efforts fo the firms performance. Manager would have the same interest as shareholder

If the purchase of Shares is leverage financed, Management would become Risk Avers.

• Stock Option and the massive shift to variable remuneration

• Salary with stock options bears more risk for the manager than a fixed salary, therfore some argue their salary is overestimated

• The Valuation of stock options are calculated with the Black-Scholes Formula. This assumes a diversified Portfolio, but a Manger do often not diversify well.

• Stock Options mostly have a lock-up period, therefore manager will value the options subjectviely (Value-Cost-Wedge)

Value of granted Stock-Options increases while shareholder concentration decreases

It is an imaginary market for Share of Control firms, in which the manager is not following the market value oriented corporate policy. It is a mechanisim for discipline

• Manne (1965)

  • The lower the stock price, compares to what an efficient manager could realize, the more attractive is a takeover

It does not have to mean a shortcoming in transactions activities

• German market is not common for example, because of the ownership strucutre (concentrated)

• However, many control transactions can ve observed

• Positive effect on firm performance is not observed

A toehold is a small but significant position. It does not exceed 5% of the outstanding shares. But for this % it is not necessary for the buyer to report such a purchase.

It is the only (small) profit that remains to the raider.

• Investor do not interfere, if there are no major governance deficits

• Intervention mostly happens when the manager deviates form the shareholder maximation policies

• Goal:

  • Maximum gain of everey transaction

• Managerial discretion and wealth transfer at the expenses of Shareholder arelimited

• But conflict between major and minoritiy owner (private benefits of control)

• Goal

  • Control and Influence, Maximum gain for the lung run

Principal is unable to observe and verify the behavior of the agent. The output is correlated with the activites from the agent but there are also external factors so its difficult to seperate them from the output.

The agent also pursue his own interest, therfore it would be not optimal to stick on the agreement with the principal so he will deviate his behavior (hidden action)

• Monitoring -> costs of monitoring are also paid by the manager-owner

• Bonding -> constrain the non financial consumptions

• Exit if they are unsatisfied

• Monitor and actively intervene with managers

• behave passive without interest in exerting control (Portfolio Approach)

Investment companies like pension funds and hedge funds are the one, who often hold a large stake of a firm. They are mostly responisble for the corporate governance.

But those investment companies are mostly vehicles with highly dispered ownership, so who monitors the monitor?

• Banks often hold a large stake of other companies

• They can use the voting rights of their investment management companies

• They often use their account voting right

There is no correlation between stock option allotmend and firm performance.

• Companies will pay the managers at or above the median salary from a reference group

• If all companies behave like that it would push the salaries further up (Ratchet effect). Managers also want to manipulate the reference group

Difference in the quality of corporate governance also explains the the difference in salaries

• Factors

  • Shareholder Structure

  • Structure of supervisory board

  • Competitive position on the market

The problem is the free rider problem.

Takeover wants to buy a major share and pay the exisiting shareholder a takeover premium. Shareholder decides whether they sell or not. The are behaving automastic and can influence the takeover success.

• Raider has to make an offer what is below the value he can achieve, so he still remain a gain

• On the other hand existing shareholder do not realize their effect and want to capture the highest possible value

• The only profit that remain for the raider is the toehold

• Raider pays a high salary to himself

• Sell assets to firm under his contorl

• They are often perceived as bad but the can be good for existing shareholder because they break the free rder problem