Topic 1 - Governance and Ownership Flashcards
The separation of ownership from control
The wealth of shareholders depends on the actions of corporate executives over whom they have limited
control.
- Limited control is inevitable because the executives run the day-to-day business where shareholders have limited control over day-to-day activities.
- Executive employment contracts are ‘incomplete’ because ‘complete contracting’ is impossible due to bounded rationality, asymmetric information and the costs of becoming informed (Hart, 1995)
- With agency theory, contracts are key to making a firm run smoothly.
- There is a danger though that executives may develop priorities and/or preferences that are different from shareholders
– Eg. Executives may be more risk-averse than shareholders with the result that they may prefer not to undertake risky but positive NPV
projects - the underinvestment problem.
- Shareholders are invested in many companies so they minimise their risk. Executives on the other hand, are more risk-averse because they rely on one company for most of their wealth. (It is their job, they have shares etc.)
– Eg. Executives may use free cash flow to invest in negative NPV projects which benefit them – the ‘overinvestment’ problem. (E.g. executives might invest in corporate jets because they’re more likely to invest in the things they like)
Managerial Theories of the Firm
Managerial theories of the firm looks at the possibility that the firm is controlled by its managers instead of its owners.
Managerial theories (e.g. Baumol, 1959;Williamson, 1964) are based on the following premises:
– Dispersal of shareholdings creates a ‘power’ vacuum which gives management effective control. Shareholders are left with very little power
– Management interests differ from those of shareholders (Agency Theory)
– Weak competitive conditions (in the product and capital markets) allow managers to divert from the profit maximising goal
Agency Theories of the Firm
Based on similar premises to managerial theories but explicitly assume that all parties will take steps to contract to reduce inefficient outcomes.
• Jensen and Meckling (1976) define an agency
relationship as:
– ‘a contract under which one or more persons ( the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent’
The manager (agent) is motivated by monetary reward from the shareholder (principal) to take actions on his/her behalf.
• Both principal and agent are assumed to be motivated by self- interest.
• Agency relationships are characterised by uncertainty, information asymmetries and conflicting interests between the shareholder and manager.
• The manager is assumed to have access to superior
information regarding his/her own performance and the
shareholder is unable to directly observe, without cost,
the actions of the agent.
• Agency problems in the form of moral hazard may arise if the manager uses his/her superior information to maximise his/her own self interest at the expense of the shareholder
Agency costs arise as a result of the need to contract in order to align the interests of managers with those of shareholders.
• Agency costs include:
– ‘the costs of structuring, monitoring and bonding a set of contracts among agents with conflicting interest, plus the residual loss
incurred because the cost of full enforcement of contracts exceed benefits.’ (Fama and Jensen, 1983)
Agency theory focuses on the specific role of contractual provisions in modifying behaviour, with the emphasis on the importance of contractual design in ensuring that agent discretion is exercised in the interest of the principal.
• Corporate governance becomes an issue when contracts are incomplete in the presence of agency costs.
Jensen and Meckling (1976)
A paper which focuses on the agency problems existing between
shareholders and managers; and shareholders, managers and debtholders.
• Much of the subsequent literature examining the agency problems derived from the separation of ownership from control draw on the Jensen and Meckling model
The model considers a firm which is wholly owned by a single owner-manager.
• In order to finance projects requiring funds in excess of the firm’s internal resources, two choices:
– issue equity, or
– issue debt.
Issue equity
– Sale of equity to outside investors reduces the ownermanagers
fractional interest in the firm.
– This increases his/her incentives to partake in excessive perk consumption (e.g. expensive business trips, expensive company car, etc.) as the effective cost of such consumption to the owner-manager is lowered.
– However the outside investors anticipate such actions
and discount the price they are willing to pay for the
equity shares,
Issue debt
– Increases the owner-manager’s incentives to invest in high-risk projects which offer high returns if successful, but increase the probability of failure.
- Issuing debt leads to riskier projects because the director can gain high returns since they own 100% of the company. However, debt holders gain nothing from investing in riskier projects because they still earn the same interest payments.
– In the event of failure, the owner-manager’s loss is limited to their equity shareholding, but all the gains accrue to them if the project is a success.
– Known as the ‘asset substitution’ effect – riskier assets are substituted for less risky assets to the detriment of debtholders, as they end up on bearing more risk without the gain of success.
– As debt increases in proportion to equity, debt holders therefore demand progressively higher premiums to compensate for the increased probability of failure.
The advantages of issuing debt, in the form of a reduction in the agency costs of equity, are offset at the margin by the agency costs of debt.
• According to the model, there will be an optimum level of debt which minimises the sum of the total agency costs.
The model suggests that the fraction of equity held in the firm affects the size of the agency costs of equity.
• Therefore, the higher the percentage of management ownership, the lower the agency costs of equity.
• Management ownership is negatively related to the agency costs of equity; hence the ownership structure of the firm has important implications for the level of agency costs.
Alternative view (Demsetz and Lehn)
Demsetz and Lehn (1985)
– Type of ownership-control structure has no effect on performance as ‘the structure of corporate ownership varies systemically in ways that are consistent with value maximisation.’
- Their findings are based on the view that diffuse ownership would not exist unless it was efficient
– Based on the view that, in a rational world, diffuse ownership would not exist unless it was efficient.
- This is a circular argument
Early Empirical studies
Earlier work (1960’s and 1970’s) attempted to examine the testable hypothesis emerging from the managerial theories. • The majority of these studies differentiated between owner-controlled (OC) firms and management-controlled (MC) firms – In general OC = dominant shareholding which owned a specified fraction of the firm – MC = no dominant holding and/or shareholdings dispersed. • Studies examined whether OC and MC firms exhibited differing performance characteristics.
Problems with early studies
– Use of a dichotomous variable (OC/MC) based on the percentage size of a controlling shareholding block took no account of the differences in shareholding dispersion between firms.
– Studies used different cut-off points to distinguish between OC and MC
– Few studies distinguished between external shareholders and management shareholders (i.e. the OC group usually included both)
Later empirical studies (improvements)
Later studies used continuous measures of control, eg.
– % of management shareholding
– % of institutional shareholdings
– shareholder concentration measures
Linearity v Non-Linearity
Use of either dummy variables (OC/MC) or continuous variables assumes that if there is some difference in performance of firms
due to different ownership structures, that relationship is uniform.
• However, more recent studies suggest that the relationship is non-linear.
Theory
– ‘Convergence of interest’ hypothesis
• As directors ownership in the firm increases, firm value increases as directors are less inclined to divert resources away from value maximisation - outcome from J and M.
• Demsetz 1983 and Fama and Jensen 1983 contend that market discipline will force managers to adhere to value maximization at very low levels of ownership.
– ‘Entrenchment’ hypothesis
• High levels of directors’ ownership allows directors to have sufficient control to follow their own interests without fear of discipline from other shareholders.
• Combination of convergence of interest and entrenchment suggests a non-linear relationship between directors’ ownership and firm performance
Non-Linearity
Morck, Shleifer and Vishney (1988) - US
– Used piecewise regression, allowing the coefficients on the directors’ ownership variable to change at 5% and 25%.
– Found a positive relationship between directors’ ownership and firm value at 0 – 5% ownership (convergence of interests dominant)
– Found a negative relationship at 5 – 25% ownership (entrenchment dominant)
– Found a positive relationship at 25% + ownership (convergence of interests dominant)
McConnell and Servaes (1990) - US
– Used the variables directors’ ownership and directors’ ownership squared.
– Found a curvilinear relationship between directors’ ownership and firm value.
– Firm value first increased and then decreased.
Short and Keasey (1999) - UK
– Used a cubic function with the variables directors’ ownership, directors’ ownership squared and director’s ownership cubed.
– The results suggested that the performance of firms is positively related to managers’ ownership in the 0% to 15% range, negatively
related in the 15% to 41% range and positively related when managers’ ownership exceeds 41%
Davies, Hillier and McColgan (2005) - UK
– Used a quintic function with the director ownership variables (i.e up to DIR5)
– Found turning points at 7%, 26%, 51% and 76%
Endogeneity
Issues of endogeneity which question whether the causal link runs from
ownership to performance.
– Himmelberg et al (1999) found no relationship between ownership structure and performance
– Demsetz and Villalonga (2001) found no relationship between ownership structure and performance.
