Agency Problems in Practice PDF

Module 5 Agency problems in practice Learning objectives After studying this section, you should • Understand the cash flow problem and its governance problems • Understand the concept of managerial empire building • Understand the role of managers’ behavioral biases in corporate governance 2 F...

Module 5 Agency problems in practice Learning objectives After studying this section, you should • Understand the cash flow problem and its governance problems • Understand the concept of managerial empire building • Understand the role of managers’ behavioral biases in corporate governance 2 Free cash flow problem • The payout of cash to shareholders creates major agency problem between shareholder and managers of the firm (Jensen, 1986) • These payouts reduce the resources under managers’ control ˗ Reduces managers’ power ˗ Increases the monitoring of managers by the capital markets, if the firm must obtain new capital ˗ Financing projects internally avoids this monitoring • Managers can also use excess cash for value-decreasing activities such as acquisitions or empire building or for pet projects, perks etc. • Consequently, managers are reluctant to payout cash 3 Free cash flow problem • Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values • Not surprisingly, conflicts of interest between shareholders and managers over payout policies are especially severe when the firms generates substantial free cash flow • How to motivate managers to payout the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies? →Corporate governance problem ˗ “Regular attempts” to solve agency problem apply here, too ˗ Free cash flow problem should be more severe, when agency problems are severe 4 Free cash flow problem • Free cash flow problem has several managerial implications • Market value of cash ˗ Market value of cash may be lower than its book value • Dividend cuts ˗ Firms may be reluctant to pay cash dividends • Value-destroying M&As ˗ Firms may use excess cash to unprofitable acquisitions • Empire building ˗ Firms may waste money for unprofitable growth • Note that (good) firms may adopt other governance mechanisms to convince investors that these problems do not exist 5 Market value of the cash • One way to assess the free cash flow problem is to explore the stock market valuation of free cash flow or cash holdings ˗ Agency problems arising from the free cash flow problem may lower the value of cash for investors ˗ “A dollar of corporate cash holding may not be worth a dollar to outside shareholders, since firm insiders may spend part or all of it on the pursuit of private benefits” Masulis et al. (2008) • Zerni, Kallunki and Nilsson (2011) explore whether board members’ monitoring incentives reduce the free cash flow problem from minority investors’ point of view ˗ They find that the value of free cash flow increases with the portion of personal wealth that board members have invested in a firm 6 Dividend payouts • Managers may be reluctant to pay high dividends • Many papers explore, wheter the free cash flow problem is reflected in low dividends • Results are mixed ˗ Some firms seem to seek for investors’ confidence by paying dividends ˗ Some firms tend not to pay dividends • E.g. Zerni, Kallunki and Nilsson (2011) find that also dividend pay-out ratios increase with the portion of personal wealth that board members and main owners have invested in a firm ˗ More stringent governance reduces the free cash flow problem 7 Value-destroying M&As • Free cash flow theory predicts that certain type of mergers and acquisitions are more likely to destroy the value of the acquiring firm • M&As are one way managers spend cash instead of paying it out to shareholders • Therefore, the theory implies managers of firms with large free cash flows and unused borrowing power and more likely to undertake low-benefit or even value-destroying M&As • M&As motivated by the diversification of business operations may involve less waste of resources than if the funds had been internally invested in clearly unprofitable projects 8 Empire building • Managers’ allocations of resources may not be efficient and can destroy investor value • If corporate governance is weak, managers may begin to build up their “empires” →Empire building stems from differences in preferences between investors and executives • Empire building may take two forms ˗ Excessive growth ˗ Excessive capital investments • Managers act in this way because increasing firm size could serve their private interests in various ways ˗ Hunger for status and prestige 9 Empire building ˗ Compensation ˗ Decrease unemployment risk ˗ Creates additional middle manager promotions ˗ Makes the manager more indispensable to the firm ˗ Power • Empire building is more likely, if managers are less accountable to the firm’s investors ˗ Financial reporting is one important means of monitoring managers to make them more accountable ˗ Investors can recognize the firm growth and investments – and, especially, profitability from financial reports ˗ Unwarranted growth together with reduced profitability is a bad sign for owners 10 Managers’ behavioral biases and corporate governance • Many studies show how managerial traits affect various corporate decisions and the key business outcomes ˗ Mergers and acquisitions (Delis et al., 2022) ˗ Capital structure choices (Hackbarth, 2008) ˗ Capital expenditures (Malmendier and Tate, 2005) ˗ Financial distress (Kallunki and Pyykkö, 2011) ˗ Tax avoidance (Hjelström et al., 2020) • Important implications for corporate governance ˗ Appointing ‘bad’ managers may worsen the agency problem ˗ Managers’ personal traits need to be matched with their tasks 11 Managers’ behavioral biases • Hambrick and Mason (1984) were first to argue that managerial experiences, values and cognitive styles, such as honesty, affect their choices and consequent corporate decisions • Behavioral models suggested in the psychology literature have been conceptualized in the context of economic decision-making • Behavioral biases may be motivated by managers’ irrational or rational behavior ˗ Irrational – managers understand they are behaving wrong, but they still do it ˗ Rational – managers believe they are not doing anything wrong 12 Managerial overconfidence • Overconfidence is defined as an individual’s tendency to be overly optimistic and overconfident regarding her own susceptibility to risk ˗ “It can certainly happen to others, but not to me…’ ˗ On average, people (men) are better-than-average drivers • Overconfidence occurs in all social categories, even among those who are more informed about the actual statistical probability of adverse events 13 Managerial overconfidence • Closely related behavioral biases are ˗ Over-optimism -- overestimating the probabilities of favorable events and underestimating the probabilities of unfavorable events ˗ The illusion of control -- overestimating the role of personal skills relative to luck in the determination of outcomes • Overconfident managers underestimate the volatility of their firms’ future cash flows • Optimistic managers overestimate the mean of the cash flows 14 Sensation seeking • Sensation-seeking refers to an individual’s tendency to take physical, social, legal and financial risks simply for the sake of the thrill ˗ ‘Gambling is so exciting…’ • Sensation seekers are relatively fearless and take risks because of the resulting thrill – not because of the expected utility resulting from actions that involve greater risk 15 Managerial traits and M&As • Roll’s (1986) ”Hubris Hypothesis” of mergers and acquisitions (M&A): Managers in acquiring firms pay too much for their targets • Consider following steps in the M&A process 1. The bidding firm identifies a potential target firm 2. The bidding firms undertakes a valuation of the equity of the target. This valuation includes cost-savings due to synergy, assessments of weak management etc. 3. The value is compared to the current market price ▪ ▪ If value is below price, a bid is not made If value exceeds price, a bid is made →Valuation errors result in too high price 16 Managerial traits and M&As • The average manager has the opportunity to make only a few takeover offers during his career • He may convince himself that the valuation is right and that the market does not reflect the full economic value of the combined firm • If there actually are no aggregate gains in takeover, the phenomenon depends on the overbearing presumption of bidders that their valuations are correct • Even if gains do exist for some corporate combinations, at least part of the average observed takeover premium could still be caused by valuation error 17 Managerial traits and M&As • How to measure managerial hubriss/overconfidence in practice? • Malmendier and Tate (2008) use two measures of CEO overconfidence: ˗ CEO’s personal over-investment in her firm: Overconfident CEOs hold their employee stock options until the year of expiration, even though the option is at least 40% in-the-money entering its final year ˗ CEO’s press portrayals: Articles in business press (The Wall Street Journal, The Economist etc.), characterize overconfident CEOs by using words like ‘‘Confident’’, as opposed to ‘‘Cautious’’ or similar expressions 18 Managerial traits and M&As • Malmendier and Tate (2008) find that ˗ Overconfident CEOs over-estimate their ability to generate returns in M&As ˗ As a result, they overpay for target companies and undertake valuedestroying mergers ˗ The odds of making an acquisition are 65% higher, if the CEO is classified as overconfident ▪ The effect is largest if the merger is diversifying and does not require external financing. ˗ Stock market reaction at merger announcement (0.9% basis points) for overconfident CEOs is significantly more negative than for nonoverconfident CEOs (0.1% basis points) 19 Managerial traits and M&As # of overconfident (Longholder) CEOs and non-overconfident (Remaining CEOs) who completed M&As divided by the total number of CEOs. Malmendier and Tate (2008) 20 Managerial traits and M&As Stock market response to M&As made by overconfident CEOs: An acquirer’s cumulative market-adjusted return around the M&A announcement day. Malmendier and Tate (2008) 21 Managerial traits and capital structure • Overconfident CEOs use more debt and issue new debt more often (Hackbarth, 2008 and Ben-David et al., 2007) • There is a positive relation between CEOs’ personal home leverage and corporate leverage (Cronqvist et al., 2010) → firms behave similarly to how their CEOs behave personally in leverage choices 22 Managerial traits and financial distress • Kallunki and Pyykkö (2013) show that appointing CEOs and directors with past personal payment default entries increases the likelihood of financial distress of the firm ˗ “If managers cannot manage their own money, how could they manage the money of their company…?” • So far, distress prediction and credit rating models have based solely on financial ratios or similar firm-level data • This is the first paper to use information on managers’ personal characteristics in distress prediction • Results show that it pays to check CEOs’ and directors’ personal credit defaults – defaulting managers are a governance problem! 23 Managerial traits and financial distress • Theoretical reasoning is based on two literatures ˗ Overconfidence, optimism, the illusion of control and sensation-seeking affect consumption attitudes and resulting saving and borrowing decisions ▪ Important factors of consumers’ over-indebtedness and credit defaults ˗ The same personal characteristics play an important role in the key managerial decisions ▪ Capital structure, investment and M&A decisions → Managers’ personal credit defaults reflect the same personal traits that have been found to affect corporate decisions, which may lead a firm into financial distress 24 Managerial traits and financial distress • Traditional ditress prediction models (Altman’s model and Ohlson’s model) use financial ratios that are likely to predict future financial distress of the firm ˗ Profitability – Weaking earnings may launch the process that leads firms into financial distress (early warning signs) ˗ Financial leverage – All too much debt is a signal of already-existing financial troubles (strong warning signs) ˗ Liquidity and working capital – Liquidity straits are a strong signal of anticipated ditress (final warning signs) • We add managers’ credit default information to these models to explore the incremental role of this information in distress prediction 25 Managerial traits and financial distress Proportion on defaulting CEOs and directors between distress and non-distress firms Bankrupt firms Insolvent firms Non-distressed firms Defaulting CEOs 6.8% 5.1% 1.2% Defaulting directors 11.9% 11.6% 2.8% 26 Bibliography • Ben-David, I., Graham, J. R., & Harvey, C. R. (2007). Managerial overconfidence and corporate policies (No. w13711). National Bureau of Economic Research. • Cronqvist, H., Makhija, A. K., & Yonker, S. E. (2012). Behavioral consistency in corporate finance: CEO personal and corporate leverage. Journal of financial economics, 103(1), 20-40. • Delis, M. D., Iosifidi, M., Kazakis, P., Ongena, S., & Tsionas, M. G. (2022). Management practices and M&A success. Journal of Banking & Finance, 134, 106355. • Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. The American economic review, 76(2), 323-329. • Hackbarth, D. (2008). Managerial traits and capital structure decisions. Journal of financial and quantitative analysis, 43(4), 843-881. • Hambrick, D. C., & Mason, P. A. (1984). Upper echelons: The organization as a reflection of its top managers. Academy of management review, 9(2), 193-206. • Hjelström, T., Kallunki, J. P., Nilsson, H., & Tylaite, M. (2020). Executives’ personal tax behavior and corporate tax avoidance consistency. European Accounting Review, 29(3), 493-520. • Kallunki, J. P., & Pyykkö, E. (2013). Do defaulting CEOs and directors increase the likelihood of financial distress of the firm?. Review of Accounting Studies, 18(1), 228-260. • Malmendier, U., & Tate, G. (2008). Who makes acquisitions? CEO overconfidence and the market's reaction. Journal of financial Economics, 89(1), 20-43. • Masulis, R. W., Wang, C., & Xie, F. (2009). Agency problems at dual‐class companies. The Journal of Finance, 64(4), 1697-1727. • Zerni, M., Kallunki, J. P., & Nilsson, H. (2010). The entrenchment problem, corporate governance mechanisms, and firm value. Contemporary Accounting Research, 27(4), 1169-1206 27