The agency problem, in the context of separation in ownership (shareholders or the principals) and control (managers or the agents), is one of the most important issues in corporate finance.
This separation may induce conflicts of interest inherent in the kind of relationship where an agent is expected to work in the best interests of a principal. In the case of a company, these conflicts of interest arise when executives, or more generally insiders which could include controlling shareholders, favour their interests at the expense of the company’s goals.
There are various manifestations of this behaviour. Managers may appropriate part of the profits, sell the firm’s output or assets at under the fair value to their own business, divert profitable growth options, or recruit unqualified relatives at high positions. See Jensen and Meckling (1976), La Porta et al. (2000, 2002), and Lambrecht and Myers (2008).
Impacts of self-interested management on corporate choices and asset prices have been extensively described by several theoretical and empirical works. They document that entrenched managers tend to underinvest and choose lower leverage. In response, shareholders may force them to increase leverage, because coupon payment reduces the firm’s free cash flows which limits the amount available for cash diversion. Therefore, debt can be used as a tool to discipline managers. Entrenched managers can also resist hostile takeovers and lead shareholders to push for the adoption of more provisions that reduce their own rights.
All these frictions reduce not only profits but also operational efficiencies and affect equity prices and volatility. To measure the impact of agency costs on equity prices, Gompers, Ishii, and Metrick (2003) and Bebchuk, Cohen, and Ferrell (2009) have constructed indexes, G-index and E-index respectively, to measure for the balance of power between shareholders and managers. High index levels (extensive management power) translate into high agency costs. They document that increases in these indexes level are associated with economically significant reductions in firm value, profits and equity price during the 1990s.
Most theoretical papers that study the impacts of agency conflicts on asset prices do not emphasise on its influence on costs of equity. Empirical papers, however, only focus on the level of the severity of the conflict.
A working paper by Dr Adelphe Ekponon, a Research Associate at the Cambridge Centre for Finance and the Cambridge Endowment for Research in Finance, proposes a theoretical approach and provides empirical evidence that time-series fluctuations of this conflict have as well the potential to explain cross-sectional differences in equity prices. Specifically, the difference in average index values in bad times compared to normal periods is positively correlated to the cost of equity, even after controlling for preeminent markets factors. Data are from 1990 to 2006.
The most important economic implications of this result are twofold: firms with countercyclical governance policy (better governance in bad times) have a lower cost of equity. Changes in governance practices in bad vs. good times is a pricing factor for stocks.
Interestingly, the paper shows that these results are closely linked to managers-shareholders conflicts, as it documents a U-shape relationship between changes in G-index and cost of equity (too many restrictions in bad times create conflicts and impediment managers ability to run the company efficiently), while this relationship is linear for the E-index. This latter index has been constructed on a subset of the G-index that focuses on managerial entrenchment.
References mentioned in this post
Bebchuk, L., Cohen, A. and Ferrell, A. (2009) “What matters in corporate governance?” Review of Financial Studies, 22(2): 783-827
Gompers, P., Ishii, J. and Metrick, A. (2003) “Corporate governance and equity prices.” Quarterly Journal of Economics, 118(1): 107-156
Jensen, M.C. and Meckling, W.H. (1976) “Theory of the firm: managerial behavior, agency costs and ownership structure.” Journal of Financial Economics, 3(4): 305-360
Lambrecht, B.M. and Myers, S.C. (2008) “Debt and managerial rents in a real-options model of the firm.” Journal of Financial Economics, 89(2): 209-231
LaPorta, R., de Silanes, F.L., Shleifer, A. and Vishny, R. (2000) “Investor protection and corporate governance.” Journal of Financial Economics, 58(1-2): 3-27
LaPorta, R., de Silanes, F.L., Shleifer, A. and Vishny, R. (2002) “Investor protection and corporate valuation.” Journal of Finance, 57(3): 1147-1170