Agency Costs and Corporate Governance, A Quick Overview: Part 1

We've written a lot about corporate governance in these posts including ways in which mergers can be caused by faulty corporate governance and value (in mergers and private equity) can be created by better corporate governance.  In the paragraphs below, I'll explore a few of the basic concepts of corporate governance.  All of this material can be attributed to the academic father of corporate governance, Michael Jensen.  (For a video interviews I did with Mike Jensen see this link.)  

Mike Jensen and William Meckling wrote the modern treatise on Corporate Governance entitled Agency Theory, in 1976.  The ideas are related to work by Alchian, Demsetz, Berle and Means and others.  In fact, ideas of corporate governance can also be traced to Adam Smith and undoubtedly much further back in history.  But Jensen and Meckling created the modern excitement about the field and showed, in an elegant model, how value is created and destroyed by good and bad governance.   Thousands of articles have since built on and tested the concepts of their pioneering work and the practice of corporate governance has been materially improved by these ideas.  The subject can and has filled volumes.  Here is an overview.

First, corporate governance involves the alignment of the interests of owners and managers.  In the modern corporation, the owners are the shareholders and the executives are the managers.  There are tremendous advantages of owners hiring professional managers, for example, not all (many) owners have the expertise or time to run the business.  However, the second a professional manager is hired, the potential for agency problems (that is, corporate governance problems) is created.  Why?  Because rational (and irrational) people will pursue their own self interests and the best interests of the executives can deviate from those of the owners.  

Here are two easy examples.  First, consider executive compensation.  CEOs want to be paid more, while owners may want to pay less.  The same can be said of executive perquisites.  The entrepreneur running his or her own firm may not even have an office, instead choosing to stroll the plant on the lookout for situations that can be improved.  After all, any office accrutements come at direct cost to the owners.  Now consider the same situation when a manager (owning just a small fraction of the firm) is hired to run the business.  And remember,  the CEO of major corporations typically owns a fraction of one percent of the business.  Suddenly, the benefits of a more comfortable office outweigh their actual costs to the person in charge, the CEO.  The corporate jet that would cost $20 million to the owners, costs a fraction of a percent to the modern CEO.  Decisions are made that would not have been made under a 100% owner.  Not all of these different decisions are bad - the situation is different, but all require careful analysis.

As a second example, consider the situation when a sale of the business is best for the owners.  It may not be best for the CEO who may loose his or her job.  Related to this, acquisitions that expand the empire may benefit the executives, but not the owners.

All of these situations can create Agency Problems or problems.  In part 2 of this post, next Thursday, we'll consider some ways to mitigage Agency Problems.

All the best,

Ralph