Thursday, April 17, 2014

Agency Theory,Corporate Governance and Acquisitions

We’ve mentioned that one of the ways going private creates value is through improved governance.  In fact, governance is strongly linked to mergers and acquisitions.  Consider the following:

Governance involves aligning the interests of owners and managers.  A merger changes the ownership of target and possibly bidding firms.  Thus, it creates possibilities for altering the alignments that previously existed.

Governance issues are called agency problems in the academic literature because they involve agents (the CEO, the board and management) working on behalf of the owners (shareholders).  Agency problems occur naturally because the best interests of owners may not coincide with those of the agents they hire.  Good governance seeks to align these interests. 

In future posts, we’ll spend more time on some of the potential agency conflicts that arise naturally in corporations and in particular in mergers and acquisitions.  They include, but are certainly not limited to:

CEO compensation.  It is natural for an executive to desire more and for owners to want to pay what is justified.

Consumption of perquisites by the executive team.  A sole proprietor may have a Spartan office and fly coach.  If he/she does not, they bear 100% of the costs of any perquisites.  This is not true for the CEO of the typical large corporation who probably owns less than 1% of the equity and hence bears that proportion of the costs of perquisites.  Suddenly the private jet looks more appealing.

Resistance to mergers.  A merger in the best interests of shareholders may nevertheless cost a target CEO his or her job.  Enough said.

Acquiring for the sake of building the empire.  An executive may desire to expand the empire for personal reasons.  After all, the size of a company is linked to measures of ‘prestige’ like being part of the ‘Fortune 500.’  And, of course, there is a strong link between size of the firm and size of the CEO’s pay.

Getting caught up in deal fever and overpaying.  We’ve noted a good deal becomes a bad deal at some price.  Most of us have encountered a bidding situation, on eBay or elsewhere, where we’ve gotten caught up in the momentum of bidding and gone beyond our preset upper limits.  Ego can also becomes a factor in heated bidding wars.  Neither of these situations is best for us as individuals and they certainly aren't best when playing with shareholder's money.

Conflicts between classes of capital.  Less obvious are the conflicts that can exist between equity holders and debt holders.  In a share repurchase, for example, equity holders may gain at debtholders expense.  This can occur when the collateral protecting the debt holders (including cash) is reduced for share repurchase.

These are but a few of the potential conflicts that must be handled carefully in mergers and related transactions.  In a subsequent post, we'll talk about the incentives created when an owner (say an institution) holds both debt and equity in a deal.    


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