Agency problems are defined as problems happening due to conflicts of interests between a principal and an agent. An agent is hired by a principal and is supposed to perform on behalf of the principal with the aim of maximizing the principal’s benefits. However, the agent also has his own interests, and, during the time working for the principal, he may diverge from the ultimate purpose of working for the principal and may perform for his own benefit. In the financial field, there are two primary types of agency problems: between shareholders and managers, and between equityholders and debtholders.
First one is the agency problem between shareholders and managers. When a company is set up, the founder is the owner and manager. He will act on behalf of himself to create more wealth. If the owner sells a part of his ownership to outsiders, the owner-manager will not possess 100% of the company and a conflict of interests occurs. The insider manager/owner will not behave in a way that maximizes the company’s wealth and will have a tendency to take advantage, consuming for his personal desire at company’s expense. The less company stocks the managers own, the more likely conflicts of interests will occur.
The solution to the shareholders-managers agency problem is aligning the interests of managers with those of the shareholders, forcing them to work in a way that maximizes shareholders wealth. The incentive compensation is used to encourage managers, for governance structure to monitor them, or for leverage to constrain them. To execute the solutions, costs occur, and they are called agency costs. There are three main types of agency costs: costs occurring due to applying methods to monitor managers’ actions such as fees for using independent auditors; costs arising due to setting up the company’s organization in order to limit the managers from diverging shareholders’ interests; and opportunity costs that happen when shareholders take time to get a consensus before letting managers take action.
Next is the agency problem between equityholders and debtholders. The debtholders give loans to the firm and get returns from firm’s cash flow in the form of interest payments. The interest rate applied for each loan is calculated based on the existing risk level of the firm at the time the loan is issued. After receiving the loan, the stockholders take action through their management in the company and change the risk level, such as selling some assets and investing in risky projects. The debt value decreases because more debt risk is borne. In case the risky project is successful, debtholders will not receive more returns because their income is fixed. However, if that project fails, debtholders have to share the risks. In this case, the interests of the two parties are not aligned. In order to protect their benefits, the debt-holders will apply some mechanisms such as stricter covenants or rising interest rates. This causes the company difficulty in accessing the financial market and the debt costs increase. This creates agency costs. To alleviate agency cost from debts, equityholders and debtholders benefits should be balanced; experts suggest the use of incentive compensation and convertibles in a company’s leverage.
Nowadays, with the evolution of the business world, many new agency problems occur. Other types of agency problems such as conflicts of interests between shareholders who are executing company control and shareholders who are not, or minority shareholders. This happens when controlling shareholders who usually own a substantial portion of a firm’s ownership make decisions that are not beneficial for minority shareholders who do not have enough power to affect the decisions with voting rights. Over-investment problems happen when there are surplus free cash flows and managers investing in projects that are not value-added without facing financial constraints. Under-investment problems arise when a company acquires too many debts, and the risk of default makes managers reluctant to invest and analyze thoroughly before deciding. Sometimes these managers ignore risky but high return projects and choose investments in safe projects without good returns. There is another type of agency cost, which arises from using money to pay dividends and not investing in positive Net Present Value (NPV) projects.
In general, agency problems are related to the structure of ownership. The problems occur when the owners do not totally operate their businesses by themselves and when the owners acquire debts to finance the business. In other words, the benefit sharing among parties make people think and act more for themselves and lead to conflicts of interests. The shareholders and the managers, the majority shareholders and minority shareholders, the equityholders and the debtholders all invest in businesses, perhaps in different forms, and want their returns. However, with the participation of many parties, no one will be able to get all of the returns.
Each agency problem has its own core causes. Each mitigation mechanism also has its strengths and weaknesses. Thus, in order to deal effectively with a specific agency problem, we have to analyze the causes of the problem and choose the most suitable approaches to deal with it. In order words, we have to know what agency problems we are facing and why they occur.
There are many approaches (internal and external) for curbing agency problems in organizations. We will concentrate on internal mechanisms that companies can choose actively by themselves. They are compensation structure, corporate governance, and capital structure.
1. Compensation Structure
The conflicts of interest between managers and shareholders cause agency costs. Shareholders put money into a company, and they want their wealth maximized. Managers are hired to manage the company’s day-to-day activities. They invest their human capital in the company, and they want to maximize their investments as well. If the interests of the managers are attached to those of the shareholders, this divergence is solved. Stemming from this approach, companies offer incentive compensation to executives as a way of encouraging them to act in value-added ways to shareholders. Thus, in the executives incomes, besides basic salaries and quarterly bonuses, there are some incentive payments tied to their company’s performance in order to encourage executives to pay more attention to long-term performances. There are two popular types of incentive compensation: stock ownership and stock-option grant.
When the managers join the company, they are given a certain amount of stocks with preferred pricing or other ways to connect their interests with their company’s interests. While stock ownership gives managers the feeling of keeping real wealth, the stock-option grant gives executives opportunities to purchase a certain amount of their company’s stock at a predetermined price for a specific range of time in the future. Managers will own the stocks if they execute their rights, or their options will expire. The logic of these incentives is that managers will try their best to increase the company’s stock price because they can get more returns. This behavior benefits shareholders as well.
It is easy to understand that even though managers’ benefits are tied to those of the company, if the current stock price is higher than their predetermined price, it is a more attractive situation for managers. However, in the case of out-of-the-money options, the current stock price is lower than the predetermined price. The reasoning for setting up the option price in this way is wise because it forces executives to do their best to push their company’s performance, increasing stock price so that they gain when they exercise their options. However, the way the option price is set up also has negative outcomes. In order to gain from their options, managers will do everything to enhance the stock price, including manipulating the performance data. This destroys the effect of the mechanism. Furthermore, the stock market responds negatively to such information about financial data restatement. This gives executives constraints, and these constraints are even stronger when they have stockownership.
The question of what types of agency problems that incentive compensation will mitigate arises. The compensation mechanism works effectively with large agency problems such as choosing strategy and investment projects. Small agency problems such as perquisite consumption will be solved more effectively with direct monitoring. Furthermore, there is an interesting finding about compensation policy. If increasing incentive compensation is used to alleviate the agency problem of equity, decreasing the compensation is applied to mitigate the conflicts of interests between shareholders and bondholders. When the incentive compensation works well, managers will act according to shareholders benefits and choose investment policies that maximize shareholders wealth at debtholders expense. This hurts debtholders, and it makes the conflicts more severe. In this case, reducing the compensation for managers is a solution.
2. Corporate Governance
Corporate governance is also a mechanism used to deal with agency problems. Managers are hired to operate the company; in order to prevent them from deviation, one solution is to monitor them: look at their activities so that shareholders can stop any improper decisions before they become worse. Governance is mostly exercised by the board of directors who control executives based on the company’s rules and regulations. Usually board members are also firm executives. People debate that if executives can control themselves, then shareholders do not need to establish supervisory boards. Then outside directors, representatives of large shareholders, institutional shareholders, mutual funds, and even the state are nominated for boards of directors with the expectation of increasing supervisory effectiveness.
To enhance the monitor role of the board of directors and to separate the power of executives and board members, outside directors’ appointments become an inevitable trend. At first, outside directors execute their jobs to maintain their reputations in the field. Later on, to attract capable directors and to stimulate them, companies start offering stock-based incentive compensation. The compensation plans for directors work well in mitigating agency problems.
However, there is also a question about whether these incentive compensations really encourage directors to work on behalf of shareholders’ interests or to protect their incomes rather than their reputations. There are reasons for this skepticism. Agency problems appear in the same way as with executives compensation packages. To protect their benefits, directors tend to depend on managers and to compromise in making financial reports. However, boards that are less dependent on executives seem to perform worse than boards that are more dependent on company executives. The research infers that there may be agency costs arising from setting up a board of directors, but the benefits in reducing agency problems outweigh the costs.
The question arises of which agency problems will be solved effectively with the governance structure. Corporate governance is effective when agency risk is high; the company has surplus free cash flow. Direct monitoring is effective for small agency issues such as perquisite consumption. It is inferred that the direct intervention of directors will effectively impede managers from using cash resources in unproductive ways such as investing in projects or activities that do not generate value for shareholders but bring benefits for themselves. If the boards work effectively, a generous donation, an unnecessary overseas meeting, or purchasing a private airplane cannot occur. More mature companies with few investment opportunities may have excessive free cash flows; these cash resources may trigger unproductive investment or perquisite consumption.
3. Capital Structure
The roots of agency problems are the imperfect alignment of the principals and agents interests. Managers do not only work for the company’s benefit but also for themselves. These personal benefits include consuming excessive perquisites such as luxurious vacations, overseas conferences, or investing in projects that are risky and do not enhance the value of the shareholders. The existence of surplus cash flow is the condition that entitles managers to make unproductive investments. Thus, to impede the managers from acting in a way that is not value-added, surplus free cash flow should be reduced. Therefore, the question arises of how to lessen the amount of cash available within a company and simultaneously encourage managers to work more value-added. The answer is using leverage. In order words, the firm should change its capital structure and increase the debt/equity ratio.
Greater financial leverage can help reduce the agency costs by impacting managers including threat of liquidation, and the pressure of making money to pay for debt interests and principals. Leverage also helps reduce the conflicts between shareholders and managers in many ways, including choosing projects to invest and payout policy. However, the relationship between leverage and agency cost is not exactly negative. When the firm uses too much debt, the increase in cost of financial distress means that bankruptcy will be bigger than the decrease in the cost from the shareholders-managers conflicts.
When the company uses debts, it has to pay for the interest and principal; the higher the debts, the greater the payment. To make more money to pay these debts puts stress on managers. If the company fails to make enough money to pay for its interest expenses and debt principal on the due dates, the company may come to default. If this happens, the managers will lose their jobs, their incomes, their perquisites, and their reputations. Thus, to protect their benefits, managers will act in a way that keeps the company alive, healthy, and prosperous. This is what the stockholders want.
One type of agency cost is the cost of over-investment. In a firm that is not levered and has excessive cash flow after investing in positive NPV projects, the surplus cash is usually over-invested in cash or real assets rather than delivered to shareholders. Furthermore, it is possible for managers to put money in projects that are not thoroughly analyzed or even risky because there are excess liquid funds; managers do not have constraints about financial funds. These investments may not create value for shareholders. When leverage is applied, debts such as long-term loans are issued, and cash guaranteed for loan and interest payments consume significant parts of surplus cash, thereby reducing the free cash flow under the manager’s discretion. So, debts play an important role in reducing the over-investment problem.
Other ways to reduce the available cash and reduce opportunities for managers to waste the company’s resources is a payout policy-share repurchase and dividend payout. When the company has excessive cash, the possibility of using it in unproductive ways by controlling managers is high. Cash extraction helps align interests between managers and shareholders, but payment is for creditors. There are other ways to make shareholders more pleased including paying money directly to them by applying a payout policy. This form of cash extraction is proven to alleviate agency problems, especially for companies that are mature, have massive surplus cash, and lack investment opportunities.
There is no obligation for managers to distribute the surplus cash to shareholders; therefore, the question arises of how to make them do this. If the company has surplus cash and investment opportunities are not plentiful, better managerial incentive alignment and closer monitoring by external shareholders are important factors stimulating such payout.
The use of leverage has two sides. It can reduce agency problems such as over-investment due to surplus cash, but when too much debt is used the conflicts of interest between the equity holders and debt holders become serious and lead to the problem of under-investment. Decreasing the incentive compensation will be the best choice to mitigate the conflicts of interests between shareholders and bondholders.
Mechanisms for dealing with agency problems are multifunctional. Each method mentioned above not only works effectively alone, but companies can substitute these mechanisms. In order to alleviate the agency problems coming from surplus free cash flow, debt can be substituted for stock options. Debt and managerial equity ownership can also be used as alternative methods in controlling equity agency problems. Within debt use, convertible bonds have different effects in comparison with straight debts.
In dealing with agency problems between equityholders and debtholders, besides using the incentive compensation, convertible bonds are effective tools. With the overuse of ordinary debts, the risk of default is high. Therefore, equityholders through managers will try to gain value at debtholders’ expenses. The introduction of convertible bonds into the existing structure of equity and straight debts gives the bondholders the right to convert debts into equity under some conditions. This conversion right reduces the conflict of interest between the two parties.