Corporate governance (introduction)
The main question to determine the point if view will be whose firm is it. Which is the main
corporate governance question
Shareholder vs stakeholders
US and UK Germany, France and Japan
Equity holder more important Employee (stakeholder) more important
Are corporate assets the collective labor of
Are shareholder and debtholder primary many generations and stakeholders?
essential?
“Why should I care about the shareholders, who
I see once a year at the general meetings. It is
much more important that I care about the
employees; I see them every day” (Kahlausen
1994, Volkswagen AG CEO
“the ways in which suppliers of finance to
corporations assure themselves of getting a “the combination of mechanism which ensure
return on their investment” that the management (the agent) runs the firm
for the benefit of one or several stakeholders
(principals). Such stakeholders may cover
shareholders, creditors, suppliers, clients,
employees and other parties with whom the
firm conducts its business”
Eventually shareholders and stakeholders will want different things. The shareholders will want to
maximize share price and profit and the stakeholders rather maximize salary, leisure, bonusses,
treatment and eventually help the customer get better quality for a better price.
Which eventually is contradictory because maximizing wealth is cutting salary and maximizing quality
may increase the project. Corporate governance deals with conflict of interest between;by
preventing and mitigating.
Providers of finance and the managers
o Managers and investors, especially without stake, are not favorable for the investor
because of the incentive to work hard.
Shareholders and stakeholders
o Whenever the stakeholders, namely the employees, are dissatisfied about their
salary, working conditions and anything else, it can cause a strike
Different type of shareholders (minority vs majority)
o The fact that majority shareholders might decide something which is value
destructive for the minority shareholders.
Agency problems: the fact that an agent acts on behalf of a principal and might not act in the best
interest of the principal.
A typical agent situation is an expert (manager) hired by the investor to do ‘’the job’’.
Moral hazard is a typical agency problem, meaning that once the contract is signed it may be
so that the maximal utility of the agent is to misbehave, spend unnecessary money for their
private benefit and be less responsible;
o Insufficient effort: rather play golf than manage the firm
o Extravagant investments: expensive real estate which they like rather than is useful
o Entrenchment: having so much power that the manager becomes irreplaceable,
which might work out as a takeover defense
, o Self-dealing: enjoy the private benefits and fund own expense such as a house or a
jet. Not to mention go in business with befriended suppliers rather than go for the
best price.
o Lack of transparency: Hide info about the prestation’s of the firm
o Account manipulations: Hide info to gain a high P/E ratio for their bonus
o Theoretically it can be avoided by using complete contracts which specific every
possible state of the world and needed action. Yet, ‘everything’ is not to be predicted
and impossible to monitor and if so it will be very costly.
Asymmetric information is a key condition for moral hazard and for complete contracts to be
impossible to achieve. Meaning that one (the agent) knows more than the principal. Whereas, if
everyone has the same information a complete contract would not be needed and moral hazard
wouldn’t hold. This principle-agent problem is described by Jensen & Meckling and is mainly about
the separation of ownership and control (Shareholder is not the CEO).
If the firm grows the owner-manager will
have to sell a% of shares to the agent(CEO).
Whereas, the agent is not incentivized to
work harder because the main profit will go
to the shareholder. Thus, the CEO is only
bearing a part of the risk for only a slight percentage of the profit. Thus the shareholder has the
funds but cannot run a firm, and the CEO can run the firm but doesn’t have the funds.
The agency costs arising is the sum of the monitoring, bonding and residual loss.
Monitoring: to avoid missteps the owner-manger has to monitor the appointed CEO.
Bonding cost: to be credible the CEO has to buy a part of the shares (at own expense) to
signal a favorable attitude
Residual loss: profit losses due not maximizing profit which is incurred by the principal caused
by the fact that the CEO may not make decisions to maximize the value of the firm.
This trade-off is captured in the provided graph by Jensen &
Meckling, which shows the trade-off between firm value and
perquisites – firm value vs leisure time.
U0 represents the utility function for the manager and it has to be
optimized between working for the firm (value) and having benefits
(perquisities). However if stake is sold by the owner the budget line
(green) will shoft and therefore a new optimum will be found
resulting in a lower firm value and higher use of perquisites.
The price will be (1-a)V* for the investor as (1-a)% of shares
are owned.
This drop of firm value is caused by the agency cost of
outside equity. Hence the value to the owner manger will be
V*-a∆P.
Payoff for the investor -(1-a)V* + (1-a)V’’ = (1-a)(V’’-V*).
Cost + benefit = (1-a)(value smaller than zero) and hence the investor will not agree.
, Hence two forms of Agency problems arise;
Perquisites: consumption by management, in form of private benefits (jets, houses, family jobs).
Firms that allow their managers to use a corporate jet on the long run underperform by 4%
according to Yermack.
Empire building: Free cash flow problem, where the manager pursues growth rather than
shareholder maximization. Power, social status and compensation might be drivers.
According to Jensen the free cash flow is very bad if left to the managers.
Management should only invest in NPV yielding a positive return. A counterexample is buying
other firms whose PVGO are negative.
o Shareholders have a wide range of investment opportunities and would rather spend
‘their’ money in yielding projects.
Upscaling a firm with 100% ownership shows a ‘slow’ decreasing line whereas not straight up.
Compared to upscaling where the ownership is less than 100% it decreases due to these
facts.
Agency problem: Shareholder versus debtholder.
Equity holders will want a high firm value and like risk.
Debtholders do not benefit from this growth. They rather
have safety and dislike risk. Debtholders namely cannot profit
from this growth and can only retain the face value.
In this case managers often prefer equity holders whereas they are
likely as risk averse as themselves. They ‘’can’’ take more risk on their
behalf without consensus. Therefore, the optimal debt to equity
structure will be so that the agency cost on both debt and equity will
be the least and intercepting each other denoted by E*.
Conflict of interest between majority and minority
Whereas obviously the majority stakeholders are stakeholders having a large stake in the firm. Most
stock exchange listed firms have such large shareholders. Because of this minority of vote they can
near to control a firm and expropriate the minority shareholders in forms of;
(related-party transfer) Tunneling: asset sales at discount to a fully owned company to
maximize their own wealth rather than behave in best interest of the minority. (51% to 100%
owned firm asset flow)
(related party transfer) Transfer pricing: overpricing servies and goods. The 51% owned
company will overpay goods delivered by the 100% owned company. Meaning that the
majority shareholder will benefit at the fully owned company. This would be even ‘worse’ in a
shareholder pyramid where the ‘’loss’’ from the 51% owned company is first passed on to a
holding who owes 51% which is again 51% owned by the large shareholder.
Nepotism: suboptimal allocation of human capital. Meaning that important places are filled
in rather with friends and family than the best candidate. This also admits to the managerial
entrenchment, the more friends in higher ranks the less endangeroud the managers position.
Infighting: fight among the (two) large shareholders, often between family. Reason why Puma
and Adidas are such competitors.
