Saturday, February 23, 2013

Two Papers on the Principal-Agent Problem in Public Companies

These are both coauthored by Shleifer who we mentioned in the previous post. The first is "What Do Firms Do with Cash Windfalls?" by Olivier Blanchard, Andrei Shleifer, and de Silanes.

They were interested in what happens if a company receives a cash windfall in the form of a won or settled lawsuit. They screened and came up with 11 firms that won lawsuits that gave them cash but did not change their investment opportunities.

They wanted to study empirically whether "selfless managers acting in the interest of all shareholders" would return the windfalls to shareholders. (Which they call the "asymmetric information model".)

The alternate hypothesis, which the principal-agent conflict model would predict, is that even firms without attractive investment opportunities do not spend the windfall on dividends or share repurchases. Also, the share repurchases that do take place under that model would be targeted at large shareholders or the management, rather than small shareholders.

What they find is that two of the firms pay out large percentages of the award to the shareholders, but both of these firms have very large management and family ownership and a substantial fraction of the dividend goes directly to controlling shareholders.

They conclude generally that "dividends are used mainly when managers stand to collect a lot themselves, and share repurchases are used to eliminate potential challenge to insiders' control from large shareholders," and that "managers strive to ensure the long-run survival and independence of their firms with themselves at the helm. They do this by keeping the resources inside and investing them in unattractive projects just to avoid giving up cash or having an outsider lay a claim on it".

Corporate governance is a huge problem! It's why I'm so skeptical of some of the value trap tech firms like Microsoft that trade at ostensibly cheap valuations. They show little inclination to return cash to shareholders, rather doing crazy things like buying Skype for $8.5 billion. Even Apple is mysteriously reluctant to return cash! It's as if they know the good times won't last forever.

The second paper is "Agency Problems and Dividend Policies Around the World" by Rafael La Porta, de Silanes, Andrei Shleifer, and Robert Vishny. One way of looking at dividends is a way to address the principal agent problem. Since the severity of the principal agent problem obviously varies worldwide according to the protections for minority shareholders, they look at whether the way dividend policies vary is consistent with the agency theory of dividends.

They find that companies operating in countries with better protection of minority shareholders pay higher dividends. Another test was whether fast growing firms pay lower dividends than slow growing firms in countries with better protections. They do, which suggests that investors in these countries are willing to wait for dividends (and allow companies to reinvest earnings) when investment opportunities are good. In countries with poor protections for minority shareholders, they find that shareholders prefer to take whatever dividends they can get, regardless of investment opportunities. 

P.S. Something else interesting is that between them, these papers have fewer than 300 downloads on SSRN. The first one has been cited 368 times and the second 113 times. I'm not sure if the CFA curriculum even mentions the principal agent problem, but if it does it is certainly much less than the EMH-assuming capital asset pricing model.

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