Week2 Agency Compensation

7/23/2019 Week2 Agency Compensation

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Agency Problems and Executive

Compensation

Corporate Finance, 3eGraham, Smart, and Megginson


2/19

The Main Participants in a irm

Shareholdersof the rm who holdresidual claim to all the cash ows ofthe rm.

Limited liabilityManagerswho control the day-to-day

operations of the rm.

Firm employees but not ownersBondholderswho have a prior but

xed claim to cash ows of the rm.

No decision-making participation 2 - 2


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The Main Participants! Goals

Shareholders !ypically hold diversied portfolios" so only face systematic risk

#beta$

Long-term investment hori%ons

&eek stock price maximi%ation

Managers 'ay not hold a diversied portfolio" so face systematic as well

as non-systematic risk

&hort-term income earning hori%on( value )ob security *+ort level lower than if , entrepreneurial ownership

/er0uisite consumption

'ay get entrenched make their own position secure at theexpense of investors

Bondholders: &tand to lose if the rm goes bankrupt

1ould like to minimi%e risk once bonds are purchased

2 - 3


4/19

Shareholder " ManagerCon#icts 2wnership 3 4ontrol separation

&hareholders expect managers to act intheir best interest

4ollective action problem too expensive forindividualshareholders to constantlymonitor the actions of managers whilesharing the benets

Free-rider problem owners rely on thee+orts of others to monitor the company *xternal auditors #*nron and 5rthur 5ndersen$

6anks

&olutions are costly 2 - 4


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Shareholder " $ondholderCon#icts

!he market value of any rm e0uals the marketvalue of its bonds plus the market value of itsstock

% & ' ( E

&hareholders have limited liability and the choiceto turn the rm7s assets over to its creditorsinstead of repaying!his optionbecomes more valuable as company cash

ows are more volatile

8f ownership transfer were costless" bondholders wouldbecome the new shareholders of the rm without loss ofvalue

4eteris paribus" the value of e0uity rises 9 and

the value of debt declines 9 in line with the 2 - 5


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:ltimately" increasing the risk of the rmredistributes wealth from bondholders tostockholders.!he risk of default has increased but bondholders are not

compensated for the added risk

Firm can issue additional debt

5ll else e0ual" therefore" shareholders have anincentive to engage in risk-increasing activities#e.g." highly risky pro)ects$ that have the potential

of big returns. Limited downside but unlimited upside potential

8f the investments pay o+" the shareholders havea high return( if the investments are unsuccessful"

the bondholders will bear most of the costs. 2 - 6


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6ondholders may anticipate these agencyproblems and demand a higher returnbecause of thepossibilityof opportunisticbehavior.

6ondholders may also re0uire certainrestrictive covenantsin bond contracts

which limit the types of actions managerscan take.

!hese are examples of the agency costs of2 - 7


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Ma)ority Shareholder "Minority Shareholder Con#icts

'inority shareholders could also faceexpropriation like creditors

4orporate governance mechanisms

should be in place to provideprotection4ould result in more disperse stock

ownership'a)ority shareholders may alter rm

investment policy

/et pro)ects" etc.

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Compensation* Stoc+ ptions

&tock options are usually issued at-the-money.!here is a vesting period before they can beexercised. 8f the employee leaves during thistime" the options are forfeited.

8f employees leave after the vesting period" in-the-money options are exercised immediately andout-of-the money options are forfeited. 2ptionsare not transferrable.

1hen options are exercised" the number of sharesoutstanding goes up.

!o reali%e cash" the employee must exercise theoptions and then sell the underlying shares.

2 - 9

A t


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Agency osts an -ners pStructure* The Case o.Privati/ation

/rivati%ation 3 government divestiture


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Prior 0iterature on Privati/ation

/rivati%ation benets reali%ed'egginson et al. #,>>?" @F$

Firm-level improvements in protability and

e=ciency following privati%ation

" BF&$*ven after divesting portions of a rm" a

ma)ority of former &2*s are still ultimatelyunder government control

2 - 11


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Prior 0iterature on Compensation

4ompensation based on rmperformance and e0uity-basedincentives aligns goals

@ensen and 'eckling #,>CD" @F*$2wnership linked to compensationEart%ell and &tarks #A" @F$

8nstitutional owners related to higherperformance-based compensation and loweroverall levels of compensation

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13/19

Compensation in Privati/ed irms

!he :G earlier wave of privati%ation #,>HA-,>>?$ 4ragg and ;yck #A" @L*2$

No relation between compensation and performance in&2*s

&trong relation in privati%ed rms( even stronger thanin de novo private rms 5uthors recogni%e this result may not be generali%able to

other institutional settings" depending on analystcoverage and legal system

4hina more recent privati%ation wave#,>>I-now$ 4ao et al. #A,," @4F$

4*2 pay is insensitive to performance when thegovernment is the controlling shareholder 2 - 13


14/19

Motivation


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1ypotheses

6ased on the government as a uni0ueshareholderE,a 4*2s of privati%ed rms have a higher

total pay

;eep-pockets of government ownersE,b 4*2s of privati%ed rms have a lower

total payalue of per0uisite consumption and political benets

EA 4*2s of privati%ed rms have a lowere0uity-linked component of compensation as afraction of total pay Less concern with external nancing

&oft-budget constraints 2 - 15


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Main Compensation %ariables

!otal pay&alary

6onuses

&tock

2ptions

Long-term incentive plan #L!8/$

*mployer contribution to pension

5d hoc payments #e.g." relocationbenets$

*0uity proportion of total pay#&tock M 2ptions M L!8/$ !otal pay 2 - 16


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2nivariate esults

Privatizedfirms

De novoprivatefirms

Mean diff.

(Privatized De

novo)

p-value Count(firm-years)

Total Pay

Full sample $3.93 mil $3.4 mil $!."# mil !.! %"9

Matched sample $3.9& mil $".#! mil $#.#4 mil !.! &4&

'uity proportion of total pay

Full sample #.# *.* &.& !.!! %"9

Matched sample #. .& #.4 !."# &4&

! Privatized firms +ave +i,+er total pay% until e mat+ on firm+arateristis (e.,.% size)

! Privatized firms +ave a loer proportion of euity pay for t+e full

sample.

2 - 17


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egression Analysis

;ependent variable *0uity proportion of total pay (#) () (3) (4)

Privatized firm -!.!&&/// -!.!&&//

(-.*3) (-.3#)

Govt ownership(t-1)

-!.!!3"/// -!.!!3!///

(-3.*) (-.&*)Sample 0ull 0ull Mat+ed Mat+ed

Observations %3!# %3!# &!& &!&

R-squared !.9 !.9 !.3*! !.3*#

! Privatized firms +ave a lowereuity omponent of total pay! 1ovt oners+ip levels lin2ed to a lowereuity omponent to total pay

! ar,er firms and firms it+ +i,+er previous year returns lin2ed to a +i,+er proportion of

euity

! loer proportion of euity ompensation is assoiated it+ a C'5 t+at is also t+e +airman

of t+e 6oard.

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Conclusions

4ontribution shed light on the e+ect of governmentparticipation on managerialshareholder incentivealignment

4*2s in privati%ed rms have lower total pay and

lower e0uity-linked wealth compared to those innon-privati%ed rms

Larger govt ownership #$ is associated with lessincentive alignment via e0uity compensation

Future testing8nstitutional ownership

2ther 4*2 features e.g." gender

2verall rm corporate governance 0uality

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Week2 Agency Compensation

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