Conflicts of interest – the ‘agency’ problemviewpoint. Unfortunately, the costs of undertaking some sort of management audit to
monitor managers’ decisions are likely to be considerable, making it unreasonable
to attempt.
The costs to the shareholders of managers making decisions that are not in the
shareholders’ best interests, and/or of the shareholders monitoring the managers, are
known as agency costs. This is because managers act as agents of the shareholders in
the management of the assets of the business. Agency cost is a factor that arises in sev-
eral areas of business finance. Of course, bonuses linked to shareholder returns and
directors’ share options, which we discussed on page 26, are examples of agency costs
incurred to encourage the managers to run the business in a shareholder-wealth-
enhancing manner. We shall look at other areas where agency is a potential problem,
in various contexts, later in the book.
There is, however, a strong sanction against managers who continually make sub-
optimal decisions, and that is the possibility of takeover. A business whose share price
reflects underutilisation of assets is likely to become a prime target for a takeover,
which might well leave the delinquent managers without jobs. Buoyant share prices
make businesses unattractive as takeover targets, so that managers have a vested
interest in promoting buoyancy, if not maximisation, of share prices. We shall look at
takeovers in Chapter 14.Short-termism
The existence of the takeover sanction may not be sufficient to cause management to
be completely selfless in its conduct of the business’s affairs, however.
One area where the takeover sanction may not be effective is where managers take
too short-term a view. Although the best interests of the shareholders may be served
by an emphasis on long-term profitability, the best interests of managers could be
served by so-called short-termism. Managers may see their careers as lasting only two
or three years with a particular business before they move on to other employment.
Their reputations may therefore depend on what happens whilst they are still with the
business rather than on the ultimate effect of their actions. Perhaps more importantly,
management remuneration may well be based on immediate profit flows. Both of
these factors could promote a tendency to concentrate on the short term.
Another factor that might encourage managerial short-termism is where managers
perceive that investors are interested only in the short term. If such a perception were
correct, it would mean that businesses whose managements failed to take decisions
that would enhance short-term profits would experience a fall in their share price.
Thus managers might promote short-term profits for one or both of two reasons:
1 It is quite common, as we have seen, for managerial remuneration to be linked to
the business’s share price: the higher the share price, the larger the bonus.
2 A weak share price might encourage a takeover of the business.
Demirag (1998) found evidence that businesses’ managers believeinvestors to be
short-termists. This supported an earlier study by the same researcher. Marston and
Craven (1998) found that there is no strong evidence that investors are in factshort-
termist. These researchers also found that, nevertheless, managers believe investors
to be so. In view of these findings, it could be the case that managers may have a
tendency to favour short-term investments, in the mistaken belief that this is what
shareholders want. There is no strong evidence to support this conjecture, however.‘
‘