Principal-Agent Issues and Managerial Compensation 1
Information asymmetries Problems before a contract is written: Adverse selection i.e. trading partner cannot observe quality of the other partner Use signaling g or screening Problem after contract is written: Moral hazard Principal-agent problems i.e. trading partner cannot be sure if the other is behaving ok after contract is written Nobel prize in economics 2001 for informational asymmetries (Akerlof, Spence and Stiglitz) 2
Contracts Contract is economic jargon for agreements that t modify behavior in ways that t are mutually beneficial. This may encompass sorts of actions, payments, rules/procedures and behavior. The term contract does not necessarily have to refer to the legal status; they can also be implicit and unarticulated. 3
Complete contracts The parties foresee all relevant contingencies (and can describe these); Agree upon an efficient course of action for each contingency; Abide to the terms of the contract (no desire to renegotiate and are able to determine violation). 4
Contracts are often incomplete Information problems: limited it foresight imprecise language of contract costly calculations and costly contracting Further, not everything can be verified and enforced (notice: there is a difference between observability and verifiability) (observability vs. verifiability: a cartel observes that the price is not at the cartel price anymore, but may not know whether h someone has deviated or demand has dropped) 5
Private information Bargaining: a buyer and a seller bargain over a price Value maximization principle: efficient transaction should occur if value to buyer is higher than value to seller With private information one party does not know the other party s payoff (see also auctions) With private information it is typically not possible to reach the same level of efficiency as under complete information, because both buyer and seller will have strategic incentive to misrepresent her real valuation. 6
PRINCIPAL-AGENT ISSUES Principal-Agent Issues: When managers (agents) make decisions that affect the wealth of shareholders (principals) Conflict of interest: t Personal utility of decision i maker (agent) conflicts with the objectives of the principal. Issue vanishes when principal and agent have identical objectives. Manager is the business owner.
PRINCIPAL-AGENT ISSUES Factors Uncertainty is a factor when the effects of an agent's decisions are not deterministic. Outcomes may be bad when decisions are good. Information asymmetry: Agents and principals do not have the same information sets. Noncooperative game The principals determine compensation rules for the agents. Agents' actions are not directly observable by principals. The consequences of decisions made by agents are not entirely predictable.
PRINCIPAL-AGENT ISSUES Managers can anticipate issues associated with the principal-agent problem and devise incentive compensation strategies that will help to minimize the problem. Product liability laws provide incentives for agents (product manufacturers) to produce safe products for the principals i (consumers).
THE DIVERGING PATHS OF OWNERS AND MANAGERS Shareholder goals Maximize value of the firm Alternative management goals Minimizing effort Maximizing job security Avoiding failure Enhancing reputation and employment opportunities Maximizing perquisites Maximizing pay
THE PRINCIPAL-AGENT SITUATION Example: Choice of distribution channel by managers at a life insurance company Existing channel: Low risk, low expected profit Managers may prefer this choice because of low risk. New channel: High risk, high potential profit Stockholders may prefer this choice because of the high potential profit and because they can reduce risk by holding a diversified portfolio.
THE EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL- AGENT ISSUES Managerial Behavior and Effort Disutility of effort: A measure of the cost to the manager of supplying effort Effort imposes personal costs on managers, who therefore prefer to exert less effort. Effort contributes to increasing the value of the firm, so stockholders prefer managers to exert more effort.
THE EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL- AGENT ISSUES Procedure Incentive conflict: What is the issue? Find the optimal contract when effort is observable Find the optimal contract t when effort is not observable Find the optimal contract when effort is not observable and profits are risky
EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL-AGENT AGENT ISSUES Model = (e) is profit and e is manager's effort. (e) = R(e) (S + C) R(e) is revenue as a function of manager's effort S R(e) is revenue as a function of manager s effort, S is manager's compensation, and C is other costs.
EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL-AGENT AGENT ISSUES Model (Continued) Figure 14.2: The Principal-Agent i Problem with Flat Salary u(e) is the disutility of effort for the manager, represented as linear with a positive slope. Net benefit to the manager is B(e) = S u(e). Utility maximizing level of effort by manager is (in this case) where e = 0. Profit maximizing level of effort is where dr/de = 0, which is higher than the manager's utility maximizing level of effort.
EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL-AGENT AGENT ISSUES Resolving the Incentive Conflict If Effort Is Observable Model: S(e) = K + U(e) S(e) is compensation as a function of observable effort, K is the fixed component of compensation, and U(e) is the portion of compensation that depends on effort. (e) = R(e) S(e) C = R(e) [K + U(e)] C
EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL-AGENT AGENT ISSUES Resolving the Incentive Conflict If Effort Is Observable Model: S(e) = K + U(e) (Continued) Profit maximizing i i compensation: (e)/ e ( = R(e)/ e U(e)/ e = 0 Manager net benefit: B(e) = S(e) u(e) = K + U(e) u(e) If U(e) u(e), then B(e) = K and managers will be willing to supply any desired effort level (net benefit is always positive so long as K is positive). The stockholders just need to communicate the optimal level of effort to managers and they will provide it.
THE EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL- AGENT ISSUES Resolving the Incentive Conflict If Effort Is Observable (Continued) Figure 14.5: The Principal-Agent Problem with Pay as a Function of Effort In practice, managers have better information than shareholders h and it is too costly for shareholders to perfectly monitor managerial effort.
EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL-AGENT AGENT ISSUES Resolving the Incentive Conflict If Effort Is Not Observable If effort is not observable then it is difficult to If effort is not observable, then it is difficult to reward or penalize effort levels.
THE EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL- AGENT ISSUES Resolving the Incentive Conflict (Continued) Model Assume that the firm's revenue R(e) is riskless and determined solely by e, the effort put forth by the manager The level of managerial effort can be inferred from R when revenue is riskless, but this does not ensure that the optimal level of effort, e*, is selected by managers.
THE EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL- AGENT ISSUES Resolving the Incentive Conflict (Continued) Model This problem is resolved by replacing K with a bonus; a share,, of profits that is selected by owners. Compensation = S(e) = Salary + Bonus = U(e) + (e) Profit = (e) = R(e) U(e) C Net benefit to manager = B(e) = S(e) u(e) = U(e) + (e) u(e) = (e) Managers and owners incentives converge. Both seek to maximize net profit.
THE EFFECT OF RISK, INFORMATION, AND COMPENSATION ON PRINCIPAL- AGENT ISSUES Resolving the Incentive Conflict (Continued) Incentive compatibility: When the agent and the owners share in the profit of the firm; and the agent s effort maximizes the principal s profit The manager chooses a level of effort to maximize profit. The owners choose such that the compensation package is competitive.
RESOLVING THE INCENTIVE CONFLICT WHEN OUTPUT IS RISKY AND EFFORT IS NOT OBSERVABLE When output is risky, owners cannot infer the level of managerial effort from observed profits. Bonus plans Contribute to efficiency by aligning managers incentives with owners objectives. Impose risk on managers in that performance measures that determine bonuses are not entirely under managers control.
RESOLVING THE INCENTIVE CONFLICT WHEN OUTPUT IS RISKY AND EFFORT IS NOT OBSERVABLE Risk Sharing Risk premium: minimum difference a manager requires in compensation to be willing to take a risk Owners can reduce risk by portfolio diversification. Managers are averse to risk in their compensation plan. This suggests that owners should absorb all risk.
RESOLVING THE INCENTIVE CONFLICT WHEN OUTPUT IS RISKY AND EFFORT IS NOT OBSERVABLE Risk Sharing (Continued) Model Revenue = R(e) = R 1 (e) + R 2 Revenue consists of two components. R 1 (e) is determined by manager effort and R 2 outside of the manager s control. Compensation should consist of a fixed component, K, which is independent of effort, and a bonus, (e), that depends on profit. Profit = (e) = R 1 (e) + R 2 K C Net benefit is the expected utility of compensation minus the disutility of effort B(e) = EU[K + (e)] u(e)
RESOLVING THE INCENTIVE CONFLICT WHEN OUTPUT IS RISKY AND EFFORT IS NOT OBSERVABLE Risk Sharing (Continued) Elements of the principal-agent conflict in this example Principal: Sets incentive compensation to align manager and owner interests Agent: Given the compensation plan, selects a level of effort to maximize expected utility Result: When profit is determined, manager receives compensation and principal keeps residual profit.
SOME REFINEMENTS TO MANAGERIAL COMPENSATION Motivating the Manager with Profit Sharing Figure 14.7: The Effect of Compensation Schemes on Managerial Effort Utility of flat salary B = U(B) with low effort With high effort, EU = (0.4)U(A) + (0.6)U(C) = U(B) Risk premium plus disutility of high effort = D B
SOME REFINEMENTS TO MANAGERIAL COMPENSATION Motivating the Manager with an Income Guarantee and Stock Options Figure 14.8: Reducing Managerial Risk with Stock Options Manager is guaranteed a salary of E plus stock options that will pay F with probability 0.35 and nothing with probability 0.65. EU of compensation is the same as in Figure 14.7, but there is a guaranteed minimum income.
Indexed Stock Options A call option is a contract that gives the holder the right (but not the obligation) to purchase a given number of shares of stock in a firm at a pre-agreed price from the counterparty (the seller of the option) The fixed price is called the striking or exercise price Example: you have the right to buy x shares in six months time (maturity) at a striking price of 50$ per share The call option allows you to make a profit if the stock price raises above the striking at maturity Indexed stock options have a striking price that is linked to an index of stock prices. They reward performance relative to the market that is indexed. 34
Composition of CEO Pay CEO payment: fixed salary, bonus, long-term incentive payments (stock options) Composition is changing with an increasing focus on incentive payments Long-term incentive payments have increased dramatically already in the 1990s, but also b/w 2000 and 2008 b/w 1994 and 1999: fixed payment decreased from about 50% to 37% in US firms 35
CEO Pay over time 36
Backdating scandal Backdating options is the practice of issuing options contracts on a later date than which the options have listed Academic researchers had long been aware of the pattern share prices of some companies rising dramatically in the days following grants of stock options to senior management Backdating stock options is not necessarily illegal; it becomes illegal when a company's shareholders are misled can be misleading to shareholders in the sense that it results in option grants that are more favorable than the shareholders approved in adopting the stock option plan. quarterly and annual financial reports to investors may be misleading As of 17 November 2006, backdating has been identified at more than 130 companies, and led to the firing or resignation of more than 50 top executives ec es and directors of those companies 37
Running the family farm Assume: you inherit the family farm halfway through your MBA program and would like to employ a manager for the time being How much should you pay? Pay a flat salary of about $ 50,000 a year Or: maximize the profits of the farm Manager relies only on this income and maximizes her utility Low effort: U = sqrt(w) High effort: U = sqrt(w) u(e) = sqrt(w) 46.3 (disutility of 46.3 corresponds to $2143.69; 46.3 = sqrt(w) W = $2143.69) Flat salary Utility with low effort: sqrt(50,000) = 223.6 Utility with high effort: sqrt(50,000) 46.3 = 177.3 38
Running the family farm Profit-related compensation Assuming a competitive labor market for managers, it has to be at least 223.6 in expected utility terms What proportion x of profits would achieve this? Profit and managerial effort low grain price (.5) high grain price (.5) Low effort $ 50,000 $ 150,000 High effort $ 100,000 $ 200,000 x should satisfy expected utility with flat salary and low effort = expected utility with bonus of x profit and high h effort 223.6 =.5 sqrt(100,000*x) +.5 sqrt(200,000*x) - 46.3 x =.5 expected compensation.5*[.5*100,000 +.5*200,000] = 75,000 extra 25,000 compensates the manager for both the disutility of effort and risk 39
Running the family farm Will the managers provide the effort? EU with high effort: EU =.5*sqrt(.5*100,000)] +.5*sqrt(.5*200,000) = 223.6 EU with high effort: EU =.5*sqrt(.5*50,000)] +.5*sqrt(.5*150,000) = 216 Are you better off? Your expected net profits will be Flat salary: E(profit) =.5*50,000 +.5*150,000 50,000 = 50,000 Earnings related: E(profit) =.5*100,000 000 +.5*200,000 000 75,000 = 75,000 40
The good and bad of incentive payments Example: Sears auto repair centers offered incentive payments to auto technicians Intend: to increase productivity What happened actually? Some Sears technicians i decided d to increase their compensation by doing repairs that were unnecessary Consumers were e.g. told that the brakes are near failure; risk averse as most of the consumers were they authorized a repair When the practice was exposed, it caused great embarrassment to Sears Stock option plans may increase the incentive to misstate the firm s financial i situation ti Stock option plans may also induce managers to take to much risk Managers do not face the negative side of a risky undertaking 41
PRINCIPAL-AGENT AGENT ISSUES IN OTHER CONTEXTS Moral hazard: When a party insured against risks behaves differently from the way it would behave if it were uninsured against these risks Ex-ante moral hazard: Tendency of insured entities to take less care to prevent future losses Ex-post moral hazard: Tendency of insured entities to attempt to minimize the cost of their losses
PRINCIPAL-AGENT AGENT ISSUES IN OTHER CONTEXTS Examples Health insurance Insured ==> more willing to take risks Doctors ==> more willing to prescribe costly treatment Car insurance ==> more risk taking Home insurance ==> less effort in taking care
Further examples U.S. Savings and Loans industry Banks make too risky investments because of deposit insurance Similar problem with equity holders and creditors in general: Equity holder (residual claimant) wants investment with higher mean return but also higher risk Employees shirking behavior In all cases: agent does not get the full reward of her effort/activity 44
PRINCIPAL-AGENT AGENT ISSUES IN OTHER CONTEXTS Asset Substitution: Example Shareholders have control over the decisions of managers through the compensation scheme, but creditors do not. A drug company is exposed to risk. Expected future earnings could be 100 or 200 with equal probability. Expected value of the firm is 150. The firm has 100 in debt. Hence, after paying off the bonds, there is 50 in expected equity. The drug company has an opportunity to invest in a new drug. Formula A is relatively risk free and Formula B is potentially more profitable and more risky. Capital cost of the new drug is 200. Certain value of A = 220 200 = 20 Expected value of B = (0.5)(20) + (0.5)(310) 200 = 35
PRINCIPAL-AGENT AGENT ISSUES IN OTHER CONTEXTS Asset Substitution: Example (Continued) Firm Value if Project A Is Chosen: Equity = 70 Firm Value if Project B Is Chosen: Equity = 80 Firm is better off with Project B because, if the project fails, the firm will go bankrupt, bondholders won t get paid, and stockholders walk away. If the project succeeds, then stockholders will reap the rewards. Bondholders, recognizing the optimal action of the firm, will refuse to provide financing above the 135 amount, which is what bondholders would receive if Project B is selected and it is unsuccessful.
Controlling Moral Hazard Monitoringing Explicit incentive contracts Bonding Ownership changes 47
Monitoring Costly There might be a problem with the credibility of the punishment (if the punishment is too severe) Problem of moral hazard of the principal: supervisor might claim that agent did not do his job in order to save wages/bonuses Maybe competitors can provide independent sources of finformation which hcan be used 48
Explicit incentive contract Agent is directly rewarded for her effort in most cases effort not directly observable, but outcome is ==> output-related pay ==> exposes the agent to uncontrollable risk. Use Value-Maximization principle: design contract such that joint value of the parties is maximized. What if agent is risk-averse? If no-wealth condition is fulfilled ==> agent can be compensated for the risk she is taking Tradeoff between incentive and insurance Incentives are highest if agent bears all the risk If she is risk-averse, incentive should be not so strong because of insurance. 49
Bonding A bond is a sum of money the agent has to deposit which is lost if the agent misbehaves Examples: trainees have to repay training costs if they leave the firm early Problem: in many cases the no-wealth condition does not hold The necessary compensation amount is independent of the decision makers wealth. One solution: seniority pay (pay rises disproportionately with stay in the firm) or big payment at end of stay (e.g. Abfertigung Abfertigung ) 50
Ownership changes Eliminate principal and agent by merging firms Problems P-A problems also within firms, or departments of firms Influence activities within firms will increase especially after merger 51
Moral hazard in the financial market rescue of the investment bank Bear Sterns in 2007, Bear Stern s stock was trading at $170 by mid March 2008 the price were down to 30$ in addition there was the danger of a failure and its impact on the financial system rescue plan JPMorgan bought Bear Sterns at $10; too high?? If the bailouts is too attractive, owners will expect them in future as well and won t be prudent 52 anymore