Theory of the Firm — Jensen and Meckling on Managerial Behaviour, Agency Costs and Ownership Structure

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Theory of the firm – Jensen and Meckling on managerial behaviour, agency costs and ownership structure

The essence of the firm

Michael Jensen and William Meckling wrote Theory of the Firm in 1976 to explain how agency costs might affect managerial behaviour and the ownership structure of firms. Today, it remains one of the most highly cited papers in economics and finance.

While agency theory has made strides over the last few decades, I don’t think their ideas are well diffused across wider areas of business. This brief post will summarise the lessons that I took from Jensen and Meckling’s original paper. I’ll focus less on the authors’ model and proofs, and more so on their economic commentary and reasoning.

A network of relationships

To begin, Jensen and Meckling point out that “the firm is not an individual”. It’s a network of contractual relationships that brings individuals, often with different objectives and wants, to collaborate on something productive.

It follows that property rights play an important role in Jensen and Meckling’s theory of the firm. The nature and specifications of these contracts shape the behaviour of individuals within an organisation. It’s important not to lose sight of this when we personify companies as singular entities for simplicity.

“Contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, etc. The problem of agency costs and monitoring exists for all of these contracts… There is in a very real sense only a multitude of complex relationships (i.e., contracts) between the legal fiction (the firm) and the owners of labor, material, and capital inputs and the consumers of output”.

Jensen, M., & Meckling, W. (1976). Theory of the Firm: Managerial behaviour, Agency Costs and Ownership Structure.

The agency problem

Agency problems can arise when the agents do not act in the best interest of the principal. For organisations, ‘the separation of ownership and control’, between that of shareholders (principal) and management (agent), is case-in-point. This happens when managers make self-interested decisions that do not align with that of shareholders.

We can think about agency costs as the sum of three components: (1) the principal’s cost of monitoring to minimise misalignment; (2) bonding costs for the agent (i.e., agreements or actions to guarantee alignment); and (3) residual losses attributed to the divergence in principal-agent interests.

The problem of agency is a general one. While Jensen and Meckling’s paper focuses on the interplay between agency costs and ownership structures, agency problem exists at many levels of organisation and cooperation. It’s not a modern problem either. As the authors note, Adam Smith made the observation too back in the late 18th century.

“The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or Iess, in the management of the affairs of such a company.”

Adam Smith, The Wealth of Nations, 1776.

In practice

As an aside, agency costs are a fundamental problem that most organisations are yet to pay special attention to. Though some have addressed it to success. For example, the alignment of interests between stakeholders is an important element of Berkshire Hathaway’s model and Warren Buffett’s Owner’s Manual. Newer conglomerates like Constellation Software and Markel Corporation pay special attention to the agency problem too.

“Agency costs are as real as any other costs. The level of agency costs depends among other things on statutory and common law and human ingenuity in devising contracts. Both the law and the sophistication of contracts relevant to the modern corporation are the products of a historical process in which there were strong incentives for individuals to minimize agency costs… Whatever its shortcomings, the corporation has thus far survived the market test against potential alternatives.”

Jensen, M., & Meckling, W. (1976). Theory of the Firm: Managerial behaviour, Agency Costs and Ownership Structure.

Agency costs of equity

With these baseline ideas in mind, Jensen and Meckling describe the agency costs associated with equity and debt. Let’s start with the agency costs of outside equity. To approach this, the authors consider how behaviours might change as owners sell stakes in their companies to outside buyers.

Two points are worth mentioning: Firstly, we expect managers who own their company in its entirety to make decisions that maximise their utility. Secondly, utility consists of monetary and non-monetary benefits. The latter might include the experience, challenge, reputation and admiration that comes with the job.

Jensen and Meckling suggest that agency costs arise when owner-managers sell shares in their company. Why? The owner-manager can obtain the same non-monetary benefits from their role at a fraction of the personal cost and risk. Furthermore, these managers may not pursue ‘optimal’ projects due to differences in personal benefits, risks and effort. Some may seek excessive risk given the limited downside. Others may play it too safe given the personal effort and reputational risk.

While owners can take actions to ensure better alignment of interests (e.g., monitoring, replacement, etc.). Outright elimination of agency costs in a practical setting is often cost-prohibitive. This is similar in concept to parasite-load in evolutionary biology.

Preferences and monitoring costs

Jensen and Meckling outline several factors that many influence the agency cost of equity: (1) the manager’s preferences and attitudes; (2) how easy it is for them to pursue their own interests over that of the principal; and (3) the cost of monitoring and bonding itself. For example, designing, implementing and enforcing appropriate performance appraisals, compensation packages and company policies to improve principal-agent alignment doesn’t happen free-of-charge.

Replacement risk

We also have to consider the labour market. If the relative supply of prospective managers decreases, then agency costs may increase. Put another way, if managers face a lower risk to replacement, they may have more confidence to pursue actions in his or her own self-interest. But the argument also works in the reverse. If the manager is in constant fear of replacement, he or she may pursue decisions that prioritise self-preservation (e.g., too risky or too safe) over the company’s long-term interest. A tricky conundrum!

Limited liability, capital irrelevance and bankruptcy risk

If agency problems exist, why do we observe non-manager ownership at the levels we do? The authors offer several ideas from other papers. One suggests that the limited liability feature of equity claims are attractive to outside-owners, despite the onset of agency costs. Then there’s the famous Modigliani and Miller theorem, which suggests the ‘irrelevance’ of capital structure (in the absence of tax subsidies on interest payments and bankruptcy costs). Another says that bankruptcy risks and the desire to preserve borrowing power may also limit demand for debt financing.

But Jensen and Meckling suggest that such theories are incomplete. They argue that the agency costs associated equity and debt can help explain the capital and ownership structures we observe. So, let’s look at the agency costs of debt.

Agency costs of debt

Debt financing is attractive for several reasons (e.g., tax subsidies on interest payments; financing when equity capital is inaccessible). But Jensen and Meckling observe three aspects of the agency problem that discourages its use: (1) incentive effects; (2) monitoring costs; and (3) bankruptcy costs.

Incentive effects

Firstly, there is the potential for perverse incentives on managerial behaviour. At high or unsustainable levels of debt, management might pursue projects with very high risk, high reward profiles. When it goes well, everyone benefits. But when it goes sour, creditors lose.

Monitoring costs

Secondly, while debtholders can introduce provisions, covenants and monitoring to limit perverse incentive effects, these costs are rarely cheap.

Bankruptcy costs

Thirdly, Jensen and Meckling suggest that the costs of bankruptcy and reorganisation has a dampening effect on debt uptake. Debtholders have to consider the net value of assets in the case of bankruptcy; And their willingness to pay for fixed claims is inversely related to the likelihood and cost of bankruptcy.

This point is also an opportunity to share a general reminder: “that the revenues or the operating costs of the firm are not independent of the probability of bankruptcy and thus the capital structure of the firm”. For example, firms that face a higher probability of bankruptcy may need to pay higher compensation packages to attract executives and talent. Likewise, customers that depend on a firm’s ongoing service and support may seek alternatives if the incumbent is of high failure risk.

Ownership structure

We can begin to imagine now, even without the authors’ underlying models and math, how the agency costs of debt and equity might ‘push’ firms towards a particular ownership structure.

The authors argue that if capital markets are efficient, then the price of debt and outside equity should incorporate these agency costs. So, if the agency cost of debt rises, then outside equity becomes relatively more attractive. From the owner-manager’s perspective, the optimal mix of debt to outside equity should result “in minimum total agency costs” for a given level of inside (manager) equity.

It’s also worth noting, perhaps in contrast to other papers of their time, that Jensen and Meckling use the term ownership structure as opposed to capital structure. This distinction is important as it brings attention to the manager’s stake in the company itself.

Diversification

Jensen and Meckling suggest that risk aversion and optimal portfolio selection can also help to explain owner-manager diversification. That is, risk averse managers that concentrate their entire wealth in a single company “will generally bear welfare loss”. So, these managers, in theory, are “willing to pay something to avoid this risk”. The cost of diversification, the author says, is reflected in the agency costs that shareholders and bondholders incorporate into pricing.

Scaling

Jensen and Meckling hypothesise that agency costs scale with firm size. The intuition is simple: the bigger the organisation, the more challenging and expensive it gets to monitor and enforce behaviours appropriately.

Control

It’s worth noting also that outside equity has voting rights. There is also, in a sense, a market for control and ownership. Outsiders may pursue this avenue when the cost-benefit trade-off of reducing agency problems are favourable to them. Business history is replete with examples of “conflicts for control which involve outright market purchases, tender offers and proxy fights”.

Multiperiod

Now, much of the discussion so far has focused on a single period financing adecision. In practice, any financing decision that owner-managers make today will influence the future set of financing available to them. Owner-managers that value their reputation and relationship with debtholders and shareholders may act moreso in their interests.

In this way, both competition and cooperation can help to regulate the misalignment and agency costs. It’s reminiscent of Robert Axelrod’s work on The Evolution of Cooperation. As Axelrod notes, if the relationships are stable and recognisable, and the “shadow” of the future sufficiently large, then self-interested individuals in a multiperiod prisoner’s dilemma can sustain cooperation and alignment. Unfortunately, business relationships are often finite, and the interests of managers aren’t always long-term.

References

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