Principal-agent problems and stakeholder conflicts

Who is the principal and who is the agent?

A principal-agent relationship exists when one party (the principal) hires another (the agent) to perform a task. It can exist with or without a contract. The agent is expected to act in the principal’s best interest, with loyalty and diligence.

In a company the chain has two links. Shareholders are the principal and elect the directors. The directors, as agents, hire the managers, who are agents in turn and are charged with maximizing shareholder value.

Agency relationships in a companya principal hires an agent, with or without a contract

• Principal and agents Memorize the chain of hiring
  • Shareholders (principal) Memorize elect the directors
  • Directors (agent) Memorize hire and monitor managers
  • Managers (agent) Memorize run the business for shareholders
• Information asymmetry Use it the agent knows more
  • Many markets Know the idea wide geographic spread
  • Complex products Know the idea hard to judge from outside
  • Little outside scrutiny Know the idea low institutional ownership or free float
• Agency costs Memorize the price of diverging interests
  • Direct Memorize monitoring, such as an audit fee
  • Indirect Memorize value lost to poor decisions

The trouble is information asymmetry : directors and managers know more about performance, risks and opportunities than shareholders or lenders do. Outsiders cannot easily verify that the agent is acting for them, and they find it harder to spot and remove poor performers. The gap is wider for companies that operate in many markets, sell complex products, or have low institutional ownership and a low free float (shares available to trade).

Diverging interests produce agency costs . Direct costs buy monitoring, for example the audit fee a company pays so that outsiders can trust the accounts. Indirect costs are the profits and opportunities lost to poor decisions. Where asymmetry is high, investors price it in: they demand a higher return, which means a lower share price and a higher bond yield.

Other stakeholders have different links. Customers and suppliers are tied to the company by contracts, and governments by compliance and oversight, so they are not principals in this sense.

Where do managers and shareholders part ways?

Pay is the main tool for aligning managers with shareholders, yet interests can still diverge in five common ways. Learn the five names and what each looks like.

Conflict	What it looks like
Insufficient effort	a chief executive sits on four other boards; loss-making divisions are never closed
Inappropriate risk appetite	heavy option grants lead to excess risk; all-cash pay leads to too little
Empire building	buying rivals to grow revenue and headcount, not value
Entrenchment	copying peers, avoiding risk, complex deals only the incumbent can run; directors staying silent
Self-dealing	lavish perks, related-party contracts, misappropriation

Insufficient effort covers managers who are unable or unwilling to make investments, control costs or take hard decisions such as closing a business line. It also covers too little monitoring of staff, which can create unintended risks and lawsuits, and too little time given to the role because of political or charitable activity, personal investments or other directorships.

Inappropriate risk appetite works in both directions. Pay dominated by shares and options can drive excessive risk, because an option holder shares only in upside moves. Pay with no shares or options can make managers too cautious, and the company may struggle to attract talent. Shareholders hold diversified portfolios and can tolerate more risk than a manager whose reputation and career sit in one company.

Empire building arises because managers’ pay and status usually rise with the size of the business (revenue, headcount). That invites growth for its own sake, such as acquisitions that do not add value.

Entrenchment is the wish to keep one’s job. Tactics include copying competitors, avoiding risk, and building complicated structures that only the current team can run. Directors may stay silent when speaking up would help shareholders.

Self-dealing is exploiting company resources for personal benefit: excessive perks (a company-paid holiday home, a chauffeur for the family), related-party contracts or outright misappropriation. The smaller a manager’s own stake, the less of the cost the manager bears.

Exam tip Time and attention elsewhere is effort. Taking money or perks from the company is self-dealing.

Go deeper Why diversified investors tolerate more risk than managers

An investor who holds forty companies can lose most of one holding and still be fine. A manager’s pay, reputation and future employment all depend on one company. That is why a manager who is paid only in cash may turn down a project with a good expected value but a real chance of failure, while a diversified shareholder would accept it.

What happens when one shareholder controls the vote?

Ownership is dispersed when many shareholders each hold too little to control the company. It is concentrated when an individual or group, a controlling shareholder such as a family, another company or a government, can exercise control. The other owners are minority shareholders .

Shareholders are not one group. A founding family with most of its wealth in the company may want management to diversify the business for stability, whereas minority holders with diversified portfolios want value maximized and can diversify cheaply themselves. A controlling holder with a decades-long horizon may also clash with minority holders who want quick gains from cost cutting, asset sales or buybacks. Shareholders can talk to one another and form voting blocs to push their case.

Votes and ownership can also be separated. In a dual-class structure one share class (Class A) carries one vote per share and is publicly traded, while another (Class B) carries several votes per share and is held only by insiders or founders. Insiders can control board elections and every major decision, and avoid dilution of their votes if new shares are issued, while holding a small share of the economic value. CFA Institute has long advocated against such structures, because they let one group override the majority for its own benefit. Where they are legal, it asks that issuers disclose them and their implications clearly.

$$\text{Stake} = \frac{B}{A + B}$$

$$\text{Voting power} = \frac{B \times v}{A + B \times v}$$

Here $A$ and $B$ are the numbers of Class A and Class B shares and $v$ is the votes per Class B share (Class A carries one).

Go deeper How minority holders fight back

A dual-class structure is hard to dismantle, because the vote needed to change it is held by the people who benefit. Minority shareholders can still communicate and form blocs, press for disclosure, sell, or push for a sunset clause that ends the extra votes after a set period. Changing the structure is slow and costly, and a founder may have to be bought out to give up control.

Why do shareholders and creditors disagree?

Both groups have claims on the same cash flows, but the claims differ. Creditors have a fixed claim and tend to be risk averse. They prefer that the company raises more equity and limits shareholder payouts, so that cash is available to meet its debt. Shareholders tend to prefer more leverage and larger distributions to a dilutive share issue.

The conflict is greater for long-term debt, because the passage of time exposes creditors to changes in business conditions, strategy and management behavior. Long-term creditors are therefore more likely to impose contractual limits on leverage and payouts.

Leverage can also hurt groups that hold no financial claim at all. Suppose a private equity owner loads Fenwick Kiln Works, a ceramics maker, with debt to fund a large payout to itself. If a downturn then pushes the company into distress, the owner has already taken its cash out. The people with most to lose are those who cannot diversify: kiln engineers whose skills are useful to few other employers, and small local firms that sell most of their output to Fenwick.

Go deeper Which conflict is the biggest?

It depends on the ownership structure. With a 55% shareholder and the rest spread widely, the structure itself points to controlling versus minority holders. Shareholder-creditor conflict appears when leverage and payouts are in play. Manager-shareholder conflict is always present, because every company has someone running it who is not the owner.