Agency Problems and Executive

Compensation
Corporate Finance, 3e
Graham, Smart, and Megginson

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The Main Participants in a Firm

Shareholders

of the firm who hold

residual claim to all the cash flows of
the firm.
Limited

liability

Managers

who control the day-to-day

operations of the firm.
Firm

employees but not owners

Bondholders

who have a prior but

fixed claim to cash flows of the firm.
No

decision-making participation

2-2

The Main Participants Goals

Shareholders:
Typically hold diversified portfolios, so only face systematic risk
(beta)
Long-term investment horizons
Seek stock price maximization

Managers:
May not hold a diversified portfolio, so face systematic as well
as non-systematic risk
Short-term income earning horizon; value job security

Effort level lower than if 100% entrepreneurial ownership

Perquisite consumption

May get entrenched: make their own position secure at the

expense of investors

Bondholders:
Stand to lose if the firm goes bankrupt
Would like to minimize risk once bonds are purchased

2-3

Shareholder Manager
Conflicts

Ownership Control separation

Shareholders expect managers to act in

their best interest

Collective action problem: too expensive for

individual shareholders to constantly
monitor the actions of managers while
sharing the benefits

Free-rider problem: owners rely on the

efforts of others to monitor the company
External

auditors (Enron and Arthur Andersen)

Banks

Solutions are costly

2-4

Shareholder Bondholder
Conflicts

The market value of any firm equals the market

value of its bonds plus the market value of its
stock:
V=D+E

Shareholders have limited liability and the choice

to turn the firms assets over to its creditors
instead of repaying

This option becomes more valuable as company cash

flows are more volatile
If ownership transfer were costless, bondholders would
become the new shareholders of the firm without loss of
value

Ceteris paribus, the value of equity rises and

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

Shareholder Bondholder
Conflicts

Ultimately, increasing the risk of the firm

redistributes wealth from bondholders to
stockholders.

All else equal, therefore, shareholders have an

incentive to engage in risk-increasing activities
(e.g., highly risky projects) that have the potential
of big returns.

The risk of default has increased but bondholders are not

compensated for the added risk
Firm can issue additional debt

Limited downside but unlimited upside potential

If the investments pay off, the shareholders have

a high return; if the investments are unsuccessful,
the bondholders will bear most of the costs.
2-6

Shareholder Bondholder
Conflicts

Bondholders may anticipate these agency

problems and demand a higher return
because of the possibility of opportunistic
behavior.

Bondholders may also require certain

restrictive covenants in bond contracts
which limit the types of actions managers
can take.

These are examples of the agency costs2 - of

7

Majority Shareholder
Minority Shareholder Conflicts
Minority

shareholders could also face

expropriation like creditors

Corporate

governance mechanisms
should be in place to provide
protection
Could

result in more disperse stock

ownership

Majority

shareholders may alter firm

investment policy
Pet

projects, etc.
2-8

Compensation: Stock Options

Stock options are usually issued at-the-money.

There is a vesting period before they can be
exercised. If the employee leaves during this
time, the options are forfeited.

If employees leave after the vesting period, inthe-money options are exercised immediately and
out-of-the money options are forfeited. Options
are not transferrable.

When options are exercised, the number of shares

outstanding goes up.

To realize cash, the employee must exercise the

options and then sell the underlying shares.
2-9

Agency Costs and Ownership

Structure: The Case of
Privatization

Privatization

Government

government divestiture

ownership of corporations: more common

outside U.S.
Government

goals when privatizing

Generate

revenue
Encourage economic efficiency
Decrease government intervention
Endorse broad share ownership
Introduce competition
Subject SOEs to market discipline
Government

presence, however, is often persistent

Partial

privatizations
Organizational transition
2 - 10

Prior Literature on Privatization

Privatization
Megginson

benefits realized

et al. (1994, JF)

Firm-level

improvements in profitability and

efficiency following privatization

Governments

often retain means of

control
Bortolotti

and Faccio (2009, RFS)

Even

after divesting portions of a firm, a

majority of former SOEs are still ultimately
under government control
2 - 11

Prior Literature on Compensation

Compensation

based on firm
performance and equity-based
incentives aligns goals
Jensen

and Meckling (1976, JFE)

Ownership
Hartzell

linked to compensation

and Starks (2003, JF)

Institutional

owners related to higher

performance-based compensation and lower
overall levels of compensation

2 - 12

Compensation in Privatized Firms

The UK: earlier wave of privatization (19821994)

Cragg

and Dyck (2003, JLEO)

No

relation between compensation and performance in

SOEs
Strong relation in privatized firms; even stronger than
in de novo private firms

Authors recognize this result may not be generalizable to

other institutional settings, depending on analyst
coverage and legal system

China: more recent privatization wave

(1995-now)
Cao

et al. (2011, JCF)

CEO

pay is insensitive to performance when the

government is the controlling shareholder

2 - 13

Motivation

Government ownership found globally

Megginson (2010, ARFE) estimates remaining
government stakes in Europe worth $700 billion;
$2 trillion outside of Europe
Recent bailouts

How does government ownership affect

compensation components in a multi-country
setting?
14 European countries, including UK
Civil

and common law systems

Compare

privatized firms, with and without

residual government stakes, to de novo private
firms
2 - 14

Hypotheses

Based on the government as a unique

shareholder:
H1a:

CEOs of privatized firms have a higher

total pay
Deep-pockets

of government owners

H1b:

CEOs of privatized firms have a lower

total pay
Value

of perquisite consumption and political benefits

H2:

CEOs of privatized firms have a lower

equity-linked component of compensation as a
fraction of total pay
Less

concern with external financing

Soft-budget constraints

2 - 15

Main Compensation Variables

Total

pay:

Salary
Bonuses
Stock
Options
Long-term

incentive plan (LTIP)

Employer contribution to pension
Ad hoc payments (e.g., relocation
benefits)
Equity

proportion of total pay:

(Stock

+ Options + LTIP) / Total pay

2 - 16

Univariate Results
Privatized
firms

De novo private
firms

Mean diff.
(Privatized De
novo)

p-value

Count
(firm-years)

Full sample

$3.93 mil

$3.42 mil

$0.51 mil

0.08

2,529

Matched sample

$3.96 mil

$5.10 mil

$1.14 mil

0.02

646

Full sample

21.1%

27.7%

6.6%

0.00

2,529

Matched sample

21.2%

22.6%

1.4%

0.51

646

Total Pay

Equity proportion of total pay

Privatized firms have higher total pay, until we match on firm

characteristics (e.g., size)
Privatized firms have a lower proportion of equity pay for the full
sample.
2 - 17

Regression Analysis

Dependent variable: Equity proportion of total pay

(1)
Privatized firm

(3)

-0.066***

-0.066**

(-2.73)

(-2.31)

Govt ownership(t-1)
Sample

(2)

(4)

-0.0035***

-0.0030***

(-3.27)

(-2.67)

Full

Full

Matched

Matched

Observations

2,301

2,301

606

606

R-squared

0.292

0.292

0.370

0.371

Privatized firms have a lower equity component of total pay

Govt ownership levels linked to a lower equity component to total pay
Larger firms and firms with higher previous year returns linked to a higher proportion of
equity
A lower proportion of equity compensation is associated with a CEO that is also the chairman
of the board.
2 - 18

Conclusions
Contribution:

shed light on the effect of government

participation on managerial/shareholder incentive
alignment

CEOs

in privatized firms have lower total pay and

lower equity-linked wealth compared to those in
non-privatized firms

Larger

govt ownership (%) is associated with less

incentive alignment via equity compensation

Future

testing

Institutional

ownership
Other CEO features: e.g., gender
Overall firm corporate governance quality
2 - 19