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The conflict between managers and shareholders.

The Conflict Between Managers and Shareholders

Randall Morck, Andrei Shleifer, and Robert W. Vishny

Economists since Adam Smith have been concerned that professional managers who own little equity in the companies they run have little incentive to serve their shareholders. This concern peaked during the Great Depression, rose again during the 1960s, and resurfaced in the 1980s with the advent of hostile takeovers. The recent concern has stimulated new empirical work asking whether managers indeed fail to serve their shareholders, and how financial markets discipline such managers. As a result of this work, we now know a lot more about the conflict between managers and shareholders than we did ten years ago.

Is Low Ownership by Managers Indeed a Problem?

Underlying the discussion of the conflict between managers and shareholders is the belief that managers who own few shares in firms they run do not maximize profits. But is this belief correct? Do the firms with lower management ownership indeed perform worse than firms with higher management ownership? For a sample of 371 Fortune 500 companies in 1980 we find that the answer is yes at low levels of management ownership.(1) Performance of firms with management ownership between 5 and 20 percent, as measured by profitability or by the ratio of market value to the replacement cost of assets, is indeed better than the performance of firms with management ownership between zero and 5 percent. This result is consistent with the standard view that ownership gives incentives for better performance.

However, we also find that performance deteriorates as management ownership rises beyond 20 percent. This result suggests that managers who own controlling blocks of shares do not care so much about becoming even richer than they already are and use their complete control to pursue personal objectives that might well be different from value maximization.

Managers of large public corporations typically own much less than 5 percent of their firms' total shares. The traditional concern that ownership levels are too low to guarantee top performance therefore is supported by the data.

What Do Managers Do That Hurts Shareholders?

Managers have many objectives that might lead them to make decisions that do not maximize value. Often they would like their firms to grow beyond what is profitable to provide opportunities for themselves and for other employees as well as to increase the scope of their control. Managers also try to reduce risk by diversifying or by having too little leverage, since they worry a great deal more about the firm's risk than do the shareholders. Some managers also buy lavish perquisites with company money, such as airplanes, or museums named after themselves, although such perquisites hardly can reduce the firm's value much.

Understanding the managers' objectives helps us look for decisions that do not maximize value. For example, are acquisitions that are likely to serve the interest of managers indeed the ones that hurt the bidding firms' shareholders? Specifically, how do the stock prices of bidding firms change when they announce different types of acquisitions?(2) We find considerable support for the view that acquisitions that hurt the bidding firms' shareholders tend to serve managers. For example, bidders who buy rapidly growing firms tend to pay too much and so lose market value when they announce such acquisitions. Of course, pursuing growth is a well-known objective of managers. We also find that bidders who buy firms outside the lines of business in which they currently operate lose market value (particularly in the 1980s). Again, diversification is typically a managerial rather than a shareholder objective. Although the short-term market reaction is not always a good gauge of the wisdom of an acquisition, it is a telling fact that these short-run reactions are negative only when the managers are likely to benefit.

Of course, overpaying for an acquisition is not the only managerial action that can hurt shareholders. Previous studies have shown that the stock market also reacts negatively to the announcements of other investment projects, particularly in oil exploration. There is also ample evidence that managers adopt antitakeover provisions and resist takeovers more generally, even when such actions reduce the market values of their firms. Interestingly, several studies have shown that managers with low ownership stakes are more likely to make value-reducing acquisitions and to resist value-increasing takeovers of their own firms. These results confirm the view that low stock ownership in part is responsible for the prevalence of behavior that does not maximize value.

What Are the Forces That Discipline Managers?

In light of the clear evidence that some managerial actions hurt shareholders, why don't shareholders do something about it? In principle, the task of monitoring the managers to assure that they serve shareholders is entrusted to the board of directors, whom shareholders elect as their representatives. In practice, however, are the boards keen and energetic proponents of shareholder causes, keeping managers on their toes, or are they just passive endorsers of managerial wishes? The evidence suggests that the answer is somewhere in between.

Recent studies show that poor managerial performance leads to a higher probability of internally precipitated turnover of the top management.(3) However, the incidence of such turnover is very low, and only very poor performance for a long time brings about turnover, which is usually an early retirement and hardly ever an outright dismissal. We have found that boards tend to respond to particularly poor performance of a firm relative to its industry peers by precipitating turnover of the top management.(4) Boards appear to need a great deal of evidence that top managers are performing poorly, gained by looking at relative performance, before they encourage them to leave. Because boards typically are not very sure and certainly do not take negative stock market reactions to acquisition and other announcements as clear evidence of mismanagement, boards do not appear to be very effective in deterring behavior that does not maximize value.

The Disciplinary Role of Hostile Takeovers

The ineffectiveness of the boards of directors in enforcing shareholder interests has made room for an alternative disciplining device: the hostile takeover. The frequency and the size of such takeovers have increased dramatically in the 1980s, and they have become perhaps the most common form of reasserting the preferences of shareholders over those of managers.

The view that hostile takeovers are an alternative disciplining device, practiced when managers deviate from value maximization and when directors fail to address this problem, receives considerable empirical support. We have found that Fortune 500 targets of hostile takeovers indeed are very poorly performing companies: the ratios of their market values to the replacement cost of their physical assets are roughly 38 percent below those of all publicly traded Fortune 500 companies.(5) We also have found that these targets of hostile takeovers tend to be in poorly performing industries, as well as being poor performers relative to their industries.(6) Interestingly, Mitchell and Lehn find that firms that lose market value when they make acquisitions themselves are likely to become future targets of takeovers.(7) Hostile acquirers sometimes get back at managers whose actions reduce market values of their firms.

Conclusion

Our research, as well as that of many others, confirms the empirical significance of the problems identified by Adam Smith. Low management ownership does cause performance problems. Managers with low ownership stakes do pursue policies that help themselves but hurt shareholders. Boards of directors at best are only partially effective in restraining such behavior of managers. Finally, hostile takeovers do tend to help shareholders of poorly performing firms to realize at least some of the value of their investment.

(1)R. Morck, A. Shleifer, and R. W. Vishny, "Management Ownership and Corporate Performance: An Empirical Analysis," NBER Working Paper No. 2055, October 1986, and Journal of Financial Economics (March 1988). (2)R. Morck, A. Shleifer, and R. W. Vishny, "Do Managerial Objectives Drive Bad Acquisitions?" NBER Working Paper No. 3000, June 1989. (3)J. B. Warner, R. L. Watts, and K. H. Wruck, "Stock Prices and Top Management Changes," Journal of Financial Economics (1988). (4)R. Morck, A. Shleifer, and R. W. Vishny, "Alternative Mechanisms for Corporate Control," NBER Working Paper No. 2532, March 1988, and American Economic Review (September 1988). (5)R. Morck, A. Shleifer, and R. W. Vishny, "Characteristics of Hostile and Friendly Takeover Targets," NBER Working Paper No. 2295, June 1987, and in Takeovers: Causes and Consequences, A. J. Auerbach, ed. Chicago: University of Chicago Press, 1988. (6)R. Morck, A. Shleifer, and R. W. Vishny, "Alternative Mechanisms for Corporate Control." (7)Mitchell and Lehn, "Do Bad Bidders Become Good Targets?" Journal of Political Economy, forthcoming.
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Author:Morck, Randall; Shleifer, Andrei; Vishny, Robert W.
Publication:NBER Reporter
Date:Sep 22, 1989
Words:1437
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