Agency Costs and Corporate Governance Mechanisms Evidence for Uk Firms Essay Example

Agency Costs and Corporate Governance Mechanisms: Evidence for Uk Firms Essay Agency costs and corporate governance mechanisms: Evidence for UK firms Chrisostomos Florackis and Aydin Ozkan* University of York, UK Abstract In this paper, we aim to extend the empirical literature on the determinants of agency costs by using a large sample of UK listed firms. To do so, we employ two alternative proxies for agency costs: the ratio of total sales to total assets (asset turnover) and the ratio of selling, general and administrative expenses (SGA) to total sales. In our analysis, we control for the influence of several internal governance mechanisms or devices that were ignored by previous studies. Also, we examine the potential interactions between these mechanisms and firm growth opportunities in determining agency costs. Our results reveal that the capital structure characteristics of firms, namely bank debt and debt maturity, constitute two of the most important corporate governance devices for UK companies. Also, managerial ownership, managerial compensation and ownership concentration seem to play an important role in mitigating agency costs. Finally, our results suggest that the impact exerted by internal governance mechanisms on agency costs varies with firms’ growth opportunities. JEL classification: G3; G32 Keywords: Agency costs; Growth opportunities; Internal Corporate Governance Mechanisms. * Corresponding author. Department of Economics and Related Studies, University of York, Heslington, York, YO10 5DD, UK. Tel. : + 44 (1904) 434672. Fax: + 44 (1904) 433759. E-mail: [emailprotected] ac. uk. We thank seminar participants at University of York, and the 2004 European Finance Association Meetings for helpful comments and suggestions. 1 1. Introduction Following Jensen and Meckling (1976), agency relations within the firm and costs associated with them have been extensively investigated in the corporate finance literature. We will write a custom essay sample on Agency Costs and Corporate Governance Mechanisms: Evidence for Uk Firms specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Agency Costs and Corporate Governance Mechanisms: Evidence for Uk Firms specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Agency Costs and Corporate Governance Mechanisms: Evidence for Uk Firms specifically for you FOR ONLY $16.38 $13.9/page Hire Writer There is a great deal of empirical work providing evidence that financial decisions, investment decisions and, hence, firm value are significantly affected by the presence of agency conflicts and the extent of agency costs. The focus of these studies has been the impact of the expected agency costs on the performance of firms. 1 Moreover, the implicit assumption is that, in imperfect capital markets, agency costs arising from conflicts between firms’ claimholders exist and the value of firms decreases if the market expects that these costs are likely to be realised. It is also assumed that there are internal and external corporate governance mechanisms that can help reduce the expected costs and their negative impact on firm value. For example, much of prior work on the ownership and performance relationship relies on the view that managerial ownership can align the interests of managers and shareholders and hence one would observe a positive impact exerted by managerial shareholdings on the performance of firms. The positive impact is argued to be due to the decrease in the expected costs of the agency conflict between managers and shareholders. Despite much valuable insights provided by this strand of literature, however, only very few studies directly tackle the measurement issue of the principal variable of interest, namely agency costs. Notable exceptions are Ang et al. (2000) and Sign and Davidson (2003), which investigate the empirical determinants of agency costs and focus on the role of debt and ownership structure in mitigating agency problems for the US firms. In doing so, they use two alternative proxies for agency costs: the ratio of total sales to total assets (asset turnover) and the ratio of selling, general and administrative expenses (SGA) to total sales. In line with the findings of prior research they provide evidence for the view that managerial ownership aligns the interests of managers and shareholders and, hence, reduces agency costs in general. However, there is no consensus on the role of debt in mitigating such problems and associated costs. Ang et al. (2000) point out that debt has an alleviating role whereas Sign and Davidson (2003) an aggravating one. The objective of this paper is to extend the investigation of these studies by analysing empirically the determinants of agency costs in the UK for a large sample of 1 See, for example, Morck et al. (1988); McConnell and Servaes (1990); and Agrawal and Knoeber (1996) among others. 2 listed firms. Following the works of Ang et al. (2000) and, Sign and Davidson (2003), we model both proxies of agency costs: asset turnover and the (SGA) ratio. More specifically, we empirically examine the impact of capital structure, ownership, board composition and managerial compensation on the costs likely to arise from agency conflicts between managers and shareholders. In doing so, we also pay particular attention to the role of growth opportunities in influencing the effectiveness of internal governance mechanisms in reducing agency costs. In carrying out the analysis in this paper, we aim to provide insights at least in three important areas of the empirical research on agency costs. First, in investigating the determinants of agency costs, the analysis of this paper incorporates important firmspecific characteristics (internal corporate governance devices) tha t possibly affect agency costs but were ignored by previous studies. For example, we explore the role the debt maturity structure of firms can play in controlling agency costs. It is widely acknowledged that short-term debt may be more effective than long-term debt in reducing the expected costs of the underinvestment problem of Myers (1977). 3 Accordingly, in our analysis, we consider the maturity structure of debt as a potential governance device that is effective in reducing the expected costs of the agency conflict between shareholders and debtholders. Similar to Ang et al. 2000) that investigate if bank debt creates a positive externality in the form of lower agency costs, we also check if the source of debt financing matters in mitigating agency problems. Another potentially effective corporate governance mechanism we consider relates to managerial compensation. Recent studies suggest that compensation contracts can motivate managers to take actions that maximize shareholders’ wealth (see, e. g. , Core et al. , 2001; Murphy, 1999 among ot hers). This is based on the view that financial â€Å"carrots† motivate managers to maximize firm value. That is, a manager will presumably be less likely, ceteris paribus, to exert insufficient effort and risk the loss of his job the greater the level of his compensation. Several empirical studies provide evidence for the effectiveness of managerial compensation as a corporate governance mechanism. For instance, 2 As explained later in the paper, the two proxies for agency costs that are used in our analysis are more likely to capture the agency problems between managers and shareholders. However, we do not rule out the possibility that they may also capture the agency problems between shareholders and debtholders. It is argued that firm with greater growth opportunities should have more short-term debt because shortening debt maturity would make it more likely that debt will mature before any opportunity to exercise the growth options. Consistent with this prediction, there are several empirical debt maturity studies that find a negative relation between maturity and growth opportunit ies (see, e. g. , Barclay and Smith, 1995; Guedes and Opler, 1996; and Ozkan, 2000 among others). 3 Hutchinson and Gul (2004) find that managers’ compensation can moderate the negative association between growth opportunities and firm value. In this paper, we examine the effectiveness of managerial compensation as a corporate governance mechanism by including the salary of managers in our empirical model. We also acknowledge that there have been concerns about excessive compensation packages and their negative impact on corporate performance. Accordingly, we investigate the possibility of a non-monotonic impact the managerial compensation may exert on agency costs. Second, our empirical model captures potential interactions between corporate governance mechanisms and growth opportunities. Following McConnell and Servaes (1995) and Lasfer (2002), we expect the effectiveness of governance mechanisms in reducing agency problems to be dependent on firm’s growth opportunities. In particular, if agency problems are associated with greater information asymmetry (a common problem in high-growth firms), we expect the effectiveness of corporate governance mechanisms in mitigating asymmetric information problems to increase in high-growth firms (Smith and Watts, 1992 and Gaver and Gaver, 1993). However, if, as argued by Jensen (1986), agency problems are associated with conflicts over the use of free cash flow (a common problem in low-growth firms), we expect governance mechanisms that are likely to mitigate such problems to play a more important role in low-growth firms (Jensen, 1986). Last but not least, in contrast to previous studies that focus on the US market, we provide evidence for UK firms. Although the UK and the US are usually characterized as having a similar â€Å"common law† regulatory system (see, e. g. , La Porta et al. 1998), the UK market bears significant distinguishing characteristics. 4 It is argued that several of these characteristics may contribute to a more significant degree of managerial discretion and, hence, higher level of managerial agency costs. For example, despite the relatively high proportion of shares held by financial institutions, there is a great deal of evidence that financial investors do not take an active role in corporate governance. Similarly, UK boards are usually characterized as corporate devices that provide weak disciplinary function. More specifically, weak fiduciary obligations on directors have resulted in nonexecutives playing more an advisory than a monitoring role. 5 Consequently, the investigation of agency issues and the effectiveness of the alternative governance 4 For a more detailed discussion about the characteristics of the prevailing UK corporate governance system see Short and Keasey (1999); Faccio and Lasfer (2000); Franks et al. (2001); and Ozkan and Ozkan (2004). 5 Empirical studies by Faccio and Lasfer (2000), Goergen and Rennebog (2001), Franks et al. 2001) and Short and Keasey (1999) provide evidence on the weak role of institutions and board of directors in reducing agency problems in the UK. 4 mechanisms in the UK, in a period that witnesses an intensive discussion of corporate governance issues, would be of significant importance. Our results strongly suggest that managerial ownership constitutes a strong corporate governance mechanism for the UK firms. This result is consistent with the fi ndings provided by Ang et al. (2000) and Sign and Davidson (2003) for the US firms. Ownership concentration and salary also seem to play a significant role in mitigating agency related problems. The results concerning the role of capital structure variables on agency costs are striking. It seems that both the source and the maturity structure of corporate debt have a significant effect on agency costs. Finally, there is strong evidence that specific governance mechanisms are not homogeneous but vary with growth opportunities. For instance, we find that executive ownership is more effective as a governance mechanism for high-growth firms. This result is complementary to the results obtained by Smith and Watts (1992), Gaver and Gaver (1993) and Lasfer (2002), which support the view that high-growth firms are likely to prefer incentive mechanisms (e. g. managerial ownership) whereas low-growth firms focus more on monitoring mechanisms (e. g. short-term debt). The remainder of the paper is organized as follows. In section 2 we discuss the related theory and formulate our empirical hypotheses. Section 3 describes the way in which we have constructed our sample and presents several descriptive statistics of that. Section 4 presents the results of our univariate, multivariate and sensitivity analysis. Finally, section 5 concludes. 2. Agency costs and Governance Mechanisms In what follows, we will discuss the potential interactions between agency costs and internal corporate governance mechanisms available to firms. Also, we will analyze how firm growth opportunities affect agency costs and the relationship between governance mechanism and agency costs. 2. 1 Debt Financing Agency problems within a firm are usually related to free cash-flow and asymmetric information problems (see, for example, Jensen, 1986 and Myers and Majluf, 1984). It is widely acknowledged that debt servicing obligations help reduce of agency problems of this sort. This is particularly true for the case of privately held debt. For example, bank 5 debt incorporates significant signalling characteristics that can mitigate informational asymmetry conflicts between managers and outside investors (Jensen, 1986; Stulz, 1990; and Ross, 1977). In particular, the announcement of a bank credit agreement conveys positive news to the stock market about creditor’s worthiness. Bank debt also bears important renegotiation characteristics. As Berlin and Mester (1992) argue, because banks are well informed and typically small in number, renegotiation of a loan is easier. A bank’s willingness to renegotiate and renew a loan indicates the existence of a good relationship between the borrower and the creditor and that is a further good signal about the quality of the firm. Moreover, it is argued that bank debt has an advantage in comparison to publicly traded debt in monitoring firm’s activities and in collecting and processing information. For example, Fama (1985) argues that bank lenders have a comparative advantage in minimizing information costs and getting access to information not otherwise publicly available. Therefore, banks can be viewed as performing a screening role employing private information that allows them to evaluate and monitor borrowers more effectively than other lenders. In addition to debt source, the maturity structure of debt may matter. For example, short-term debt may be more useful than long-term debt in reducing free cash flow problems and in signalling high quality to outsiders. For example, as Myers (1977) suggests, agency conflicts between managers and shareholders such as the underinvestment problem can be curtailed with short-term debt. Flannery (1986) argues that firms with large potential information asymmetries are likely to issue short-term debt because of the larger information costs associated with long-term debt. Also, short-term debt can be advantageous especially for high-quality companies due to its low refinancing risk (Diamond, 1991). Finally, if yield curve is downward sloping, issuing short-term debt increases firm value (Brick and Ravid, 1985). Consequently, bank debt and short-term debt are expected to constitute two important corporate governance devices. We include the ratio of bank debt to total debt and the ratio of short-term debt to total debt to our empirical model so as to approximate the lender’s ability to mitigate agency problems. Also, we include the ratio of total debt to total assets (leverage) to approximate lender’s incentive to monitor. In general, as leverage increases, so does the risk of default by the firm, hence the incentive for the lender to monitor the firm6. 6 Ang et al. 2000) focus on sample of small firms, which have do not have easy access to public debt, and examine the impact of bank debt on agency costs. On the contrary, Sign and Davidson (2003) focus on a sample of large firms, which have easy access to public debt, and examine the impact of public debt on 6 2. 2 Managerial Ownership The conflicts of interest between managers and shareholders arise mainly from the separation b etween ownership and control. Corporate governance deals with finding ways to reduce the magnitude of these conflicts and their adverse effects on firm value. For instance, Jensen and Meckling (1976) suggest that managerial ownership can align the interest between these two different groups of claimholders and, therefore, reduce the total agency costs within the firm. According to their model, the relationship between managerial ownership and agency costs is linear and the optimal point for the firm is achieved when the managers acquires all of the shares of the firm. However, the relationship between managerial ownership and agency costs can be non-monotonic (see, for example, Morck et al. , 1988; McConnel and Servaes, 1990,1995 and, Short and Keasey, 1999). It has been shown that, at low levels of managerial ownership, managerial ownership aligns managers’ and outside shareholders’ interests by reducing managerial incentives for perk consumption, utilization of insufficient effort and engagement in nonmaximizing projects (alignment effect). After some level of managerial ownership, though, managers exert insufficient effort (e. g focus on external activities), collect private benefits (e. g. build empires or enjoy perks) and entrench themselves (e. g. undertake high risk projects or bend over backwards to resist a takeover) at the expense of other investors (entrenchment effect). Therefore the relationship between the two is non-linear. The ultimate effect of managerial ownership on agency costs depends upon the trade-off between the alignment and entrenchment effects. In the context of our analysis we propose a non-linear relationship between managerial ownership and managerial agency costs. However, theory does not shed much light on the exact nature of the relationship between the two and, hence, we do not know which of the effects will dominate the other and at what levels of managerial ownership. We, therefore, carry out a preliminary investigation about the pattern of the relationship between managerial ownership and agency costs. Figure 1 presents the way in which the two variables are associated. [Insert Figure 1 here] agency costs. Our study is more similar to that of Ang et al (2000) given that UK firms use significant amounts of bank debt financing (see Corbett and Jenkinson, 1997). 7 Clearly, at low levels of managerial ownership, asset turnover and managerial ownership are positively related. However, after managerial ownership exceeds the 10 per cent level, the relationship turns from positive to negative. A third turning point is that of 30 percent after which the relationship seems to turn to positive again. Consequently, there is evidence both for the alignment and the entrenchment effects in the case of our sample. In order to capture both of them in our empirical specification, we include the level, the square and the square of managerial ownership in our model as predictors of agency costs. 2. 3 Ownership Concentration A third alternative for alleviating agency problems is through concentrated ownership. Theoretically, shareholders could take themselves an active role in monitoring management. However, given that the monitoring benefits for shareholders are proportionate to their equity stakes (see, for example, Grossman and Hart, 1988), a small or average shareholder has little or no incentives to exert monitoring behaviour. In contrast, shareholders with substantial stakes have more incentives to supervise management and can do so more effectively (see Shleifer and Vishny, 1986; Shleifer and Vishny, 1997 and Friend and Lang, 1988). In general, the higher the amount of shares that investors hold, the stronger their incentives to monitor and, hence, protect their investment. Although large shareholders may help in the reduction of agency problems associated with managers, they may also harm the firm by causing conflicts between large and minority shareholders. The problem usually arises when large shareholders gain nearly full control of a corporation and engage themselves in self-dealing expropriation procedures at the expense of minority shareholders (Shleifer and Vishny, 1997). Also, as Gomez (2000) points out, these expropriation incentives are stronger when corporate governance of public companies insulates large shareholders from takeover threats or monitoring and the legal system does not protect minority shareholders because either of poor laws or poor enforcement of laws. Furthermore, the existence of concentrated holdings may decrease diversification, market liquidation and stock’s ability to grow and, therefore, increase the incentives of large shareholders to expropriate firm’s resources. Several empirical studies provide evidence consistent with that view (see, for example, Beiner et al, 2003). In order to test the impact of ownership concentration on agency costs, we include a variable that refers to the sum of stakes of shareholders with equity stake greater than 3 8 per cent in our regression equation. The results remain robust when the threshold value changes from 3 per cent to 5 per cent or 10 per cent. 2. 4 Board of Directors Corporate governance research recognizes the essential role performed by the board of directors in monitoring management (Fama and Jensen, 1983; Weisbach, 1988 and Jensen, 1993). The effectiveness of a board as a corporate governance mechanism depends on its size and composition. Large boards are usually more powerful than small boards and, hence, considered necessary for organizational effectiveness. For instance, as Pearce and Zahra (1991) point out, large powerful boards help in strengthening the link between corporations and their environments, provide counsel and advice regarding strategic options for the firm and play crucial role in creating corporate identity. Other studies, though, suggest that large boards are less effective than large boards. The underlying notion is that large boards make coordination, communication and decision-making more cumbersome than it is in smaller groups. Recent studies by Yermack, 1996; Eisenberg et al. , 1998 and Beiner et al, 2004 support such a view empirically. The composition of a board is also important. There are two components that characterize the independence of a board, the proportion of non-executive directors and the separated or not roles of chief executive officer (CEO) and chairman of the board (COB). Boards with a significant proportion of non-executive directors can limit the exercise of managerial discretion by exploiting their monitoring ability and protecting their reputations as effective and independent decision makers. Consistent with that view, Byrd and Hickman (1992) and Rosenstein and Wyatt (1990) propose a positive relationship between the percentage of non-executive directors on the board and corporate performance. Lin et al. (2003) also propose a positive share price reaction to the appointment of outside directors, especially when board ownership is low and the appointee possesses strong ex ante monitoring incentives. Along a slightly different dimension, Dahya et al. (2002) find that top-manager turnover increases as the fraction of outside directors increases. Other studies find exactly the opposite results. They argue that non-executive directors are usually characterized by lack of information about the firm, do not bring the requisite skills to the job and, hence, prefer to play a less confrontational role rather than a more critical monitoring one (see, for example, Agrawal and Knoeker, 1996; Hermalin 9 nd Weisbach, 1991, and Franks et al. , 2001)7. As far as the separation between the role of CEO and COB is concerned, it is believed that separated roles can lead to better board performance and, hence, less agency conflicts. The Cadbury (1992) report on corporate governance stretches that issue and recommends that CEO and COB should be two distinct jobs. Firms should comply with the recommendation of the report for their own benefit. A decision not to combine these roles should be publicly e xplained. Empirical studies by Vafeas and Theodorou (1998), and Weir et al. (2002), though, which study that issue for the case of the UK market, provide results that do not support Cadbury’s stance that the CEO – COB duality is undesirable. In the context of the UK market, UK boards are believed to be less effective than the US ones. For instance,. To test the effectiveness of the board of directors in mitigating agency problems we include three variables in our empirical model: a) the ratio of the number of non-executive directors to he number of total directors, b) the total number of directors (board size) and c) a dummy variable which takes the value of 1 when the roles of CEO and COB are not separated and 0 otherwise. 2. 5 Managerial Compensation Another important component of corporate governance is the compensation package that is provided to firm management. Recent studies by Core et al. (2001) and Murphy (1999) suggest, among others, that compensation contracts, whose u se has been increased dramatically during the 90’s, can motivate managers to take actions that maximize shareholders’ wealth. In particular, as Core et al. (2001) point out, if shareholders could directly observe the firm’s growth opportunities and executives’ actions no incentives would be necessary. However, due to asymmetric information between managers and shareholders, both equity and compensation related incentives are required. For example, an increase in managerial compensation may reduce managerial agency costs in the sense that satisfied managers will be less likely, ceteris paribus, to utilize insufficient effort, perform expropriation behaviour and, hence, risk the loss of their job. Despite the central importance of the issue, only a few empirical studies examine the impact of managerial compensation components on corporate performance. For example, Jensen and Murthy 7 Such a result may be consistent with the governance system prevailing in the UK market given the fact that UK legislation encourages non-executive directors to be inactive since it does not impose fiduciary obligations on them. Also, UK boards are dominated by executive directors, which have less monitoring power. Franks et al. (2001) confirm this view by providing evidence on a non-disciplinary role of nonexecutive directors in the UK. 10 (1990) find a statistically significant relationship between the level of pay and performance. Murphy (1995), finds that the form, rather than the level, of compensation is what motivates managers to increase firm value. In particulars, he argues that firm performance is positively related to the percentage of executive compensation that is equity based. More recently, Hutchinson and Gul (2004) analyze whether or not managers’ compensation can moderate the negative association between growth opportunities and firm value8. The results of this study indicate that corporate governance mechanisms such as managerial remuneration, managerial ownership and non-executive directors possibly affect the linkages between organizational environmental factors (e. g. growth opportunities) and firm performance. Finally, Chen (2003) analyzes the relationship between equity value and employees’ bonus. He finds that the annual stock bonus is strongly associated with the firm’s contemporaneous but not future performance. Managerial compensation, though, is considered to be a debated component of corporate governance. Despite its potentially positive impact on firm value, compensation may also work as an â€Å"infectious greed† which creates an environment ripe for abuse, especially at significantly high levels. For instance, remuneration packages usually include extreme benefits for managers such as the use of private jet, golf club membership, entertainment and other expenses, apartment purchase etc. Benefits of this sort usually cause severe agency conflicts between managers and shareholders. 9 Therefore, it is possible that the relationship between compensation and agency costs is non-monotonic. Similar to the case of managerial ownership, we carry out a preliminary investigation about the pattern of the relationship between salary and agency costs. As shown in figure 2, the relationship between salary and agency costs is likely to be non-linear10. In our empirical model, we include the ratio of the total salary paid to executive directors to total assets as a determinant of agency costs. Also, in order to capture potential 8 Rather, the majority of the studies in that strand of literature reverse the causation and examine the impact of performance changes on executive or CEO compensation (see, for example, Rayton, 2003 among others). Concerns about excessive compensation packages and their negative impact on corporate performance have lead to the establishment of basic recommendations in the form of â€Å"best practises† in which firms should comply so as the problem with excessive compensation to be diminished. In the case of the UK market, for example, one of the basic recommendations of the Cadbury (1992) report was the establishment of an independent compensation committee. Also, in a posterior report, the Greenbury (1995) report, specific propositions about remuneration issues were made. For example, an issue that was stretched was the rate of increase in managerial compensation. In the case of the US market, the set of â€Å"best practises† includes, among others, the establishment of a compensation committee so as transparency and disclosure to be guaranteed (same practise an in the UK) and the substitution of stock options as compensation components with other tools that promote the long-term value of the company 10 A similar preliminary analysis is carried out so as to check potential non-linearities concerning the relationship between the rest of internal governance mechanisms and agency costs. Our results (not reported) indicate that none of them is related to agency costs in a non-linear way. 11 non-linearities, we include higher ordered salary terms in the regression equation. Finally, we include a dummy variable, which takes the value of 1 when a firm pays options or bonuses to managers and 0 otherwise. Including that dummy variable in our analysis enables us to test whether or not options and bonuses themselves provide incentives to managers. As Zhou (2001) points out, ignoring options is likely to incur serious problems unless managerial options are either negligible compared to ownership or almost perfectly correlated with ownership. [Insert Figure 2 here] 2. 6 Growth Opportunities The magnitude of agency costs related to underinvestment, asset substitution and free cash flow differ significantly across high-growth and low-growth firms. In the underinvestment problem, managers may decide to pass up positive net present value projects since the benefits would mainly accrue to debt-holders. This is more severe for firms with more growth-options (Myers, 1977). Asset substitution problems, which occur when managers opportunistically substitute higher variance assets for low variance assets, are