Mitigating the Friction Between Shareholders and Managers

“Building dynamic agency theory into the basic investment framework is a very promising way to understand firm behavior.”

The allocation of funds between investment in new projects, and payout to shareholders and managers is among the most important decisions that firms make.

“Firm investment and payout decisions are often affected by the conflict of interest between shareholders and managers,” says Assistant Professor Hengjie Ai. “This conflict is dynamic in nature, because when making a decision today, shareholders and managers should take into account not only the prospect of the market going forward, but also the possibility of conflict of interest in the future.”

To study the impact of these conflicts, Ai investigated how limited commitment—the option to terminate a contract—factors into managerial compensation and investment. Ai showed that forward-looking contracts that are designed to efficiently mitigate the lack of commitment between shareholders and managers have two implications: small firms should invest more and grow faster than large firms, and the CEO compensation in large firms must have a fat-tailed distribution. Both findings are consistent with empirical evidence.

Economists used to believe that small businesses invested more than larger ones because technology has a decreasing return to scale. Ai’s research suggests this is probably not the answer, or at least cannot be the only reason. His results imply that small firms invest more to mitigate the conflict of interest between shareholders and managers.

“According to our model, agency frictions imply that managers in small firms are poorly diversified,” Ai says. “To achieve better risk-sharing and reduce the probability of bankruptcy, the best thing for small firms to do is to invest more and expand their operation. Thinking about the conflict of interest between decision makers and the contractual relationship that are designed to mitigate it is a fruitful way to understand firm behavior.”

“Investment and CEO Compensation under Limited Commitment” Ai, H., Li, R., Journal of Financial Economics (2015)