Agency costs arise when someone else makes decisions on your behalf. They arise because the agent may make decisions that are not value-maximising for the principal, that is, they are relatively suboptimal. The need for agents (managers) in corporations arises because of the benefits of specialisation, economies of scale and scope, and the associated challenges in accessing capital markets to achieve these benefits. The modern corporation brings together the following parties:
professional managers acting as agents for shareholders (the principals) – specialists in initiating ideas, decision-making and implementation;
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board of directors – specialists in ratifying key management decisions, monitoring performance and appointing management to operate in the interests of shareholders;
debt-holders – specialists in providing capital under contractual arrangements; and
shareholders/residual risk bearers – specialists in providing capital and diversifying to minimise risk.
These ‘typical’ arrangements lead to agency costs of equity arising from potential conflicts of interest between management and shareholders because managers are naturally motivated to act in their own interests. Similarly, these arrangements lead to agency costs of debt arising from conflicts between the interests of debt-holders and management when they are acting in the interests of shareholders.
I.A.5.2.1.1 Agency Cost of Equity
Agency costs of equity arise because of the separation of decision-making from ownership and risk bearing. Management will be motivated by their interests rather than those of shareholders.
To the extent these diverge there can be costs to shareholders. For example, management might be motivated by maximising the size of the firm and therefore their prestige and power rather than maximising the value of the firm. Maximising size can mean taking on, or retaining, value-destroying investments, over-investing in staff, expanding into unrelated areas of business that
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increase size but not value.3 Mechanisms can be put in place to minimise agency costs but these cost money; for example, a board of directors is supposed to oversee management in the interests of shareholders, but such oversight, along with other monitoring systems, is costly. So agency costs not only include the opportunity cost of suboptimal decisions by management but also the costs of monitoring management to minimise these suboptimal decisions. Such mechanisms are not needed in the case of an owner-managed firm. However, owner-managed firms are not practical in large capital-hungry businesses so professional managers are employed and shares are offered more widely. This brings the benefit of skilled decision-makers but also the associated agency costs mentioned above. In a large publicly listed firm each shareholder typically owns a small portion of it and has little direct influence over it. Not surprisingly, shareholders are generally less focused in their interest.
I.A.5.2.1.2 Agency Costs of Debt
For this discussion we will assume that management does operate in the interests of shareholders, which is their primary responsibility. There are a number of ways that management, operating in the interests of shareholders, can transfer wealth from debt-holders to shareholders. In anticipation of this, debt-holders may take a number of actions to protect their interests, for example agreeing to restrictive covenant arrangements to minimise the likelihood of this happening and/or charging a higher interest rate to compensate them for expected losses. We also observe different forms of debt arising with different exposure to risk, with consequent different pricing arrangements. Understanding the agency costs of debt assists our understanding of why there are different forms of debt and different ‘protection’ arrangements.
Debt-holders could respond to the possibility of agency costs through ‘price protection’. That is, they could assume that management will act in the adverse way described and therefore charge an interest rate that covers these expected losses as well as providing the return on the investment they require. However, it is generally much more cost-effective for management to offer some form of guarantee that they will not actively pursue such activities. This line of thinking says that it is in the interests of shareholders to offer protection from agency costs of debt to save interest costs. For example, management could offer to employ an independent auditor to review the state of the company and thereby offer protection to debt-holders. Since the ultimate goal is to find the best trade-off between interest costs and monitoring costs, we can see that the incentive for audit is from the shareholders rather than from the debt-holders! This says that the benefit of the reduced cost of interest outweighs the cost of the audit.
3 Curiously many takeovers fall into this category.
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What actions could management pursue to the detriment of debt-holders? What protection might they offer debt-holders to avoid higher interest costs?
Priority of dividends: Management could pay out cash earnings to shareholders, leaving insufficient to pay debt-holders. As a result, we see the requirement that interest be paid before dividends.
Similarly, we see priorities defined in favour of debt-holders when a business either voluntarily or involuntarily winds up.
Sale of cash-generating assets and/or excessive dividend payments: Once management has raised debt to finance part of the business, they could liquidate the assets and pay a mammoth dividend to shareholders, leaving nothing but a shell for holders. This transfers wealth from debt-holders to sharedebt-holders. We see several responses to this possibility. Firstly, we see general rules captured in company security regulations that prohibit dividends being paid out of capital (i.e.
they cannot exceed earnings). Secondly, we see special resolutions required for return of capital or limits around the amount and price of share repurchases without special agreement by debt-holders (and sharedebt-holders). Thirdly, we see collateralised loans whereby debt-debt-holders have first claim over particular assets and management agree not to sell them, and also that debt-holders have first claim over the assets in event of default or a wind-up.
Issue higher-ranking debt: Once management has raised debt at a particular interest rate they could subsequently issue new debt with a higher priority to receive interest (and principal in the event of bankruptcy). This leaves the original debt-holders bearing more risk than was originally expected and potentially uncompensated in terms of return, that is to say, there has been a transfer of wealth from one set of debt-holders to another. To protect against this possibility management can contract with the original group to define the amount of senior debt they will issue (which could be none). Why do we see debt with different seniority in the first place?
Simply because it offers a broader range of risk/return securities for investors to choose from in order to establish their desired risk profile.
Increase operating risk of business: Again there is a potential for management to transfer risk from debt-holders to shareholders by increasing the operating risk of the business after the debt contract has been established. Management might signal that the debt will be used to finance assets with a particular level of operating risk, and then, once the debt is raised with an interest rate struck accordingly, might switch and use the debt to finance riskier assets. Collateralised loans which tie the debt to particular assets is one response to this situation. Another is for management to offer convertible debt whereby debt-holders can transfer the debt to equity if there is a high chance of this happening. Convertible debt can minimise these agency costs. This
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is why we tend to see more convertible debt issued in industries/firms facing lots of investment opportunities and assets with changing values.
Agency costs of debt are even higher when a firm is facing default on its debt. In such a case managers are more inclined to make high-risk decisions and less inclined to invest in value-creating strategies. These and additional problems are discussed in Section I.A.5.4.3.
Agency costs help us understand the nature of debt contracts and the circumstances under which some forms of debt may be more prevalent than others. We also recognise that an all-equity firm experiences agency costs of equity but not of debt. As debt is substituted for equity to finance a firm’s activities, the agency costs of debt increase and the importance of agency costs of equity decreases. We pick up this theme again in Section I.A.5.4.3.