« Origins of CSR and Stakeholder Theory | Main | Welcome to The Spiral Path »

July 16, 2006

Agency Theory and Shareholder Value

At the complete opposite end of the spectrum from the warm and fuzzy Stakeholder Theory and Corporate Social Responsibility are the cold hard Agency Theory and ‘Shareholder Value’ approaches

Agency Theory

Agency theory first arose in the 1970s and was apparently developed by Ross (1973), Mitnick (1973) [10] and Jensen & Meckling (1976, as cited in Eisenhardt 1989) [11]. Eisenhardt describes it:

"Specifically, agency theory is directed at the ubiquitous relationship, in which one party (the principal) delegates work to another (the agent), who performs that work. Agency theory attempts to describe this relationship using the metaphor of a contract." (Eisenhardt, 1989:58).

Agency theory talks about two agency problems. 1) There is likely to be a conflict between the interests and goals of managers and principals and 2) managers and principals will have different levels of risk aversion. The costs of agency are said to be the cost to principals of 1) obtaining information about what managers are actually doing and 2) enticing managers to act in the interests of the principal.

Agency theory is both based on self interest (the agent will act in their own interests and against those of the principal) and relies on self interest in part to resolve this problem (different levels of incentive based on the self interest of the agent are required to motivate the agent to act according to the principal’s wishes).

This emphasis on self-interest causes concern for many of the theory's detractors. According to Eisenhardt (1989), "Perrow (1986) also criticized the theory for being unrealistically one-sided because of its neglect of potential exploitation of workers." and Mintzberg et al argue that the promulgation of this theory through business schools as contributing to a wider social phenomenon of selfishness: 

The fabrication of economic man drives a wedge of distrust into society between our individual wants and our social needs. (Mintzberg et al, 2002). [12]

Shareholder Value

If you've read anything in the business press over the last 20 years, you would know that every board and senior executive has but one goal and responsibility - to increase 'Shareholder Value.' Regarding this concept, Sally Eastoe observes:

The term ‘shareholder value’ was first introduced in the 1980s by US consultants who were selling value-based management to companies already under stock-market pressure to increase returns. (Eastoe, 2005: 33) [13]

If you really want to undestand where this idea came from, you need to look at Lazonick and O’Sullivan (I'll mostly refer to them as L&O from now on) trace the phenomenon back to the 1980s when “a relatively small number of giant corporations … dominated the economy of the United States” (Lazonick & O’Sullivan, 2000: 14). Accumulating huge revenues these corporations allocated them according to a principle L&O call “retain and reinvest”. The corporations tended to “retain both the money that they earned and the people whom they employed.” (Ibid.) According to L&O this enabled them to build a strong foundation for growth. However, they argue, this principle began to run into problems because of the sheer size of the organisations they had built and competition — mainly from Japan at that time. Noting the rise of agency theory at this time and the

relatively poor performance of companies in the 1970s, agency theorists argued that there was a need for a takeover market…. The rate of return on corporate stock was their measure of superior performance, and the maximization of shareholder value became their creed. (Ibid: 16)

In parallel with the agency theorists during the 1970s “the institutional investor” (look up Jonk Bonds) also became prominent at this time, resulting in the “transfer of stockholding from individual households to institutions such as mutual funds, pension funds and life insurance companies. (Ibid.) [14] L&O trace how these developments, including the development of the junk bond market which facilitated launching hostile takeovers, led to a new paradigm — “downsize and distribute”

Finally, L&O argue that while it appears that a focus on shareholder value has paid off (at least for US shareholders)

We must consider the possibility that the US stock-market boom is encouraging US households to live off the past while corporations have less incentive to invest for the future. (Ibid. 32)

and

Yet the stock-market boom has not made capital available to industry. The persistent and massive flow of funds into stock-based mutual funds in the 1990s has bid up stock prices, increasing the market capitalizations of corporations. But, as we have seen, net corporate equity issues have been negative over the course of the 1990s because of corporate stock repurchases, while the main impact of the stock-market boom on capital markets has been to raise consumption. (Ibid.)

This suggests that the focus on shareholder value has not achieved the results suggested by its proponents at the macro level. In a future post, I am going to discuss Sally Eastoe’s Swinburne DBA thesis. Sally makes a strong argument that it does not produce results at the individual corporation level either.

I argue that something else is needed, and has always been needed, to develop commercial enterprise that is truly wealth creating over the long term. I suggest that what we need is an enduring purpose.

Posted by chriscurnow at July 16, 2006 12:12 PM

Trackback Pings

TrackBack URL for this entry:
http://www.chriscurnow.com/cgi-bin/mt/mt-tb.cgi/313

Comments

Post a comment