Magoosh GRE

Agency cost and ownership structure in aim traded companies

| December 3, 2012

Introduction

The aim of this chapter is to explain and discuss a number of prior researches that have been developed in relation with agency cost. The literatures are grouped into four parts based on their different research area. The first part gives the overview of Alternative Investment Market (AIM). Subsequently, the issue of corporate governance in AIM companies will be discussed. The next part will focus on the causes of agency problem. Both direct and indirect measurement of agency cost, include asset utilisation, operating expense and the firm’s performance, will be detailed analysed in the final part.

Overview of Alternative Investment Market

Alternative Investment Market (AIM) is the world’s leading market for smaller and growing companies. It helps them to raise new capital and allowing their shares to be traded widely. Since it was launched in 1995, over 3000 companies from across the world have joined AIM and a large proportion of them are in oil and gas industry. Its admission requirement and on-going rules are less onerous. For example, there is no requirement on prior trading, minimum public float or market capitalization. In fact, to be admitted to AIM, a firm is only required to have the support from a nominated advisor (Nomad). Subsequently, the only disclosure obligation for the firm is the general duty of disclosure requiring information which is reasonably considered to be necessary by the issuer which will enable investors to have a full understanding of the applicant’s financial position. AIM membership roles were thus kept simpler for encouraging a wide variety of companies to join, keeping capital rising and reducing membership cost. However, a SEC commissioner, Roel Campos likened AIM as a casino, and he stated that 30% of the issuers that list on AIM are gone within one year (Bawden & Waller, 2007). This comment has aroused great amount of abjections and London Stock Exchange (LSE) claimed that the only 2% companies go into liquidation each year.

Corporate governance in AIM companies

AIM is crucial for investor’s confidence to the market and companies’ significant failures on AIM market would have a negative effect on the overall confidence in the UK market. A consequence of the deliberately light regulatory burden placed in AIM companies means that they are not obliged to abide the UK’s Combined Code (2006). However, based on the UK’s Combined Code, the Guidelines on the Quoted Corporate Governance for AIM companies have been produced by Companies Alliance (QCA). According to the wide range of interviews and detailed analysis of the corporate governance statements in the annual report and accounts, Mallin and Kean (2008) found the majority of their sample AIM companies disclose some basic elements of good governance practice, such as including a corporate statement, identifying the directors and their responsibilities, and splitting the role of chairman and the CEO, and the presence of board sub-committees. However, their sample of AIM companies did not disclose as much corporate governance practice as they were expected by the QCA Guidelines’ recommendations. Some interesting results were given by the regression of the firm and market related factors on the disclosure score. Firstly, the young AIM companies tend to disclose more of their governance practices than the older ones. Secondly, larger companies disclose more than smaller ones. Thirdly, by the presence of the institutional investors has influence on the disclosure levels. Subsequently, the higher gearing ratio of the company, the lower disclosure level there will be. It also suggested that the AIM companies with no long-term debt may be required better governance structures to protect the claims of equity investors, because there are no debt holders to monitor the companies. In addition, the board size has positive impact on the reporting of governance practice and the companies with small board are less likely to obey to the QCA Guidelines. Therefore, the efficiency of corporate governance in AIM companies is related to the age of companies, size, gearing ratio, debt, as well as board size.

The causes of agency problem

When discussing the ownership of an organization, ‘agency problem’ is an inevitable vocabulary. According to Jensen and Meckling (1976), the agency relationship is defined as a contract between the principal(s) and the agent who is given some decision making authority to run the firm on the behalf of principal(s).

In fact, for majority of companies, both agent and principals are utility maximizes. Consequently, the agent will not always act in the interest of principal. To mitigate the conflict in interest between both parties is a big issue in corporate governance. Besides establishing appropriate incentives for the agent, monitoring cost will be designed to limit the aberrant activities of the agent. In some situations, the agent needs to pay to expend resources (bonding costs) to guarantee he/she will not take the actions that will harm the principal’s interest or to ensure that the principal will be compensated if the agent does take such actions. Additionally, there will be some divergence between the agent’s decisions and those decisions which would maximize the principal’s welfare. The reduction in the principal’s welfare caused by thus divergence is also a cost of agency relationship which is referred by Jensen et al. (1976) as ‘residual loss’. They also stated that the costs of deviation from value-maximization decline as the management ownership rises. As their stakes rise, managers pay a larger part of these costs and are less likely to squander corporate wealth. However, limited direct evidence exists on the magnitude and extent of the actual costs with the agency problem.

The measurement of agency cost

Direct measurement

Ang et al. (2000) analyzed the how agency cost is affected by the firm’s ownership structure, number of outsider managers and non-manger shareholders and external monitoring by banks. They measured firm’s agency cost with two measures, sales to asset ratio and expense to sales ratio. They argued that agency cost can be directly measured by assets-to-sales ratio as it measures the efficiency with which management uses the firm’s assets to generate sales. A high ratio reflects that the assets are generating significant sales and therefore indicates low agency cost. Conversely, a low ratio shows that manager makes poor investment decisions, exerts insufficient effort, resulting in low revenues, and consumes excessive unproductive assets, such as automobiles, fancy office space and resort properties. The expense ratio is the operating expense scaled by annual sales. It is a measure of how effectively the firm’s manager controls operating cost, including excessive perquisite consumption and other direct agency cost. In contrast to the sales-to-asset ratio, agency cost is in line with the expense ratio. Banks usually require managers to report results regularly and honestly; consequently, managers may be forced to run the business efficiently. Thus, bank monitoring complements the monitoring of managers by shareholders, thereby reducing owner-manager agency cost indirectly. Ang et al. (2000) utilized a sample of 1708 small corporate from the National Survey of Small Business Finances (NSSBF) database and found agency costs are significantly higher when an outside manager manages the firm and when there are more non-manager shareholders. In this situation, managers’ ownership share and monitoring by banks may be a helpful corporate control mechanism that can decrease agency costs.

Singh and Davidson (2003) adopted the approach used by Ang, Cole, and Lin to study large firms and sales, general, and administrative expenses were applied to measure agency cost instead of total operating expenses. Moreover, they analysed the role of corporate leverage in influencing the agency cost experienced by the large corporations instead of the banking relationship because large firms have larger access to the public debt market and therefore less depend on bank financing. They found that higher managerial ownership does positively influence asset utilization efficiency which was in line with result of Ang, Cole, and Lin. However, excessive discretionary expenses cannot be decreased by such ownership. Additionally, larger board size and outside block ownership does not improve the efficiency of a large corporation.

However, this measure has three potential drawbacks. As McKnight and Weir (2009) suggested, sales may not actually come from profitable activities so sales may not be consistent with shareholders welfare. Secondly, cash flows that generated by the sales may being expropriated instead of being distributed to shareholders. Thirdly, as Coles et al. (2005) stated, productivity can vary even between firms within the same industry. Generally speaking, Ang et al. (2000) and Singh and Davidson (2003) provided a useful indicator of agency costs.

Jacky Yuk-Chow So (2005) noticed that in Ang, Cole, and Lin’s study, ownership variables and external monitoring variables are highly significant statistically when a single regression is applied. However, some of these variables, such as family ownership and a banking relationship become insignificant when they are regressors of the multiple regressions. Therefore, he focused on the combined effect of expense ratio and asset-to sale ratio to measure agency cost using the NSSBF database from 1993 survey. This combined effect was analysed using both internal and external control variables. Debt-to-asset ratio and ownership variables were applied to study the impact of internal corporate control and the firm’s relationship to its bank was as proxies for external corporate control. Additionally, a dummy variable was also employed to capture the industry effect. Jacky Yuk-Chow So proposed that, the ‘combined effect’ approach implies that cash flow is a more appropriate measure of managerial performance since it captures not only efficiency, but also leverage, which is measured by the debt-to-asset ratio. The ordinary least squares (OLS) method and seemingly uncorrelated regression (SUR) were used to test his hypotheses and found out firms in manufacturing industry tend to have the highest agency cost; family ownership more appropriately resolves the agency problem; cash flow reflect the joint impact of agency cost and efficiency; agency cost increases when there are more non-shareholder managers; the number of banks involves and the length of the bank relationship do not have significant impact to the agency cost.

Indirectly measurement

Jensen (1986) paid attention to the conflicts of interest between shareholders and managers over payout policies when the organization generates large free cash flow, which is the cash flow in excess of that requires to fund all projects that have positive net present value when discounted at the relevant coat of capital. He stated that agency costs will increase when high free cash flows are combined with poor growth opportunities and hence large free cash flows suggest greater managerial discretion and higher agency costs. Therefore, motivating managers to disgorge the cash rather than investing in low-return project or wasting it on organization inefficiencies is a puzzle of many firms. This theory explains the benefits of debt in reducing agency cost of free cash flows and how debt can substitute for dividends. Managers may increase dividends or repurchase stock or even announce a ‘permanent’ increase in dividend to control the use of free cash flow. However, such promises are weak since the dividends can be reduced in the future. In fact, the organization will be punished if dividend is cut with significant stock price reduction is consistent with the agency of free cash flow. Debt enables managers effectively bond their promise to pay out future cash flows. Thus debt reduces the agency cost of free cash flow by reducing the cash flow available for spending at the discretion of managers and can be an effective substitute for dividends.

The interaction of free cash flow and growth prospects are used to measure of agency cost in many previous literatures. Opler and Titman (1993) stated that firms that have good growth prospects are more likely to be better managed. They are also less likely to have excess free cash flows because the available cash will be spent on positive net present value projects. Thus, as Jenson (1986), Doukas, Kim, and Pantzalis (2000) argued, agency costs may be regarded as a function of the interaction of growth opportunities and free cash flow. Firms that combine high free cash flow and low growth prospects can be regarded as suffering from high agency costs. Therefore, control function of debt is more important in thus organizations.

Acquisitions are one way in which funds can be spent by managers rather than distributed to shareholders. Free cash flow theory (Jensen, 1986) predicts acquisitions decrease, rather than increase, shareholder wealth, particularly from the perspective of the acquirer’s shareholders. There is a significant literature which is in consistent with this theory. Servaes (1991) and Houston, James and Ryngaert (2001) have found significant negative short run returns to acquirers. Agrawal, Jaffe & Mandelker (1992) undertook a thorough analysis of the post-merger performance of acquiring firms, measured by the stock market performance of a large number of acquiring firms over a long period of time. They concluded there is a strong evidence of long term underperformance following merger and this result is supported by Kohers and Kohers (2001). Accounting studies such as Sharma and Ho (2002) also show poorer post-acquisition performance. Finally, the survey done by Kelly, Cook, and Spitzer (1999) provide evidence that 53% of acquisitions were believed to have destroyed value. Given the extensive evidence that indicates a lack of positive returns to acquiring firms’ shareholders, it can be concluded that acquisitions can represent agency costs as directors use funds on negative net present value projects.

Demsetz (1983) recognized, when a manager owns a small stake, market discipline may still force him toward value maximization. In contrast, a manager who controls a substantial fraction of the firm’s equity may have enough voting power or influence more generally to guarantee his employment with the firm at an attractive salary. In this case, manager may indulge his preference for non-value-maximizing behaviour. This Entrenchment hypothesis predicts the agency may increase and corporate assets can be less valuable when managed by an individual free from checks on his control.

Morck et al. (1988) investigated the relationship between management ownership and the market value of the firm which is measured by Tobin’s Q. They found that Tobin’s Q increases as the board ownership increases from 0% to 5%, declines as the ownership rises further to 25%, and then continues to rise slowly when the board ownership rises beyond 25%. The increase of Tobin’s Q with ownership can be explained the convergence of interests between managers and shareholders, while the decline reflects entrenchment of the management team. The results confirm the conclusion that imposing a linear relationship between profit and the ownership by large shareholders is not appropriate. They also found that the presence of the founding family adversely affects Tobin’s Q in older firms, where the entrepreneurial of the founder might be less valuable.

Conclusion

The perspective of the development of AIM is optimistic. Mitigating the agency cost is a core part in corporate governance. Based on previous study, agency costs are higher when an outside manager manages the firm and when there are more non-manager shareholders. Managers’ ownership share and monitoring by banks may be a helpful corporate control mechanism that can decrease agency costs. However, imposing a linear relationship between profit and the ownership by large shareholders is not appropriate. The decrease of free cash flow will also decrease the agency cost.

References

  1. Agrawal, A., Jaffe, J.F. & Mandelker, G.N., 1992. The Post-Merger Performance of Acquiring Firms: A Re-Examination of an Anomaly. Journal of Finance, 47, 1605-1621.
  2. Ang, J., Cole, R., & Lin, J., 2000. Agency Costs and Ownership Structure. The Journal of Finance, 55(1), 81–106.
  3. Bawden, T. & Waller, M., 2007. London vs. New York: top US regulator attacks AIM ‘casino’.

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article1490202.ece (accessed: 14 Jan 2011).

  1. Coles, J., Lemmon, M., & Mescke, J., 2005. Structural Models and Endogeneity in Corporate Finance: The link between managerial ownership and corporate performance. Arizona State University working paper.
  2. Demsete, H., 1983, The Structure of Ownership and the Theory of the Firm. Journal of Law and Economics, 26, 375-390.
  3. Doukas, J., Kim, C., & Pantzalis, C., 2000. Security Analysts, Agency Costs, and Company Characteristics. Financial Analysts Journal, 56(6), 54–63.
  4. Houston, J., James, C., & Ryngaert, M., 2001. Where do merger gains come from? Bank mergers from the perspective of insiders and outsiders. Journal of Financial Economics, 60, 285–311.
  5. Jacky Yuk-Chow So, 2005. Agency Costs and Ownership Structure: Evidence from the Small Business Finance Survey Data Base. Texas A&M International University working paper.
  6. Jensen, M., & Meckling, W, 1976. Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure. Journal of Financial Economics, 3, 305–360.
  7. Jensen, M. C., 1986. Agency Costs of Free Cash Flow, Corporate Finance and Takeovers. American Economics Review, 76, 323–339.
  8. Jensen, M. C., 1993. The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems. Journal of Finance, 43(3), 831–880.
  9. Kohers, N., & Kohers, T., 2001. Takeovers of technology firms: Expectations vs. reality. Financial Management, 30, 35–54.
  10. Kelly, J., Cook, C., & Spitzer, D., 1999. Unlocking Shareholder Value: The Keys to Success. New York: KPMG LLP.
  11. McKnight, P. J. & Weir, C., 2009. Agency Costs, Corporate Governance Mechanisms and Ownership Structure in Large UK Publicly Quoted Companies: A Panel Data Analysis. The Quarterly Review of Economics and Finance, 49, 139–158.
  12. Opler, T., & Titman, S., 1993. The Determinants of Leveraged Buyout Activity: Free Cash Flow vs. Financial Distress Costs. Journal of Finance, 48, 1985–1999.
  13. Servaes, H., 1991. Tobin’s Q and the gains from takeovers. Journal of Finance, 46, 409–41.
  14. Sharma, D., & Ho, J., 2002. The Impact of Acquisitions on Operating Performance: Some Australian Evidence. Journal of Business Finance and Accounting, 29, 155–200.
  15. Singh, M., & Davidson, W. A., 2003. Agency Costs, Ownership Structures and Corporate Governance Mechanisms. Journal of Banking and Finance, 27, 793–816.
  16. Morck, R., Shleifer, A. & Vishny, R. W., 1988, Management Ownership and Market Valuation. Journal of Financial Economics, 20, 293-315.
  17. Mallin, C. & Kean Ow-Yong, 2008. Corporate Governance in Alternative Investment Market. The Institute of Chartered Accountants of Scotland.

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