Investment Capital and Conflicts of Interest in the Principal-Agent Relationship

In principal-agent relationships, conflicts often arise because each party is interested in his/her own well-being. The principle of self-interested behavior suggests that in business arrangements, parties will work toward their own financial self interest, often at the expense of the other party. In corporations, owners do not have direct control over the decision-making in the organization. Managers hired to run the company in the interests of the owners often find ways to maximize their own self interest at the expense of owners. When this happens, manager-owner conflict in the principal-agent relationship is said to occur.

Investment Capital Decisions

The principle of diversification suggests that holding more than one asset in a portfolio has the effect of reducing the risk of an investor because his/her wealth and value is not dependent on one or only a few investments. The more diversity, the lower the risk enjoyed by the investor. Consequently, diverse investors are not heavily impacted by transitory market fluctuations, news about an industry, or even the complete failure of a company. Each investment represents only a small percentage of the total value of the portfolio. Loss of one small part has little impact of the portfolio as a whole.

Managers, however, have much more to lose if the company is affected by market fluctuations and news about the industry in which the firm competes. If the company goes under and files bankruptcy, the manager may be out of a job, not to mention the loss of any stock held as compensation for employment. Also, if the company goes under, the failure is tied to the managers of the firm not the investors which may impact their ability to find employment elsewhere. Other firms may be hesitant to hire a manager whose previous company under his/her control failed.

This relationship between the manager and the company he/she is hired to run may lead to conservative decisions on the part of the manager. The manager has much more to lose than the investor who owns only a small part of the company and only stands to lose a small portion of his/her portfolio if the company fails. An investment can be thought of in terms of risk and return. Investments with positive Net Present Values are worth more than the risk of losing the money if the investment fails. But managers, when faced with alternatives of where to lead a company, may choose conservatively because managers have more to lose than investors. This results in lower returns for investors because managers are concerned with reducing their own risk of losing their employment. This decision bias increases an investor’s risk because sub-optimal decisions are being made.

Conclusion

Sub-optimal decision-making arising from different assumptions of risk borne by managers and investors creates manager-owner conflict. The result is more security for managers but lower returns for investors. Diverse investors lose little when a company files bankruptcy because ownership of the company represents only a small percentage of the investor’s portfolio. Managers have far more to lose than any one investor. This erosion of value is the direct responsibility of the separation of ownership and control under which the modern corporation operates.