Owner-Manager Agency Relationships: The Horizon Problem PDF

Preview

Summary

Information/summary regarding the "Horizon Problem" posed by owner-manaer agency relationships....

Description

1. BACKGROUND INFORMATION Organizations no longer operate with owners in the traditional sense. Today, most entities not only have multiple owners but, the owners are also typically dispersed. As such, entities are often managed by agents who are hired to act on the behalf of the owners. This delegation of tasks and authority between a principal and an agent is referred to as an agency relationship – whereby the specific association between a shareholder and a manager is an owner-manager agency relationship. There are two theories that underpin the owner-manager agency relationship concept: the contracting theory and the agency theory. The contracting theory is the study of legally binding contracts. The theory suggests that an organisation is characterised as a legal ‘nexus of contracts’ because, despite conflicting interests, parties within an agency relationship will take mutually beneficial actions when provided with the right incentives and motivations. As mentioned, managers are hired by shareholders to run their entity on their behalf. Hence, managerial contracts – which details of the manager’s role and how shareholders will remunerate them for their efforts, must be used to manage the association. The agency theory is used to understand the relationship of parties in an agency association. This is to resolve issues in the relationship caused by unaligned interests. The theory suggests that while agents have a legal and fiduciary duty to act in the best interests of their principal, if both parties’ interests are not aligned, the separation of ownership and control of the entity instigates agents to act in their own interests – which might be detrimental to the principal’s interest. An example of this is illustrated by the horizon problem. 2. ISSUES Time horizon refers to the total length of time a plan, program or project is expected to be held by an investor and, depending on their aims, these can vary from short to long term. According to the agency theory, managers and shareholders have differing time horizons. Shareholders, as owners, aim to enhance their entity’s current earnings and also secure its future earning. Hence, they favour more long-term investments. Managers, on the other hand, prefer short-term investments as these more readily demonstrate the effectiveness of their management skills. This horizon disparity is known as the ‘horizon problem’. But why is it a problem? Whether they are short- or long-term, investment opportunities and decisions can adversely affect an entity’s immediate and future productivity. If a manager intends to retire or switch entities, they may favour investments that prove their managerial skills but conflict and impair an entity’s future productivity. A contemporary example illustrating of the consequences of horizon disparity is the demise of the Enron Corporation. The Enron Corporation was a major American energy, commodities and services company with claimed revenues of nearly $101 billion in the year 2000. At the end of the following year, however, the corporation became bankrupt. According to commentators, managerial greed coupled with interest discrepancies between owners and managers were some of the major factors leading to the downfall. It was alleged that the corporation focused solely on achieving positive accounting numbers as this

enhanced the perception of their performance. Managers and staff began prizing short-term gratification above the long-term potential of the firm. They even went as far as developing restrictive confidentially clauses to hide their activity from the corporation’s maintenance controls – which hindered the executives from foreseeing of the firm’s ill fate. 3. SOLUTION So, this begs the question, what options can owners implement to deter the managerial, self-interested behaviour fuelling the horizon problem? As mentioned, managerial contracts detail the actions expected of the manager. However, according to Magee this is not enough. He suggests that such contracts must also clearly detail the inactions expected from the managers. In doing so, it would clearly communicate the needs of the entity and deter the manager from self-interested behaviour as their accountability is heightened. Another option is to link managerial payments to the entities shares – which includes linking managerial bonuses to the entity’s share price and paying portions of managerial remuneration as shares. Rankin and others suggests that this encourages managers to focus on the entity’s long-term performance as this is linked to the manager’s own future wealth. CONCLUSION The owner-manager agency relationship, though straightforward in concept, bears many problems that are detrimental to the livelihood of an entity. The contracting theory, agency theory and the case of Erin Corporations, illustrate the necessity of principal and agent interest alignment to deter managerial self-interested behaviour. The options presented today, aim to deter self-interested behaviour arising from owner-manager horizon disparity. When implemented, the options should reduce the occurrence of the problem by ensuring the parties interests are aligned at the beginning and throughout their relationship....