Management Share Ownership

List of Contents

I List of Appendixes

II Abbreviations

III List of Symbols

1. Introduction

2. Why give managers a stake in the company?
2.1. Separation of ownership & control
2.2. Theoretical perspectives
2.2.1. Agency Theory
2.2.1.1. The conflict
2.2.1.2. Agency solutions.
2.2.3. Stewardship Theory
2.2.4. Takeover Market Theory.
2.2.5. Environmental Contingency Model

3. Empirical Literature Appraisal
3.1. The effect of managerial stock ownership on corporate value
3.2. The turning point - facing the endogeneity problem.
3.3. Recent literature - reconciling the antithesis?

4. Critical analysis of selected studies
4.1. Morck et al. (1988)
4.2. Himmelberg et al. (1999)
4.3. Davies et al. (2005)

5. Conclusions

Appendix

References

I List of Appendixes

Appendix 1: Summary of major empirical studies

Appendix 2: Piecewise linear OLS-regression results of Morck et al. (1988)

Appendix 3:Piecewise linear 2SlS-regression results of Davies et al. (2005)

II Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

III List of Symbols

4.1. Morck et al. (1988)

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

A considerable amount of literature has looked into the question whether compa­nies with higher levels of managerial stockholding show evidence of superior fi­nancial performance than firms with lower management share ownership. How­ever, the empirical results till this day have been inconclusive and ambiguous so that the role of managerial stockholdings in terms of sophisticated corporate gov­ernance has not (yet) been illuminated. Therefore, this rather mature issue remains an interesting and challenging theme in nowadays research. This paper seeks to explain theoretical and empirical approaches as well as the problems encountered by scholars examining the nature of management stock ownership.

In view of the fact that the scientific discussion on the topic has evolved in the Anglo-Saxon literature, this paper will predominantly be based on articles from that region. Consequently, this study carries the underlying assumption of an An­glo-Saxon corporate governance structure. Nevertheless, it is sensible to assume that most of the implications and lines of reasoning presented in this paper are applicable to other countries, at least to those which have effective governance structures in place like Germany or Japan. Moreover, managerial stockownership will be the only corporate governance instrument analysed. Other aspects like the board’s composition or alternative incentive contracting tools (e.g. stock options) and their effect on firm performance will not be contemplated.

The paper starts off by outlining some theoretical perspectives which serve as an overall framework. They provide different motives and reasons whether and how management stock ownership should be implemented. In the third section the ma­jor empirical studies and their implications will be examined in order to provide a good grasp of the subject matter. To my mind, the literature can be broken down into three main episodes. The first one running up to the mid nineties, primarily tries to determine whether managerial stockholding influences corporate value in a positive or negative way. The second period lasts roughly until the turn of the century. During this phase several studies emerged which claim that earlier inves­tigations were mistaken due to their disregard of endogeneity in the relationship.

The third group consists of recent studies which tackle the antithesis, i.e. they try to revive the initial concept with regard to endogeneity.

In the forth section I will analyse three papers which are representative for one of the three periods, respectively.^[1]In particular the arguments and analytical meth­ods scholars use to verify a particular theory or previous empirical results they side with will be evaluated and criticised. This part builds on the theoretical per­spectives and empirical findings outlined in section two and three which are pre­liminary to the analysis. The paper concludes in summarizing the key points.

2. Why give managers a stake in the company?

2.1. Separation of ownership and control

The split between owners and managers is a consequence of the industrial revolu­tion which transformed small enterprises into the giant corporations which run the business in many industries in today’s economy.^[2]Mass production and complex company processes called for professional managers that could handle the increas­ing challenges of the changing corporate environment. The enhancement of capi­tal markets further widened the gap between ownership and management as risk­averse individuals were able to diversify the idiosyncratic risk in their portfolio by investing their proceeds into various companies across different industries. Berle and Means (1932) argue that the resulting dispersion of ownership and the delega­tion of shareholder rights create an intense concentration of power at the top man­agement level.^[3]Another consequence of dispersed ownership is that shareholders’ monitoring incentives are diluted. The cost of gathering and analysing information on managerial actions outweighs the benefit to the individual shareholder and is also subject to the free-rider problem.^[4]Hence, executives are in a position to pur­sue self-serving corporate policies in day-to-day operations that might violate the interests of the shareholding community.

Management share ownership is a governance instrument presumed to close the gap between ownership and control. It is based on the notion of aligning interests by awarding a shareholder-perspective to executives. The question whether this tool is useful in overcoming the illustrated conflict depends on the behavioural assumptions one attributes to managers as well as the circumstances which char­acterise the business environment. The following section outlines theoretical per­spectives which characterise the managerial ownership-performance relation and thus helps to understand associated empirical studies. It is worth emphasising that the agency model and takeover market theory corroborate management ownership to enhance corporate value whereas stewardship theory and the environmental contingency model contradict to this perception.

2.2. Theoretical Perspectives

2.2.1 Agency Theory

2.2.1.1. The Conflict

With reference to the issue under consideration it is reasonable to limit the agency model to the ex post contractual relationship between shareholders as principals and managers as agents. Three problems emerge for the principals: First, they are removed from the operating decision process carried out by the agents and do not have the specific expertise to determine whether the decisions taken by the agent coincide with their interests. Second, principals incur agency costs^[5]in order to mitigate the consequential information asymmetry. Since resources are limited the asymmetry cannot be entirely eliminated. Thirdly, principals and agents do not have the same attitude towards risk because the principals can diversify their port­folio whereas agents cannot diversify the firm specific risk in their employment.^[6]Already Adam Smith pointed out that managers watching over the funds of some­one else cannot be supposed to use the resources in the same careful manner rela­tive to their own property.^[7]More precisely, managers prefer greater perquisite consumption at lower effort levels and favour less risky short run investment pro­jects as well as lower leverage to reduce the probability of bankruptcy and hence employment termination.^[8]If we assume that the manager behaves opportunisti­cally in accordance with stated preferences he might for instance deny highly profitable projects despite stockholders’ preference for more corporate risk taking or excessively consume perquisites at shareholders’ expense.^[9]Thus, even if we relax on the assumption of a counterproductively acting manager in terms of lying and stealing at the expense of the principal, executives might still expend less ef­fort than what is required to make the most of shareholders’ welfare. The expres­sion moral hazard refers to this potential menace of suboptimal managerial behav­iour and the ex post conflict arising from it.^[10]

2.2.1.2. Agency Solutions

The classical approach to limit the agents’ unwanted activities is to conduct inter­nal and external monitoring.^[11]Internally the board of directors is in charge of watching over managers. However, their governance function may be restricted for a variety of reasons.^[12]Internally as well as externally senior managers can be effectively disciplined and monitored by the competitive managerial labour mar- ket.^[13]But the associated pressures and fluctuation of managers might result in disruption and inefficiencies. In order to forward external monitoring conducted by the capital market, Easterbrook (1984) suggests that companies distribute cash dividends to their owners. Lowering retained earnings prevents managers from squandering cash flows to pursue empire building^[14]strategies. In addition, they are forced to raise equity or dept capital in the market to finance future projects. Hence, the capital markets will engage in monitoring in the course of providing funds. An increased dept-to-equity ratio might initiate risk shifting^[15]behaviours towards more profitable projects which is in the interest of shareholders.^[16]How­ever, creditors are aware of this potential expropriation of their wealth and seek for higher contractual protection due to increased agency cost of dept.^[17]

Another popular argument regarding the external reduction of agency costs is to use large shareholders such as institutional investors or family holdings as moni­toring agents. These groups invest in superintending managers because they own a larger stake which implies greater capital endowment and concern about the en­tity’s affairs.^[18]In line with the latter argument and due to restrictions of the classi­cal monitoring scheme, Jensen and Meckling (1976) recommend management stock ownership as a vehicle to align the incentives of executives with interests of stockholders. Using a 100% owner-manager as a reference point, falling manage­ment ownership leads to higher inevitable agency costs which decrease corporate value due to the managers’ greater incentive to consume perquisites.^[19]Inversely, an increase in stock hold by executives intensifies their value maximisation be­haviour and implies a reduction in agency costs. The market is assumed to recog­nize this, assigning greater value. This principle of a uniformly positive relation­ship is known as the convergence-of-interest hypothesis.^[20]Essentially, this view corresponds to the underlying assumption of an opportunistic and self-interested managerial behaviour. This simplistic premise, however, is also a weakness of agency theory. Failure is attributed to opportunistic self-interest conduct although it could follow from poor assessment and governance by the principal.^[21]Nonethe­less, recent scandals like the Enron case validate the nature of the relationship between shareholders and managers drafted by agency theory.

2.2.3. Stewardship Theory

In contrast to agency theory Davis et al. (1997) advocate a model in which execu­tives value pro-organisational and collectivistic behaviour above their individual desires. The “steward” regardless of his personal interest incessantly caters for the sake of the company from which he derives his utility.^[22]Following Hofstede (1980) Davis et al. (1997) argue that an individualistic culture pattern and high power distance encourage the development of agency relationship and corre­sponding governance. Collectivism and low power distance are more likely to generate a principal-steward relationship. In fact, principals and agents can choose the mode of the relationship communicated in the underlying management phi- losophy.^[23]A tough control-oriented philosophy will lead by means of a self­fulfilling prophecy to an agency theory relationship. Involvement-oriented gov­ernance by contrast rather supports a stewardship relation.

Since managers are intrinsically motivated by self-actualization there is no need for implementing compensation contracting. The interests between owners and executives are already aligned. Hence, management ownership is not a device to motivate extrinsically but rather to reward managers for their efforts to enhance
firm performance. In this regard stewardship theory is useful in predicting reverse causality, that is, firm performance affects the level of managerial stockholding.

2.2.4. Takeover Market Theory

This theory contrasts to the two previous ones in the way that it does not address the issue of managerial stockholding from the perspective of the relationship be­tween managers and shareholders. For this reason share ownership is not used to align interests in order to solve the conflict inherent in agency theory.^[24]Instead Stulz (1988) argues that increased stockholding provides managers with bargain­ing power in a hostile takeover attempt. Since tender prices are expected to in­crease if managers oppose the attempt, capital markets pay a premium on compa­nies in which executives hold shares.^[25]However, the premium will not be gener­ated if the fraction of managerial stockholding exceeds the point at which no hos­tile takeover attempt is made because managers cannot be contested anyhow.

2.2.5. Environmental Contingency Model

This approach originally stems from the management literature. Child (1974) notes that industry differences and bureaucracy, i.e. the context in which the entity operates^[26]influences performance. In the context of this paper I myself transfer this concept in the sense that both ownership-structure and corporate value are contingent on other factors such as technology or firm size.^[27]In addition, the envi­ronment in which an entity operates might also be influenced by other internal and external corporate governance mechanisms^[28]. For example, La Porta et al. (1998) emphasize the importance of the legal system as such an external mechanism. Although contingency research has not yet been well linked to management com­pensation models,^[29]it offers a framework to explain missing causality. Crucially, the environmental factors might influence managerial share ownership and firm performance simultaneously and hence cause spurious correlation between them.

3. Empirical Literature Appraisal

3.1. The effect of managerial stock ownership on corporate value

In Jensen and Meckling’s (1976) theory of the firm the role of managers’ share ownership is central in solving the conflict inherent in agency theory. Their theo­retical model is based on the notion of achieving convergence-of-interest. Indis­putably their paper served as a starting point in triggering off an extensive body of empirical literature. The present section focuses on early studies trying to verify empirically in which way managerial ownership influences firm value.^[30]

Kesner (1986) presents the first empirical study on the effects of managerial stock ownership.^[31] Using six measures for firm performance in total ^[32] the author claims to identify a positive effect on firm performance in growth industries since man­agers see the opportunity to increase the value of their stock investment at a rapid pace. Thus, the executives’ motivation and performance is enhanced. In low growth businesses managers are less likely to be motivated by share ownership as corporate value is rising less quickly due to the nature of the industry. Disregard­ing this industry effect, however, implies an unrelated relationship between share ownership and firm performance.^[33]

Conversely, Morck et al. (1988) (henceforth MSV) find a significant non-linear relationship between stock ownership of managers and outside board members and firm performance. As a proxy variable for the latter they use the market-to- book ratio Tobin’s Q, which is the market value of the firm’s equity and dept^[34] divided by the replacement value of assets.^[35] In three piecewise liner regressions MSV estimate a nonmonotonic relationship. As management ownership rises from 0% to 5% the value of Tobin’s Q increases. Between 5% and 25% the value of Q declines but rises again beyond the 25% level of stock holdings, albeit slower than in the 0% to 5% range. The following figure illustrates this pattern:

Abbildung in dieser Leseprobe nicht enthalten

Figure 1^[36]

The initial boost in Q due to rising managerial ownership levels reflects execu­tives’ greater incentive to increase performance. This is consistent with the con- vergence-of-interest hypothesis. The counterpart to this concept is the entrench­ment hypothesis which associates higher ownership levels with a negative effect on corporate value. Between 5% and 25% managers gain so much power that they are in a position to use the company’s assets in their private interest.^[37] In other words management stock ownership is not aligning but misaligning interest. MSV point out that entrenchment is not only the consequence of power but can also arise because of managers’ outstanding status as founders.^[38] The authors show empirically that that in old companies (established before 1950) the presence of a founding family member reduces corporate value whereas entrepreneurial talent enhances firm performance in young firms.^[39] Moreover, if managerial stockhold­ing leads to dominance of inside over outside directors, outside boards would risk loosing their job in case of objecting to insiders’ choices.^[40] This implies limited means of monitoring and hence increased agency cost which in turn reduces cor­porate value. MSV argue that between 5% and 25% convergence-of-interest might still be at work but it might be overshadowed by a prevailing entrenchment effect.^[41] Positive effects on firm performance kick back in at very high levels of share ownership since executives refocus on value maximisation due to the sig­nificant quantity of undiversifiable risk in their portfolio.

McConnell and Servaes (1990) also use Tobin’s Q as a proxy for firm perform­ance. Like MSV they reject the general prediction of a linear relationship but claim to find a curvilinear dependency of Q on the fraction of stock hold by cor­porate insiders. Figure 2 reveals their empirical findings.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2^[42]

At low and intermediate levels of management stock ownership the model of Jen­sen and Meckling (1976) is reinforced. On the contrary, the results obtained at very high levels contradict to their model and the empirical findings of MSV. They rather support Stulz’s (1988) takeover market theory. The inflection point at which managers gain “too much” control (this prevents the take-over market pre­mium from being generated), lies somewhere in the 40% to 60%.^[43]

Hermalin and Weisbach (1991) obtain a positive relationship between managerial ownership and firm performance at ownership levels at less than 1%. The authors attribute this effect to a reduction in agency cost in accordance with the conver- gence-of-interest hypothesis. But if holdings exceed the 20% barrier, managers become increasingly entrenched resulting in a reduction of corporate value.^[44]

[...]

^[1]These include the research papers by Morck et al. (1988), Himmelberg et al. (1999) and Davies et al. (2005).

^[2]See Rajan, Zingales (1998), pp. 9 et seqq.

^[3]See Rajan, Zingales (1998), p. 2.

^[4]See Kang, S0rensen (l999), p.129.

^[5]See Jensen, Meckling (1976), p. 308.

^[6]See Eisenhardt (1989), pp. 60-61.

^[7]See Jensen, Meckling (1976), p. 305.

^[8]See Masulis (1988), p.48.

^[9]See Jensen, Meckling (1976), p. 313.

^[10]See Eisenhardt (1989), p. 61.

^[11] See Bathala et al. (1994), p. 39.

^[12]See Walsh, Seward (199o), pp. 425 et seqq.

^[13]See Fama (1980), p.292-293.

^[14]Since individuals derive utility from becoming more powerful and important they might not invest funds in the most profitable and efficient ways but use them for mere expansion purposes.

^[15]See Bathala et al. (1994), p. 39.

^[16]See Easterbrook (1984), p. 653.

^[17]See Short et al. (2002), p. 378.

^[18]See Shleifer, Vishny (1986), p. 463.

^[19]See Jensen, Meckling (1976), pp. 312-313.

^[20]Morck et al. (1988), p. 294.

^[21]See Walsh, Seward (1990), pp. 447-448.

^[22]See Davis et al. (1997), p. 24.

^[23]See Davis et al. (1997), p. 34.

^[24]See Stulz (1988), pp. 25-26.

^[25]See Stulz (1988), pp. 29-30.

^[26]See Child (1974), pp. 188-189.

^[27]See Fisher (1998), p. 50 for an overview of some other contingent factors.

^[28]For an overview see Denis, McConnell (2003), pp. 2-5.

^[29]See Fisher (1998), p. 61.

^[30] See Appendix 1.

^[31] See Kesner (1987), p. 499.

^[32] See Kesner (1987), p. 502.

^[33] See Kesner (1987), p. 505.

^[34] Many scholars use also book value of dept. The resulting differences are negligible because the ratio of Tobin’s Q is predominantly driven by the market value of an entity’s equity.

^[35] See Morck et al. (1988), p. 296.

^[36]Taken from Morck et al. (1988), p. 301.

^[37]See Weisbach (1988), p. 435.

^[38]Johnson et al. (1985) find that announcements of CEOs’ sudden death are accompanied by posi­tive stock price responses enforcing the entrenchment conjecture, see Johnson et al. (1985), p. 173.

^[39]Hence there is a difference of founder-managers and professional managers since some execu­tives can pursue entrenchment already at fairly low level of stock hold. However, Morck et al. (1988) are exceptional in addressing this issue.

^[40]See Morck et al. (1988), p. 307.

^[41]See Morck et al. (1988), p. 302.

^[42]Taken from McConnell and Servaes (1990), p. 604.

^[43]See McConnell, Servaes (1990), p. 603.

^[44]See Hermalin, Weisbach (1991), p. 106.