Dynamic Agency Model Research Articles

Dynamic Contracting with Intermediation: Operational, Governance, and Financial Engineering

ABSTRACTPrivate equity funds intermediate investment and affect portfolio firm performance by actively engaging in operational, governance, and financial engineering. We study this type of intermediation in a dynamic agency model in which an active intermediary raises funds from outside investors and invests in a firm run by an agent. Optimal contracting addresses moral hazard at the intermediary and firm levels. The intermediary's incentives to affect firm performance are strongest after poor performance, while the agent's incentives are strongest after good performance. We also show how financial engineering, that is, financial contracting with outside investors, interacts with operational and governance engineering.

Dynamic multitasking and managerial investment incentives

We study non-contractible intangible investment in a dynamic agency model with multitasking. The manager’s short-term task determines current performance, which deteriorates with investment in the firm’s future profitability, his long-term task. The optimal contract dynamically balances incentives for short- and long-term performance. Investment is distorted upwards (downwards) relative to first-best in firms with high (low) returns to investment. These distortions decrease as good performance relaxes endogenous financial constraints, implying negative (positive) investment-cash flow sensitivities. Our results shed light on how corporate investment policies, liquidity management, and executive compensation structure differ across industries with different returns to intangible investment.

Financing a Black Box

This paper studies the implications of persistent private information on a firm's optimal financing and investment policies. In a dynamic agency model, an investor supplies capital to an entrepreneur with an opaque production technology. The investor observes neither the true productivity of the technology nor the actual amount of the output produced. The entrepreneur can generate private benefit from misreporting productivity and diverting output, both of which bear a persistent negative effect on the long-term growth of the technology. In contrast to the predictions of standard investment models, the persistence of the agency friction rationalizes overinvestment especially among firms with a strong history of cash flow but a low Tobin's q, and reconciles the optimal financing policy with the empirical observations of a strong investment-cash-flow sensitivity and a weak or even negative investment-q sensitivity.

The Ratchet Effect: Theory and Empirical Evidence

We use a dynamic agency model to examine the implications of different target-setting processes for managerial incentives and for the interpretation of empirical tests used to make inferences about the ratchet effect. We assume that firms cannot commit to any specific future targets but they can commit to a process that generates future targets as a function of observed performance. Our findings suggest that commonly used empirical tests based on the target ratcheting model often falsely reject the null hypothesis of no ratchet effect. Alternative tests based on the serial correlation in performance relative to target perform better but can still lead be inconclusive about the incentive effects of target revisions. Next, we show that the ratchet effect can be identified as an effect of past performance on changes in perceived target difficulty. We use panel data from nine annual 2011–2019 surveys to implement this test. Similar to prior studies, we find strong evidence of target ratcheting in that targets are revised upward following good performance. Nevertheless, the estimation approach motivated by our model rejects the ratchet effect hypothesis because we find that good performance in one period is also associated with a decrease in perceived target difficulty in the next period.

Agency conflicts and short- versus long-termism in corporate policies

We build a dynamic agency model in which the agent controls both current earnings via short-term investment and firm growth via long-term investment. Under the optimal contract, agency conflicts can induce short- and long-term investment levels beyond first best, leading to short- or long-termism in corporate policies. The paper analytically shows how firm characteristics shape the optimal contract and the horizon of corporate policies, thereby generating a number of novel empirical predictions on the optimality of short- versus long-termism. It also demonstrates that combining short- and long-term agency conflicts naturally leads to asymmetric pay-for-performance in managerial contracts.

Dynamic financial contracting with persistent private information

AbstractWe study a dynamic agency model where the agent privately observes the firm's cash flows that are subject to persistent shocks. We characterize the policy dynamics and implement the optimal contract by financial securities. Because bad performance distorts investors' beliefs downward, the agent has less incentive to misrepresent information. The agent's compensation is less than what he can divert and is convex in performance. As private information becomes more persistent, (i) the agent is compensated more by stock options; (ii) firm credit limits vary more with history, dropping after bad performance; (iii) the firm is financially constrained for longer time.

How Important Are Dismissals in CEO Incentives?: Evidence From a Dynamic Agency Model

I estimate a dynamic agency model to quantify the importance of dismissals in CEO incentives -vis-a-vis pecuniary compensation. The model features endogenous dynamics in deferred and flow compensation, as well as exogenous departures, and endogenous dismissals after poor firm performance. Thus, the model functions as a classification device for CEO turnover events that exploits information from all the departures in the data. I estimate the model via the Simulated Method of Moments, using data for CEOs in U.S. public firms appointed from 1993 to 2013. The estimated CEO dismissal rate is 1.2 percent, and the CEO replacement cost represents 3.4 percent of firm assets, 64 million in 2015 U.S. dollars for the median firm. Poor governance, proxied by director independence, increases the replacement costs for big firms. The relationship reverses in small firms, so board independence must also capture better hiring policies or career concerns of directors. The results confirm that CEO dismissals are infrequent. However, changes in the cost of replacements that generate small increases in the underlying dismissal rate lead to substantial reductions in the size of incentive compensation.

Delegated Monitoring and Contracting

In a dynamic agency model, investors finance a firm run by an agent while delegating monitoring and contracting with the agent to an intermediary. The intermediary passes through part of its incentives to the agent. After good performance, the agent's incentives create an agency overhang problem, that is, the reduced incentives of the intermediary for monitoring because its benefit accrues mostly to the agent. Conversely, after poor performance, the agent's incentives generate incentives for monitoring to avoid further distress. Investors can benefit from directly contracting with the agent to prevent propagating agency conflicts between the agent and the intermediary.

What’s behind Smooth Dividends? Evidence from Structural Estimation

I study the driving forces behind dividend smoothing by developing a dynamic agency model in which dividends signal the earnings persistence of firms. In equilibrium, managers treat dividends and earnings as informational substitutes. They smooth dividends relative to earnings to smooth negative news releases and lower their turnover risk. Empirical estimates of the model parameters imply that 39$\%$ of observed dividend smoothness among U.S. firms is driven by managers’ own career concerns, not shareholders’ preferences. Managers cut investments and adjust external financing policies to accommodate this career-concern-based dividend smoothing. These effects lead to a 2$\%$ decline in firm value. Received May 28, 2016; editorial decision September 13, 2017 by Editor David Denis. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

The Dynamics of Investment, Payout and Debt

We develop a dynamic agency model of a public corporation. Managers underinvest because of risk aversion. They smooth rents and payout. They do not exploit interest tax shields fully. The interactions of investment, debt, and payout decisions can change drastically depending on managers’ preferences. Managers with power utility set investment, debt, and payout proportional to the firm’s net worth, generating a constant (possibly negative) net debt ratio. With exponential utility, investment decisions are separated from decisions about debt and payout. More profitable firms become cash cows, and less profitable firms accumulate debt, as in a pecking-order model. Received July 9, 2015; editorial decision January 30, 2017 by Editor Itay Goldstein.

Agency Conflicts over the Short and Long Run: Short-Termism, Long-Termism, and Pay-For-Luck

We develop a dynamic agency model in which the agent controls current earnings via short-term effort and firm growth via long-term effort and the firm is subject to both short- and long-run shocks. Under the optimal contract, agency conflicts can induce both over- and underinvestment in short- and long-term efforts compared to first best, leading to short- or long-termism in corporate policies. Exposure to long-run shocks introduces pay-for-luck in incentive compensation but only after sufficiently good performance due to incentive compatibility, thereby rationalizing the asymmetric benchmarking observed in the data. Correlated short- and long-run shocks to earnings and firm size lead to externalities in incentive provision over different time horizons.

Dynamic Financial Contracting with Persistent Private Information

This paper studies a dynamic agency model in which the agent privately observes the firm's cash flows that are subject to persistent shocks. Persistent private information alleviates the agency problem. Because bad firm performance distorts investors' forecast downward, it's optimal to lower future investment, leading to smaller future information rents. The compensation is therefore less than what the agent can divert and is convex in performance. We show that promising agent utilities contingent on performance today and tomorrow is effective in providing incentive and formulating the problem recursively. The optimal contract can be implemented by equity, stock options, credit line, and long-term debt. In contrast to the iid case, our findings are more in line with the empirical evidence, viz, (i) the agent is compensated via equity and stock options; (ii) firm credit line limits and coupon payments are contingent on compliance with a cash flow covenant; (iii) the firm (possibly) experiences longer time of being financially constrained; (iv) investment is efficient in the constrained firm, and is varying with cash flow in the unconstrained firm.

The firm as the locus of social comparisons: Standard promotion practices versus up-or-out

We suggest a parsimonious dynamic agency model in which workers have status concerns. A firm is a promotion hierarchy in which a worker's status depends on past performance. We investigate the optimality of two types of promotion hierarchies: (i) standard promotion practices, where agents have a job guarantee, and (ii) “up-or-out”, in which agents are fired when unsuccessful. We show that up-or-out is optimal if success is difficult to achieve. When success is less hard to achieve, standard promotion practices are optimal provided the payoffs associated with success are moderate. Otherwise, up-or-out is, again, optimal.

Mandatory deferred compensation, managerial turnover and the stewardship perspective of financial accounting

In light of the recent financial crisis and corresponding debates on the pay and incentives of managers, especially in the financial sector, regulators aim at strengthening the sustainability of managerial activities by prescribing deferred compensation for executive contracts. While such deferred compensation can take on multiple forms, we focus on one specific variant which relates post-retirement pay to an accounting performance measure. In a dynamic agency model we analyze analytically how a mandatory deferred compensation regime interacts with characteristics of an accounting system. Our results reveal that mandatory deferred compensation is no panacea for solving incentive problems as it does not increase shareholder value in every scenario. However, deferred compensation is helpful in promoting long-term incentives and potentially mitigates negative effects arising from earnings management, while its interaction with the timeliness of the accounting system needs to be considered.

Optimal Lending Contract with Uncertainty Shocks

I develop a dynamic agency model of financial contracting, where borrowing constraints appear as part of the optimal contract. The novelty of the paper relative to previous work is that volatility is stochastic and exogenous to the agent behavior. A line of credit appears in the optimal long term contract similar to (DeMarzo and Fishman, 2007). The novelty of the contract is that the credit limit varies over time, as a function of the state of volatility. Credit limit does not vary monotonically over firms. When uncertainty increases, credit limits are reduced for highly constraint firms, because the frictions become harder and the firms lose profitability. Instead, it is optimal to increase the credit limits for less indebted firms, they are still profitable and they need more flexibility to respond to the bigger shocks.

Contracting with Fair Performance Evaluation as Reference Point

I examine robust incentive provision in a dynamic agency model where the agent disagrees with the principal on how he should be evaluated and paid. I use reference points to capture the incentive payment that the agent thinks he deserves and let him inict a disagreement cost on the principal whenever the incentive payment based on the actual output falls short of its counterpart based on the reference point. Results show that many seemingly rigid personnel policies such as eciency wage contract and seniority-based promotion are indeed robust tools for achieving incentive provision and disagreement management simultaneously when the employment relationship is reasonably long.

A Lintner Model of Payout and Managerial Rents

ABSTRACTWe develop a dynamic agency model in which payout, investment, and financing decisions are made by managers who attempt to maximize the rents they take from the firm, subject to a capital market constraint. Managers smooth payout to smooth their flow of rents. Total payout (dividends plus net repurchases) follows Lintner's (1956) target adjustment model. Payout smooths out transitory shocks to current income and adjusts gradually to changes in permanent income. Smoothing is accomplished by borrowing or lending. Payout is not cut back to finance capital investment. Risk aversion causes managers to underinvest, but habit formation mitigates the degree of underinvestment.

Testing Dynamic Agency Theory via Structural Estimation

We quantify agency conflicts induced by the separation of ownership and control in large public firms by means of structural estimation. We use a simulated method of moments estimator (SMM) to back out the structural parameters of a q-theoretic dynamic agency model of firms from observed financing and investment choices. In the model, an optimal contract resolves the agency conflict between investors and managers, which can be implemented using cash, debt and equity. Our estimates suggest that in order to rationalize observed firm financing and investment policies, the agency conflict between investors and managers needs to be substantial. We provide additional cross-sectional tests based on sample splits according to governance and firm characteristics.

The Firm as the Locus of Social Comparisons: Internal Labor Markets Versus Up-or-Out

We suggest a parsimonious dynamic agency model in which workers have status concerns. A firm is a promotion hierarchy in which a worker’s status depends on past performance. We investigate the optimality of two types of promotion hierarchies: (i) internal labor markets, in which agents have a job guarantee, and (ii) 'up-or-out', in which agents are fired when unsuccessful. We show that up-or-out is optimal if success is difficult to achieve. When success is less hard to achieve, an internal labor market is optimal provided the payoffs associated with success are moderate. Otherwise, up-or-out is, again, optimal. These results are in line with observations from academia, law firms, investment banks and top consulting firms. Here, up-or-out dominates, while internal labor markets dominate where work is less demanding or payoffs are more compressed, for instance, because the environment is less competitive. We present some supporting evidence from academia, comparing US with French economics departments.

Alternatives to Traditional Repricing of Executive Stock Options

The main purpose of this paper is to examine two commonly used alternatives to traditional repricing (TR) of executive stock options (ESOs) in a dynamic agency model. TR practices have become obsolete since new accounting rules took effect in July 2000. To avoid associated variable accounting charges that cause uncertainty in future reported earnings, companies have tried several TR alternatives as solutions to rescuing underwater options. We justify the occurrence of TR alternatives and quantify the impact of the marking-to-market feature imbedded in the new accounting rules. We also propose an incentive measure which is comparable to the subjective value of ESOs claimed by Ingersoll, J (2006) to rank TR alternatives in terms of agent's incentive.