Chapter 2:Literature Review
The Agency Problem
Shareholder Communication and Expectations
Travis Perkins Plc.
Serco Group Plc.
Smiths Group Plc.
Wolverhampton & Dudley Breweries Plc.
Travis Perkins Plc.
Serco Group Plc.
Smiths Group Plc.
Wolverhampton & Dudley Breweries Plc.
Chapter 6: Conclusion
Appendices: A - T ravis Perkins T rading statement
B - Sercos’ Acquisition announcements C - Smiths’ interim results D - WPP AGM update E - Hansons’ Interim report
With the increase in companies issuing shares as a means of raising capital the way companies are monitored has changed. Incidents such as the Enron scandal serve as a reminder of directors’ inclination to act in an opportunistic way, with the aim to increase their personal wealth at the expense of their Companies’ shareholders. As a result of this Corporate Governance regulations have become more stringent in a bid to remove the agency problem, increase the transparency of organisations and protect shareholders.
This dissertation looks at how six UK Pic’s report to their shareholders regarding their merger and acquisition activity, to determine if they comply with the Best Practice guidelines for reporting to shareholders, laid out by academics. The level of communication they provide is considered to ascertain if there is any evidence that the agency problem is still evident within organisations.
Using a content analysis of the company information collected the Companies are classified into one of four classifications, depending on the level of communication that they have provided to their shareholders. The role that communication with shareholders plays, in managing shareholder expectations, is also considered when determining if the promises made to shareholders have been fulfilled. This is because acquisitions can be considered a failure by shareholders, even if all promised outcomes have been achieved, because their expectations are higher than those of the Company. Failure to manage expectations indicates that the Company is not transparent enough to the shareholders.
I would like to thank:
- My parents for their help and support through this project and my time spent at University.
- My friends for their continued support and putting up with me when I was stressed.
- My dissertation tutor, Richard Slack, for all his help and guidance and believing in me.
Recent developments in Corporate Governance regulations have increased the pressure on organisations to act responsibly. Organisations must now be seen to be acting with the interests of their shareholders in mind, by maximising shareholder wealth, rather than working in a self-opportunistic way. More companies than ever are looking to mergers and acquisitions as a way of expanding their business and achieving shareholder wealth maximisation.
With this in mind the research aims to answer the question;
How do companies report to their shareholders regarding their merger and acquisition activity?
This research will consider the promises made to the shareholders, by the directors of six UK companies, when they announce their plans to undertake merger or acquisition activity, and the reasons they give for their decision to do so. Focus is placed on how the organisations subsequently report to their shareholders on the progress of the merger or acquisition with the aim of discovering the extent to which the promises are met.
The first section of the research is a literary review of the relevant theories that have been proposed by academics within in the area of the research. This literature is included to act as a theoretical backing for the findings of the investigation. The theory considered is split into two sections; Agency Theory, and the separation of ownership and control, and Shareholder Communication and Expectations.
The second section of the research discusses the methodology behind the investigation that was undertaken, looking at the theory of Content Analysis, as the method used for the evaluation of the collected data, and the limitations of the investigation.
The third element of the research outlines the findings observed from the analysis of the data collected, and the forth part is an analysis of the findings, with the view to ranking each company in terms of how it has reported to its’ shareholders. The analysis uses the theory discussed in section one to underpin the conclusions that have been drawn.
The final part of the research draws conclusions from the findings to answer the research question proposed at the start of the investigation. The limitations of the research are discussed and opportunities for further research are proposed.
The Agency Problem
Agency Theory is essentially the separation of ownership and control. In other words, those charged with making decisions within organisations do not generally bear the risk associated with the decisions they make. Agency theory has evolved from the risk-sharing literature of authors such as Arrow (1971) and Wilson (1968) in the 1960’s and early 1970’s, and in literature published by Berle & Means (1932), regarding the separation of ownership and control. Agency Theory expands on the idea, as written about by the above authors, that a risksharing problem arises when two co-operating parties have different attitudes to risk. This includes the problem of a difference of goals between the two parties.
In this research Agency Theory will be considered in the context of a large corporation, where the shareholders (the principals) own the organisation and employ a board of directors (the agents) to run the organisation on their behalf. The role of the board of directors, in this context, is to represent the shareholders’ interests, providing vigilance and expertise (Walters, Wright & Kroll 2006). A board comprising of independent, outside directors, as noted by Shen (2003) (as cited in Walters et al. (2006)) is likely to increase their vigilance. Increased vigilance leads to a decrease in the value of agency costs, which arise within a company as a result of agent opportunism, benefitting the shareholders.
Berle & Means (1932) distinguish owners by the fact that they are in a position either to manage their organisation or to delegate its management to others, whilst benefiting from any profits that may arise. The managers, on the other hand, are distinguished by the fact that they are employed to manage the organisation on behalf the owners. Both the board of directors and the Companies’ managers are employees who, except in the case of management shareholding, do not directly benefit from any profits generated by the organisation.
Corporations can be considered with respect to three functions;
1) Having an interest in an organisation,
2) Having power over an organisation, and
3) Acting with respect to an organisation.
Agency Theory looks at the problems that arise when the second function, power over the organisation, becomes separated from the first function, having an interest in the organisation. The owner has an interest or stake in the organisation but the management has the legal power over its control.
As summarised in Eisenhardt (1989) Agency Theory is concerned with resolving two problems that occur in agency relationships;
1) The agent and principal have conflicting goals or desires and the principal is unable to verify what the agent is doing, or if they are acting appropriately.
2) The principal and agent have different attitudes to risk and an issue of risk-sharing arises when each party prefers a different course of action, due to their degree of risk aversion.
Agency Theory also focuses on finding the most efficient contract for governing the agency relationship, the contract being the unit of analysis used when looking at this theory. The type of contract deemed most efficient, whether it is behaviour-orientated or outcome-orientated, will be established by taking into account the information available about the individuals and organisations who will be involved in the relationship.
There are two branches of Agency Theory:
- Positivist Agency Theory focuses on the principal - agent relationship between owners and managers of large, publicly traded corporations. It also focuses on describing the governance mechanisms used to deal with the problems arising from the agency relationship. This branch of Agency Theory is thought to help curb agent opportunism as the interests of the agent and principal are more closely aligned. r Principal - Agent Theory focuses on the general principal - agent relationship which is applied in many situations such as, client / lawyer and buyer / supplier relationships. This branch of the theory looks at the agent - principal relationship in a more detailed and mathematical manner, which in many ways makes it less accessible to organisational scholars.
Both branches share a common unit of analysis, which is, the Contract, and the conventional assumptions about individuals, organisations and information. Although there are differences between the two branches of the theory, they both complement each other. As expressed by Eisenhardt (1989) Positivist theory identifies various contract alternatives and Principal - Agent theory then indicates which contract is the most efficient, given the circumstances.
The branch of Agency Theory that is most appropriate for the purpose of this research is Positivist Theory, because it is specific to the principal - agent relationship in large corporations, which is the relationship under investigation.
Agency Theory however has one main disadvantage when considering the performance of an organisation, that of agent opportunism or self interest. When there is a separation of ownership and control, and owners do not have ultimate control over the organisation but merely an interest in how the organisation is performing, the way in which the organisation is being run by the management may be brought into question. As discussed by Berle & Means (1932) the principals will expect that the organisation is being managed by the agents with their interests in mind, however this is not always the case. Owners of an organisation generally retain ownership because they wish to increase their personal wealth by benefiting from the profits of the company. However, is there any reason to believe that the agents will have taken their role for any purpose other than increasing their own personal wealth, when it is common to hear that agents have acted with their own personal interests in mind, rather than the interests of the principals? Mallin (2007) notes two examples of agent opportunism:
1) The agent misuses his power for pecuniary or other advantage,
2) The agent does not take appropriate risks in pursuance of the principals’ interests, where the agent and principal have different attitudes to risk, because he does not view those risks as being appropriate.
Within the context of a large corporation, where the principals are the shareholders and the managers the agents, the principals will be at a disadvantage regarding the information available to them because of their reliance on the integrity of the managers. In this instance corporate governance mechanisms play an important part in minimising the problems brought about by the agency relationship. Blair (1996) as cited in Mallin (2007) states:
Managers are supposed to be the ‘agents’ of a corporations ‘owners’, but managers must be monitored and institutional arrangements must provide some checks and balances to make sure they do not abuse their power. The costs resulting from managers misusing their position, as well as the costs of monitoring and disciplining them to try to prevent abuse, have been called ‘agency costs’.
Mallin (2007), backs this statement by discussing the need for institutional shareholders to take the role more of owners than investors, as a way of reducing the opportunities for managers to act in their own interests, rather than those of their employers. The move from stockholder towards ownership of any business by investors will increase the influence they have on the managers of the Company, forcing them to become more accountable for their actions and increasing the transparency of the organisation. This move towards transparency of activities, which has grown in importance as a result of the Enron scandal, is also backed by the International Accounting Standards Board (IASB) as they continue to introduce new standards and practices, and monitor existing standards in a bid to keep investors better informed. Deegan (2005) discusses Public Interest Theory as one of the reasons for this increased transparency. It states that regulation is supplied as a result of public demand and is put in place primarily to benefit society, and not the private interests of the regulators.
There is however a potential downside for institutional investors as highlighted by Useem (1996) (cited in Mallin (2007)) who become more involved in the running of the organisation. They in turn are likely to be held accountable for some aspects of company performance by the ultimate owners, who may question the policies that result from institutional investor interference. It has long been recognised that greater managerial ownership generates a greater alignment of interests between principals and agents, which helps to mitigate the agency problems arising between the two parties, Berle & Means (1932), Jensen & Meckling (1976), Demsetz (1983), (as quoted in Lafond & Roychowdhury (2008)). Jensen (1993) adds that when contemplating events such as mergers and acquisitions, higher levels of board ownership will result in improved acquisition performance.
Attempting to curb agent opportunism by exerting greater control on agents’ behaviour is likely to lead to a decrease in the effort applied by agents to their work. A possible way around this, as considered by Caers, Du Bois, Jegers, De Geiter, Schepers & Pepermans (2006), is to change the way in which agents are compensated for their work. By using an outcome-based method of compensation instead of an effort-based method this reduction in effort will counteracted. If compensation and reward depends on the Companies’ outcomes agents will increase the effort they put into their roles as a way of increasing the performance of the company. This in turn will increase their individual personal wealth as well as the personal wealth of the shareholders. A downside to this however is that the agents may be held accountable for factors outside their control. Another option as noted by Levinthal (1988) (as cited in Caers et al. 2006) is to introduce a monitor into the relationship to increase the principals’ knowledge ofthe agents’ effort, which would revive the connection between effort and compensation, and free the agent from inefficient risk-bearing arrangements within their contract.
With Agency Theory comes agency cost. Costs will be incurred from the management of the agency relationship as a way of curbing agency opportunism. Agency costs are made up of 3 types, as dictated by Jensen & Meckling (1976):
- Monitoring expenditure by the principal,
- The bonding expenditures of the agent, - The residual loss.
The residual loss is the monetary equivalent of the reduction in welfare of the principal resulting from the conflict of interests of the agent and principal. Agency costs can be viewed in many ways depending on the type of agency relationship that exists. For the purpose of this research the type of agency costs discussed will relate to those resulting from an agency relationship between owners and top management of an organisation.
Jensen & Meckling (1976) also note that principals will incur agency costs at any percentage of ownership, other than 100% management ownership, since a divergence of interests takes place. The lower the percentage the management of a company own the less they will operate with the interests of the shareholders in mind. As a result agency costs will rise as outside owners introduce controls to monitor agent behaviours. Agency cost is an increased expense for the principals to bear, however they will benefit from the entire wealth increase that should eventually result, providing the increase is enough to offset the initial monitoring cost.
When it comes to Agency Theory there are conflicting views. Some, such as Jensen 1983 (as cited in Eisenhardt 1989) believe that Agency Theory is revolutionary and a powerful foundation, while others, such as Perrow 1986 (as cited in Eisenhardt 1989) argue that it addresses no clear problem, is narrow and lacks testable implications. In practice however, there is evidence to support the belief that agency problems do occur within organisations, but with the increase in corporate governance and international accounting standards these problems are being mitigated. The ideal then when looking at firm ownership is perhaps to look at Agency Theory in conjunction with other organisational theories, in order to get a more detailed overview of the issues that are relevant to the firm in question.
Shareholder Communication and Expectations
When announcing a merger or acquisition most Companies will discuss and illustrate the synergies to be exploited by the move, yet in reality, most mergers undertaken will fail or be perceived to fail as they will often be considered to have fallen short of their objectives. As MacDonald (2005) discusses a merger may succeed in realising the promised value, yet still be perceived to have failed because of the shareholders perception of success, where their expectations are higher than those of the organisation. Managing shareholder expectations is a key aspect of mergers and acquisitions. Unrealistic expectations result in a perceived failure and therefore an adverse affect on share price can be identified. The most obvious approach available to any Company is to set goals that are easily achievable in the short-term. However, taking a long-term view, this is no better a strategy than setting targets that are unrealistic and difficult to achieve.
Bert et al. (2003) consider the importance of ‘quick win synergy projects’ when managing shareholder expectations. Where ‘quick wins’ regarding the promised synergies can be demonstrated to shareholders, the merger will be seen to be creating value. The perception of created value bolsters the shareholders confidence in a Companies’ strategy and helps manage their expectations.
The fiduciary responsibility of management toward shareholders’, means that management should be aware of their shareholders perceptions of the company. The decisions made by management when planning to undertake any merger or acquisition plays a key role in managing shareholder perceptions. The higher the perceived risk or uncertainty held by shareholders, the higher the discount rate they will apply. By increasing the transparency of the deal the perceived risk will be lowered, reducing the adverse affect on the share price.
A key factor in and Merger or Acquisition is communication. Hubbard (2001) lists the following characteristics of communication which can increase the acquirers’ communicational effectiveness:
1) Honest communication. This is the element of communication that is valued most highly. Communications will be scrutinised to determine truthfulness, where a communication is proven to be true the estimations of the source will increase, creating a benefit, whereas a false communication results in a fall in credibility. Research has also shown that news, even if it is bad news, is favoured over no communication at all.
2) Consistent information. This is a key factor in managing expectations. A lack of consistency may result in suspicions of hidden agendas, secrets and political manoeuvrings. This in turn may result in low trust for the organisation and rumours spreading.
3) Believable communication. This is closely linked with honest communication. Stating ‘business as usual’ straight after a merger is unbelievable as it will be obvious that changes are imminent.
Lajoux (1998) echoes the issue of rumours amongst shareholders, stating that they should be an important consideration when communicating the progress of mergers and acquisitions. Rumours can be seen as a symptom of a more serious issue, namely of a lack of information, the responsibility for which lies with senior management. As Bert et al. (2003) state: “Communication does not just happen; managers must take responsibility, plan it carefully and then control it over time.
The process of how to inform Stakeholders’ publicly about an intended merger has been summarised as follows by Lajoux (1998). In general, companies that plan to combine should announce the amalgamation as soon as possible to both shareholders and Stakeholders. When making an acquisition or merger announcement as wide a range of media as practicable should be considered. In todays’ market a press conference, teleconference, a posting on a website or a press release, will all reach a wide audience in a short space of time. This initial announcement should be the first in a series of communications in relation to each phase of the transaction, and statements should continue at regular intervals until the integration is complete. The methods used to communicate directly with shareholders can use a variety of media, for example, personal letters, bulletins and circulars, shareholders meetings etc. Once a planned acquisition has been completed, or is close to completion, both firms should release a position statement, an individual statement from each company and a combined declaration as a group. Communications should include not only a description of post merger plans but also reasons in support of how and why certain decisions where made and in what way they will be carried out. Ideally effected parties should have some input into the formulation of the plan in order to reduce opposition. Gadiesh, Ormiston & Rovit (2003) define this point further, stating that all major announcements, such as office closures and redundancies, should be made by day 10 in the integration process.
To help build shareholder ownership of plans, announcements should contain financial information which will measure the success or failure of the planned policies. The goal is to have numerous stakeholders ‘buy into’ the plan by being aware of the transformation process, whilst understanding its components and checking on its success. Constant communication is paramount when keeping potential stakeholders informed and should always take place by means of an appropriate media.
In every Merger or Acquisition promises will be made to the shareholders of the Company. These promises will be made in different ways, either through contracts or annual reports, which will often be echoed in press releases made.
Shareholders will be expecting the Company to fulfil the promises it has made, both in unspoken expectations and in written contracts relating to the acquisition. Although the Companies’ fiduciary duty is to the shareholders the interests of shareholders and the company will generally conflict in the short-term. Lajoux (1998) lists the main responsibilities companies have to shareholders as:
-To apply professional and diligent management in order to secure a fair and competitive return on owners’ investments,
-To disclose relevant information to owners / investors, subject only to legal requirements and competitive restraints.
- To conserve, protect and increase the owners / investors’ assets.
- To respect owners / investors’ requests, suggestions, complaints and formal resolutions.