• Strategy
  • Monitor Group

So, Why Be Public?

This is a question more and more companies have been asking. Many of the traditional advantages of being public are no longer valid, and the mounting costs all the more obvious.

Uninformed Owners, Deceptive Metrics

That complexity not only affords desperate executives and fraudsters the opportunity to obscure reality for extended periods, but also undermines the flexibility of the best-intentioned managers. The lack of informed owners can restrict management’s ability to act on the owners’ long-term behalf. Uninformed owners prefer easily understood, often deceptive metrics of corporate success, such as sales growth or earnings per share growth rates. Their capacity and willingness to invest in their understanding of the vagaries of markets and the nuances of risks inherent in any strategy is limited. Take the example of a pharmaceuticals company in the late 1980s, struggling to overcome a weak product pipeline. It staunchly refused to cut its research and development budget in favor of short-term earnings, as the capital markets feted its rivals. While things ultimately turned out well for the company in question—Pfizer, the darling of today’s industry—it had to overcome the market’s predilection for the immediate and observable.

Few management teams or boards demonstrate that constancy of purpose; therefore, their vulnerability remains great. Andrew Carnegie and John D. Rockefeller had both the means and the opportunity to understand fully the companies they owned, just as Warren Buffett and Charlie Munger have done in recent years. John Q. Public has no such opportunity, most likely lacks the necessary technical skill, and will likely exercise no such patience. So because shareholders cannot, will not, or simply do not police managers, boards have become more and more responsible for doing the work that owners once did routinely. That is, they must act as watchdogs ensuring that a company reflects the shareholders’ interests as it makes strategic decisions and incurs business risks.

Board’s Role in Principal/Agent Problems

For any board, the fundamental issue in resolving the principal/agent dilemma revolves around how to prevent the careerism and innate self-interest of executives from expressing themselves at the expense of shareholders. The recent heated debates over compensation reflect the public reemergence of that issue. It is, however, far from new. As far back as 1932, Berle and Means explored agency costs and noted their centrality in the design of the modern corporation. “The management of a corporation was thought of as a set of agents running a business for a set of owners.” Managers are not owners, and developing mechanisms that cause them to act like owners has proved frustrating. This intractable challenge has given rise to a vast array of economic literature that addresses the issue, formally known as the “principal/agency problem” or, more simply, as “agency costs.”

While Berle and Means set out the dilemma, it was Michael C. Jensen and William Meckling who developed agency theory as we know it today. Jensen and Meckling wrote about agency costs throughout the 1970s. Jensen, in particular, wrote about the need to consider a full range of strategies in mature industries, including exit. More importantly, he noted, along with other scholars, the propensity of management to invest in marginal businesses or projects in order to grow their companies, retaining cash beyond the clear reinvestment needs of the corporation in the interest of preserving managerial flexibility. Jensen dubbed this the “free cash flow” problem. For a time in the late 1980s, the threat of hostile takeovers and leveraged buyouts served to discipline managers who hoarded the shareholders’ cash. However, those financial techniques were blunt remedies, used primarily to cudgel the most obtuse or recalcitrant executives into submission. Shareholders had to rely upon the integrity of managers and wisdom of boards to offset the all too real pull of managerial self-interest.

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