Assessing the optimality of corporate short-termism

Dirk Hackbarth, Alejandro Rivera, Tak-Yuen Wong 19 December 2018

a

A

Corporate short-termism has often been criticised because it could harm long-term performance. That is, managers arguably take actions that are favourable for them in the short term at the expense of shareholders’ interests in increasing stock prices. Consistent with this view, recent research led by a team from the McKinsey Global Institute in cooperation with FCLT Global (e.g. Barton et al. 2017a) finds that companies that operate with a true long-term mindset have consistently outperformed their industry peers since 2001 across almost every financial measure that matters. Although their results are useful, they also beg more questions (e.g. Summers 2017). Related to this, it also seems unclear whether public firms that face stock market pressures engage less in long-term investment policies. Indeed, Asker et al. (2015) find that publicly listed companies are more short-termist, but Feldman et al. (2018) find the opposite. 

Lack of clear guidance by prior research indicates that corporate short-termism is a controversial issue, with varied perspectives among academics and practitioners. Are financial managers irrational when they do not invest largely in long-term projects? Is short-termism sub-optimal for shareholders? Or can the behaviour of managers, which appears to be myopic, actually be a result of rational shareholder value maximisation? To tackle these questions, we study a dynamic model of a debt-equity financed firm with future growth opportunities. As it turns out, basic firm characteristics, such as the debt-equity ratio and growth opportunities, go a long way in determining a deeper understanding of the trade-offs associated with corporate short-termism.

We build a dynamic model of a company funded with equity and risky debt, which is a typical capital structure for most public corporations – and especially for the ones in the S&P500. We consider a setting in which shareholders incentivise a multi-tasking manager to select long-term effort and short-term effort. Shareholders also make debt-equity and bankruptcy decisions. This formal model enables us to study equilibrium interactions between financial policies, investment policies (i.e. long-term growth and short-term profits), and managerial compensation (incentive pay) in a contracting framework.

Notably, a budget (time) constraint that binds managerial effort captures short-termism – an increase in short-term effort makes long-term effort costlier, thereby undermining long-term performance. In addition, shareholders incorporate compensation costs and timing effects in designing an optimal contract, based upon which the manager selects long-term effort (growth) and short-term effort (profit) in a multi-tasking environment. Because the manager’s efforts are unobservable for shareholders, the manager needs to be exposed to some of the firm’s risk and upside, which creates incentive costs for a risk averse manager with limited resources. However, risk makes the shareholders’ option to delay bankruptcy more valuable, which we refer to as timing effect. The analysis of the model yields four results.

Short-term investments may not always be inefficient 

We show that short-termism is not necessarily the result of myopic managerial behaviour (as argued in the first generation of short-termism papers in the 1990s) but, perhaps surprisingly, short-termism ex post is optimal for shareholders. Shareholders receive all the benefits from short-term effort immediately but do not internalise all the benefits from long-term effort, because they split the latter with bondholders. In other words, a free rider problem creates scope for short-termism that ex post is optimal for shareholders. Shareholders trade off the benefits of short-termism (current cash flows) against the benefits of higher growth from long-term effort (future cash flows) at an interior optimal solution that does not put zero weight on the manager’s less productive, short-term effort.

A focus on long-term investments may not be optimal

Our model’s optimal contracting solution reveals that potential endogeneity problems have plagued the short-termism debate. Indeed, we find that firms with bright growth prospects optimally choose to focus on long-term growth, while firms with grim growth prospects optimally focus on the short term. Hence, in equilibrium, one would observe that high-growth firms are those that invest in the long-term, whereas low-growth firms are those that invest less in the long term. Absent any concerns about short-termism, this result is simply stating that firms with better future growth prospects should invest more today. In other words, it does not make sense for low-growth firms to mimic the long-term approach of their high growth counterparts, because it would be less value-enhancing – or even value-destroying – for low-growth firms to implement higher levels of costly, long-term effort.

Assessing the cost of optimal short-termism

The model enables us to quantify the economic magnitude of distortion in short-term and long-term policies, which economists often refer to as agency costs. We decompose them into investment-related long-term costs, and the costs of short-termism. We calculate the reduction in total value is about 1%, where up to one half of this reduction is due to short-termism. Importantly, short-termism is not detrimental to shareholder value but is, in fact, desirable. After all, shareholders designed the optimal incentive contract. However, bondholders are the ones who are made worse-off as a result of short-termism, so that the sum of shareholder and bondholder (or total) value is reduced by optimal levels of short-termism.

Impatient shareholders and excessive short-termism

Adverse effects of short investor time horizons have been criticised prominently by the FCLT Global and McKinsey's short-termism study (Barton et al. 2017b).  In an extension of the baseline model, we therefore consider the situation where a subset of myopic shareholders with a shorter time horizon (i.e. investors with an excessively high discount rate) takes over control of the firm. In this way, we can provide cost estimates of excessive short-termism, which further underscores the economic significance of our baseline results that short-termism reduces total value. Notably, impatient shareholders find even higher short-term effort and even lower long-term effort optimal, which in turn reduces equity value for patient, regular shareholders and bondholders, who both employ the baseline, patient discount rate. A 1% point increase in the discount rate of impatient shareholders leads approximately to a reduction of 1% in equity value, 5% of debt value, and 2.5% of total firm value. Thus, our model predicts that a transfer of control to investors with shorter time horizons induces a sizable reduction in debt and equity values, which is consistent with the conventional critique of short-termism.

Conclusion

Corporate short-termism will remain a hotly debated topic, as there are more open questions than commonly agreed upon answers.  To the best of our knowledge, our paper is the first to advance our understanding through the lens of an equilibrium model featuring interactions between financial policies, investment policies (long-term growth and short-term profits), and managerial compensation (incentive pay). Its economic mechanisms and predictions are novel and subtle. Notably, we establish that short-termism is not necessarily the result of myopic managerial behaviour – as argued since early works by Stein (1989) and Shleifer and Vishny (1990) or other sup-optimal policies, but a result of shareholder value maximisation – perhaps surprisingly, it can be optimal for shareholders. In addition, our paper reveals that grim growth prospects produce higher levels of optimal short-termism, but impatient or myopic shareholders at the helm of a firm may produce excessive short-termism counter to the objectives of other, more patient shareholders.

References

Asker, J, J Farre-Mensa, and A Ljungqvist (2015), “Corporate Investment and Stock Market Listing: A Puzzle?”, Review of Financial Studies 28, 342-390.

Barton, D, J Manyika, and S Williamson (2017a), “Finally, Evidence That Managing for the Long Term Pays Off”, Harvard Business Review.

Barton, D, J Manyika, T Koller, R Palter, J Godsall and J Zoffer (2017b), "Measuring the Economic Impact of Short-Termism", Discussion Paper, McKinsey Global Institute.

Feldman, N E, L Kawano, E Patel, N Rao, M Stevens, and J Edgerton (2018), “The Long and Short of It: Do Public and Private Firms Invest Differently?”, SSRN Working Paper.

Hackbarth, D, A Rivera, and T-Y Wong (2018), “Optimal Short-Termism”, ECGI Finance Working Paper no. 546/2018.

Shleifer, A, and R Vishny (1990), “Equilibrium Short Horizons of Investors and Firms”, American Economic Review: Papers and Proceedings, 80, 148-153.

Stein, J (1989), “Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior”, Quarterly Journal of Economics, 104, 655-669.

Summers, L (2017), “Is Corporate Short-Termism Really a Problem? The Jury’s Still Out”, Harvard Business Review.

a

A

Topics:  Microeconomic regulation

Tags:  short-termism, corporate governance, shareholders, incentivisation

Professor of Finance, Questrom School of Business, Boston University

Assistant Professor of Finance, University of Texas at Dallas

Associate Professor, Shanghai University of Finance and Economics

Events

CEPR Policy Research