In our previous article, “Dealing with Information Asymmetry in Private Market Investing,” we discussed how investors need to minimize the information barrier that exists between them and their investees. In this post, we narrow in on another type of principal-agency issue called Management Entrenchment, a concept in agency cost largely developed by Michael Jensen from Harvard Business School and William Meckling from the University of Rochester.
What is Management Entrenchment?
In corporate governance, management entrenchment is a term used to describe a situation where managers use their position to act in ways that only benefit themselves and not the shareholders. The most often cited examples of this are managers: pursuing acquisitions simply so they can manage a bigger organization (empire building), engaging in manager-specific investments, and constructing extravagant offices at the expense of the shareholders.
How Entrenchment Comes About
At its core, entrenchment occurs due to the separation of ownership and control. While shareholders are owners, it is the managers that are stewards of a company. The board of director’s job is to ensure that the right management team is selected to ensure the alignment of interest between the two parties. This alignment, however, often does not occur in reality. In the absence of proper corporate governance controls, the board of directors is sometimes “captured” by the managers through influence, authority, or personal relationships. Consequently, the board may no longer function as intended and shareholders’ interest are put at risk.
The kind of entrenchment we have described above happens at the very top and is mostly readily apparent, but there is a more subtle form of entrenchment that takes place lower down in the organization. This is the type we will focus on as it rarely gets talked about.
Entrenchment, an Example
In Episode 13, Season 5 of The Office, in response to people ignoring his fire safety training, Dwight simulated a realistic fire situation in the office to teach his coworker a lesson. He strategically heated door handles, lit dustbins on fire, and shouted safety instructions as people scrambled to save their lives. Everyone was focused on trying to put out the fire, but nobody paid attention to the fire starter. Amidst the smoke and calamity, Dwight stood there observing, rejoicing in his doing.
Dwight’s action is an apt analogy for the example we will discuss next.
Consider a manager who was brought in to be the head of a department in a company. The manager, having been dismissed from his previous employer, landed the new job through sheer luck and was ready to find a place where he can ensconce himself.
Being the new face in the organization, he knew it was imperative to surround himself with people he knew well – people that share his proclivities – so there would be no one to dislodge him from his new position. He slowly gets rid of the people in his department and replaces them with friends and colleagues from previous jobs so he can trade favors. As time passes, he participates in buying equity options in amounts large enough to claim alignment of interest with shareholders but small enough that he will not feel the pain should the company’s value decrease. To consolidate power, he rearranged the company’s reporting procedures and made them such that every other department must report to his department. This way he would also be able to exert influence on decisions made outside his unit.
As people take notice, talent begins to leave the door and slowly the company is left with a workforce that exudes incompetence and breeds mediocrity. Infighting becomes more frequent and quid-pro-quo relationships begin to develop. Morale starts to falter, productivity begins to descend, and a dysfunctional culture emerges.
By the time the founder and leadership teams realized what was going on, their focus and efforts are spent putting out fires, and the manager gets to enjoy collecting paychecks while slowly turning the company inside out.
Who bears the cost of all of this? The shareholders.
How to Prevent Management Entrenchment?
The example above is real and by no means remote.
The question becomes, what can be done to prevent it?
Here are some of our suggestions.
1) Pay Close Attention to Hiring
Entrenchment begins with hiring wrong. Successful companies understand the importance of hiring. This is why many founders spend the time doing all the hiring and recruiting work themselves. Ken Griffin, the founder of Citadel, one of the world’s largest hedge funds, said he personally interviewed roughly 10,000 people in his career and does on average 2 interviews per day.
Similarly, Ray Dalio, the founder of Bridgewater Associates, goes so far as to develop a scientific way of assessing candidates. In his article, Dalio mentioned how critical hiring right is to Bridgewater, “the most important thing you can do is understand that hiring is a high-risk gamble that needs to be approached deliberately.” He further goes on to emphasize the impact of hiring wrong, “Months or even years and countless dollars can be wasted in training and retraining. Some of those costs are intangible, including loss of morale and a gradual diminishment of standards as people who aren’t excellent in their roles bump into each other.”
Both of these hedge fund founders manage over $150 billion in capital and over 3,000 employees, and they are still heavily involved in hiring.
2) Decentralize Your Organization
Tom Murphy and Dan Burke are two people whom Warren Buffett called “the greatest two-person combination in management that the world has ever seen or maybe ever will see.” Murphy and Burke ran Capital Cities, whose stock returned a remarkable 19.9% from 1966 to 1995 under their leadership. The S&P 500, on the other hand, returned 10.1% and other leading media companies returned 13.2% during the same period. Murphy and Burke attributed this phenomenal result to the company’s decentralized culture. This notion is reflected by the following credo that is mentioned at the beginning of every big meeting and annual reports of Capital Cities:
“Decentralization is the cornerstone of our management philosophy. Our goal is to hire the best people we can find and give them the possibility and authority they need to perform their jobs. All decisions are made at the local level, consistent with the basic responsibilities of corporate management.”
In the book The Outsiders by William Thorndike, the author mentioned, “As Burke told me, the company’s extreme decentralization approach kept both costs and rancor down.” “Rancor,” in this context, seems to connote an unhealthy work environment that emanates from employees trying to outmaneuver each other in pursuit of power and status.
When a company is decentralized, the chance of a single employee having too much influence is low. Furthermore, decentralization by design requires managers to carry significant responsibilities. Consequently, they are more likely to focus their attention on executing those responsibilities and not on trying to insidiously consolidate power or authority.
3) Mandate Co-investments
We believe one of the reasons why the Forbes 100 list contains a significant number of family-owned enterprises is because the owners are/were the operators. The alignment of interest was never in question, as they are exposed to the same upside and downside. Managers today, however, do not have the same symmetric payoff as the founders.
Instruments such as convertible notes and warrants were created and used extensively to address this problem, but in our opinion they have largely missed the mark. While these securities encourage managers to outperform so they can participate in the rise of the company’s value, they do not penalize them for poor performance. These instruments are essentially call options (with positive carry) on the company’s value. Management can simply coast along and collect their paychecks without having to go out of their way to increase shareholder value.
To address this problem, we believe shareholders need to mandate managers to invest directly in the company. Management needs to have skin in the game and have their net worth tied to their performance, so they are truly incentivized to act and think like owners. Subpar managers or those like the one in our example will eventually leave and those with true managerial stewardship will eventually emerge.