Sunday, July 12, 2009

Managers should act like owners open for business

What would your customers say if they could see your expenses claim? The abstemious can rest easy. But extravagant restaurant receipts, first-class travel and accommodation, huge taxi fares - such things might not endear you to the people you are supposed to be serving.

You should expect a tough conversation about the prices you charge if customers get the impression you are enjoying the high life with their money.

That is why smart business leaders advise their colleagues to imagine they are spending their own money when they are out on company business. Act like an owner, the adage goes. Be responsible. Think before you splash the company's cash about.

This is a micro-level example of what has been called the "principal-agent problem". Even the most senior managers are not, usually, the owners of the business they are working for.

It may not be easy for them to think and act like an owner. At the same time, can owners be confident that managers are working in the company's best interests and not simply pursuing their own selfish agenda?

This question was explored by two academics, Michael Jensen and William Meckling, in a famous 1976 paper (Theory of the firm: managerial behaviour, agency costs and ownership structure), which popularised so-called agency theory.

Their answer to the problem? Among other things, try to align the interests of managers and shareholders. Use share options to give managers "skin in the game", a personal interest in the success - or failure - of the company.

There have been, to put it at its gentlest, regrettable unintended consequences to the spread of this theory. It turns out that the simple solution of share options does not solve the complicated problem of how to encourage and reward effective, responsible management.

For one thing, senior managers may not have the same time horizons as owners. A chief executive might reasonably calculate that he or she will be given no more than three or four years to run the business before their time is up.

You would understand it if that CEO worked pretty hard to get the share price up fast in order to make those share options more valuable.

Prof Jensen conceded in 2002, in the wake of the dotcom crash, that the incentives he regarded as crucial could do terrible harm.

"In the bubble, the carrots (options) became managerial heroin, encouraging a focus on short-term prices with destructive long-term consequences," he said. "It also encouraged behaviour that actually reduced the value of some firms to their shareholders."

In an important critique published in 2004 (Bad management theories are destroying good management practices), Sumantra Ghoshal condemned agency theory as an example of all that was wrong with management.

Amoral theories taught in business schools, he said, had "actively freed their students from any sense of moral responsibility".

According to this critique, the theory seems to launch a cycle of distrust. Managers are knaves, out for themselves, who have to be tied in with share options.
But managers who feel regarded in this way can become unmotivated and in the end untrustworthy. Why has executive pay exploded over the past 20 years? Partly, Prof Ghoshal suggested, because managers have sunk to reach the low expectations people have for them.

So is the idea of managers acting like owners a futile dream? Not necessarily but it's a tricky path to navigate - Financial Times
Published: July 08, 2009, 22:52

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