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Review of Accounting Studies

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20-11-2019

Integrated ownership and managerial incentives with endogenous project risk

Authors: Tim Baldenius, Beatrice Michaeli

Published in: Review of Accounting Studies | Issue 4/2019

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Abstract

Integrated ownership is often seen as a way to foster specific investments. However, even in integrated firms, managers invest to maximize their compensation, which is chiefly driven by divisional income. Thus it is not clear that integration has any effect on investments in a world of decentralized decision-making. Building on recent findings that efficiency-enhancing investments raise not only the expected value of a project but also its variance, we show that, under plausible conditions, integration calls for low-powered incentive contracts: the managers invest more as they are less exposed to the investment-related (endogenous) risk, and the principal of an integrated firm has more to gain from greater investment. On the other hand, integration may result in higher-powered incentives if the project is inherently very risky or if the project-specific input is personally costly to the managers (rather than a monetary investment). The qualitative takeaway remains, however, that the contract adjustments under integration mitigate any input distortions present under non-integration. We also allow for firmwide performance evaluation under integration and show that it may lead to larger input distortions, but those are outweighed by improved risk sharing.

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See also Forbes and Lederman (2009, p.1836).

Edlin and Reichelstein (1995), Che and Hausch (1999), Arya and Mittendorf (2010).

While the compensation weight on firmwide metrics in divisionalized firms is indeed increasing in the extent of intrafirm externalities, the lion’s share of compensation weight for business unit managers is still tied to their own divisions’ performance; see Bushman et al. (1995), Keating (1997), Abernethy et al. (2004), Bouwens and Van Lent (2007), and Bouwens et al. (2018). Recent analytical papers dealing with PPS in agency settings are Heinle et al. (2012), Friedman (2014), Fan and Johnson (2016), and Feltham et al. (2016).

See also Anctil and Dutta (1999). Krapp et al. (2015) study firmwide performance evaluation for centralized and decentralized quantity choices in a transfer pricing setting.

The investment-risk link also affects the PPS predictions for managers without upfront specific investment/effort opportunities (who only participate in ex-post project implementation): Holmstrom and Tirole (1991) predict no PPS effect of integration; in contrast, our results show that their PPS will be adjusted to the anticipated equilibrium project investment/effort level and are inversely associated with the latter.

See Bresnahan and Levin (2012). Grossman and Hart (1986) point out the opportunity costs of integration. Edlin and Reichelstein (1995), Che and Hausch (1999), and others ask whether hold-up problems can be overcome by generalizing the contract or bargaining space.

Whinston (2003, p.4): “Integrated asset ownership changes incentives, but does not result in coordinated investments”.

Holmstrom and Tirole (1991) discuss verbally that allowing for compensation of Manager i to depend on the profit of Division j would improve, but in equilibrium not fully eliminate, the hold-up problem. This is formally proved by Anctil and Dutta (1999), who derive optimal compensation weights on own- and other-division performance, trading off investment incentives and risk sharing.

Hart and Holmstrom (2010) and Casas Arce et al. (2017) address the ex-post adaptation aspects of integration. Baldenius (2006) derives an alternative rationale for low-powered PPS under integration: if intrafirm trade takes place under asymmetric information, muted PPS induces managers to bid less “aggressively”, which improves ex-ante investment incentives.

Williamson (1985) argues that the owner of an integrated firm has incentives to manipulate performance metrics to withhold compensation from managers. A conceptual problem with the selective intervention argument is that it is orthogonal to the investment story—in the words of Bresnahan and Levin (2012, p.856, emphasis added): “These [hold-up] stories provide a motive for vertical integration [...]. Williamson (1975, 1985) suggests a related but distinct set of inefficiencies inside organizations. These include low-powered incentives...”

Williamson (1975), Holmstrom and Tirole (1991).

The basic technology follows closely that of Baldenius and Michaeli (2017).

For a more general formulation of M(⋅), see Appendix B. We focus on unilateral specific investments (or later project efforts). Our results (except in Section 3.2) are qualitatively robust to allowing both managers to invest. The project surplus function M(⋅) can be derived from a linear-quadratic formulation of the canonical supply chain example, where an upstream business unit makes q units of some product at variable cost C, which are sold by a downstream unit at revenues R. Let C(q, 𝜃₁, k₁) = (c − 𝜃₁ − k₁)q and \( R(q,\theta _{2})=\left (r+\theta _{2}-\frac {q}{2}\right )q,\) for independent shocks (𝜃₁, 𝜃₂). The surplus M(q, 𝜃, k₁) ≡ R(⋅) − C(⋅) then collapses to the term above, if we normalize \({\sum }_{i}\theta _{i}=\theta \) and r = c (with r sufficiently high). Because of equal surplus-splitting at the project implementation date, the investment k₁ could equivalently be cooperative in nature (Che and Hausch 1999), that is, raising downstream revenues R(q, 𝜃₂, k₁), while leaving upstream relevant costs, C(q, 𝜃₁), unchanged.

See Appendix C for details.

Assuming β_i ∈ [0, 1] ensures neither party has incentives to destroy output. We restrict attention to linear contracts for tractability reasons. For a discussion of the conceptual issues that arise under more general contracts, see Baldenius and Michaeli (2017, Section II).

It is easy to show that this result holds for more general distributions of 𝜃. In that case, φ(k₁) becomes a function of higher moments of the distribution (variance, skewness, and kurtosis). Specifically, \(\varphi (k_{1})=\left (q^{\ast }(\mu ,k_{1})\right )^{2}S+skew(\theta ) q^{\ast }(\mu ,k_{1}) S^{3/2}+\frac {S^{2}}{4}(kurt(\theta )-1)\). Thus \(\varphi ^{\prime }(k_{1})= 2q^{\ast }(\mu ,k_{1})S+ skew(\theta )S^{3/2}\), so the project risk is increasing in the investment for any symmetric distribution (i.e., distribution with zero skewness such as normal, uniform etc.) and any positively skewed distribution.

Baldenius and Michaeli (2017) discuss the role of linear contracts, aside from the customary tractability advantage. With nonlinear contracts, added outcome uncertainty does not necessarily translate into added compensation risk, if the (more dispersed) outcome distribution gets shifted to a region in which the contract is “flatter”.

The bounds invoked in A1 can be restated in terms of exogenous constructs. First, \(S_{risk}= 4 \left (\frac {f-1}{\mu f} \right )^{2}\min \limits \{{\sigma _{1}^{2}},{\sigma _{2}^{2}}\} \). Assuming S ≤ S_risk ensures the project-related risk premium for Manager i, \( \frac {\rho }{8} ({\beta _{i}^{o}}(k_{1}))^{2} \cdot \varphi (k_{1})\), is increasing in k₁ for any \(k_{1}\leq k_{1}^{rf}\) in the contractible-investment benchmark case. Second, \(S_{pos}= \frac {4}{\rho }\left ({\sum }_{i=1}^{2} (1+\rho v {{\sigma }_{i}^{2}})^{-2}\right )^{-1}\). Taking the derivative of the planner’s expected utility, \(W_{k_{1}}=E \left [M_{k_{1}}(\theta ,k_{1})\right ] - \frac {\rho }{8} {\sum }_{i} ({{\beta }_{i}^{o}}(k_{1}))^{2} \varphi ^{\prime }(k_{1}) - F^{\prime }(k_{1})= q^{\ast }(\mu ,k_{1})\left (1- \frac {\rho S }{4}{\sum }_{i}({\beta _{i}^{o}}(k_{1}))^{2}\right )-f k_{1}\). Hence for S ≤ S_pos, the marginal investment return is positive for small k₁.

To compound this aggregation issue, project investments may also take the form of personnel training or other intangibles (rather than in PP&E), which are hard for the CFO to reliably distinguish from operating expenses.

We abstract from message games designed to elicit the information from the managers. See Maskin and Tirole (1999) for a related critique of the foundations of incomplete contracting.

Our Condition UI is more general than the similarly-labeled one in Baldenius and Michaeli (2017), in that the condition in the current paper adds σ₁ ≤ σ₂ as an alternative sufficient condition. The precise thresholds given in UI and OI are stated in the proof of Lemma 0.

See equations (11) and (13) in Appendix A for details.

While RPE is common also across firms, it is typically applied at the firm level. Firms usually do not have access to profit data at the divisional level of peer firms, which would be required to implement RPE in our non-integration setting.

To see why, recall that \(E[M(\theta ,k_{1})]=\frac 12 (\mu +k_{1})^{2}\) and φ(k₁) = (μ + k₁)²S.

This argument is related to that of Baldenius and Michaeli (2017) about why a manager who has complete bargaining power vis-a-vis the other manager does not have efficient investment incentives, if one takes into account the investment-risk link.

This finding may seem at odds with Anctil and Dutta (1999), who show that the investing party’s profit-sharing coefficient may take either sign in the absence of any investment-risk link. In their model, the joint project surplus is uncertain, but the associated risk is assumed to be independent of any specific investment; therefore RPE arguments continue to apply. In our setting, as S → 0, the investment-risk link disappears, and so does any project-specific uncertainty. Firmwide performance evaluation then plays the sole role of mitigating hold-up.

Note the parameterization in Table 2 still ensures underinvestment, relative to the contractible benchmark

Similar to the case of monetary investments, assuming the personal project cost is sufficiently convex (c is sufficiently high) ensures the principal’s payoff is globally concave.

For example, for imperfectly competitive intermediate good markets, pricing internally at market may result in double-marginalization (Baldenius and Reichelstein 2006; Johnson et al.2016; Arya and Mittendorf 2010). We also ignore ex-ante fixed-priced contracts to be renegotiated after the realization of the state variable, as in Edlin and Reichelstein (1995). In contrast to earlier hold-up models that ignore the investment-risk link, Baldenius and Michaeli (2017) show that investment distortions may not be monotonic in the allocation of bargaining power. A manager who has complete bargaining power always underinvests (their Lemma 2), but he may overinvest under certain conditions (their Proposition 2). To focus on alternative ownership structures, we assume equal-splitting of the project surplus in this paper.

We abstract from other differences between the ownership structures—for example, under non-integration managers may not observe each other’s information (which would affect the surplus splitting); integration may facilitate collusion among the managers—and we ignore “hybrid” ownership structures—for example, joint ventures or strategic alliances (Menard 2012).

Baldenius and Michaeli (2017) discuss the investment-risk link for more general contracts. However, to determine the direction of the investment distortion under delegation, requires trading off the hold-up (first-moment) and risk transfer (second-moment) externalities. This is intractable beyond the linear-quadratic model.

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Title: Integrated ownership and managerial incentives with endogenous project risk
Authors: Tim Baldenius
Beatrice Michaeli
Publication date: 20-11-2019
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 4/2019
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-019-09504-0

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