Advanced Corporate Strategy

ST104x

Managerial agency and Hubris

Agency problems may explain why managers do not always act in the best interests of
shareholders. Managerial incentives are, in most cases, misaligned with the firms’ value
addition to shareholders.

For instance, when managers are compensated on the basis of firm size rather than short-
and medium-term returns, it would be expected of managers to pursue growth as a strategy,
even if it is not adding long-term value to the firm or it’s shareholders.

Such agency problems could be mitigated by instruments like providing stock options for
managers and robust corporate governance processes. Many a diversification attempt has
failed just because the motive has been to benefit managers, rather than shareholders.

Managers may also overestimate the extent of relatedness between their existing business
and the ones they are diversifying into, and consequently become overconfident of their own
ability to manage the diversified business. This is known as managerial hubris.

Such behaviour might result in managerial entrenchment; which is managers becoming more
and more powerful in deciding firm strategy than shareholders or their representatives, and
empire building; which is misuse of firm free cash flows to pursue profitless growth strategies.

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