Agency Problem

Agency relationships arise whenever one party, termed as Principals (party who is delegating authority), delegates decision-making authority or control over resources to another party, termed as Agents (party to whom authority is delegated).

Agency problems arises when Agents and Principals do not have exactly same goals. Agency problem concerns the difficulties in motivating agents to act in the best interests of principals rather than in his own interests. Agents may pursue goals that are not in the best interests of their Principals. Agents may take advantage of information asymmetries to maximize their interests at the expense of Principals.

The challenge for Principals due to agency problems is:

• Shape the behavior of agents so that they act in accordance with goals set by principals
• Reduce information asymmetry between agents and principals
• Develop mechanisms for removing agents who do not act in accordance with goals and principals

Principals try to deal with these challenges through a series of Governance Mechanisms including mechanisms:

• To align incentives between Agents and Principals,
• To monitor and control Agents
• Strategic control systems
• To establish standards against which performance can be measured
• To create systems for measuring and monitoring performance
• To compare actual performance against targets
• To evaluate results and take corrective actions

Agency costs are the inefficiencies due to Agency problem:

• Separation of ownership and control
• Professional managers have enormous powers
• How do you ensure that the power is not misused?
• What about business ethics vi-à-vis maximization of profits

Examples 

• Shareholder vs. manager agency conflict: Shareholders want to maximize their wealth and firm's managers want to secure their job. These agency issue lead to cost inefficiencies in a form of managerial perks paid by the shareholders. If managers have created inefficiencies, then the stock price will not be as high as possible had such inefficiencies not existed. The presence of inefficiencies opens the opportunity for an outsider to buy assets at a discount, resolve the inefficiencies, and bring the assets up to full value. Additionally, the Agency Theory for M&A, suggests that firm manager tries to build a larger empire and take benefits from mergers that provide less risky cash flows through diversification. 
• Stockholders vs. bondholders:Agency Problems between corporate claimants includes agency costs of equity and takeover threats, Debt overhang, Agency cost of debt and financial flexibility. Whenever a company takes debt in its capital structure, there is a conflict of interest between equity holders and debt holders in the operations of a company. The debt holders try to protect their interests by imposing restrictive clauses in loan agreements, which reduce the flexibility of business managers. The managers implement those restrictive clauses or protective covenants in the company as agents of debt holders. This is the agency issue and results in monitoring costs that are borne by the company. These agency costs reduce the value of the company or increase the cost of debt.