Fund Advisor Compensation: An Application of Agency Theory (1999)

INTRODUCTION Compensation is a topic of controversy among investors, governments, and academicians. Public interest is indicated in articles such as Why the CEO May Be Worth $100 Million, Good, the Bad, the Ugly of CEO Salaries, Can Even Heroes Get Paid Too Much? American Rattles Foreign Partners, Shares Fall; Chief's May Not, and A CEO Cuts His Own Pay which have recently appeared in the popular press. Legislated interventions in the structure of compensation and in the required reporting of the magnitude and, sometimes, the reporting of the actual compensation contract, indicate the governmental interest generated by compensation (1). Articles by authors such as Aggarwal & Samwick (1999), Bhagat, Brickley, & Lease (1985), Brickley, Bhagat, & Lease (1985), Callahan & Rutledge (1995), Campbell & Kracaw (1987), Golec (1988), Grinblatt & Titman (1989), Hall & Liebman (1998), Hallock (1998), Harris & Raviv (1979), Jensen & Meckling (1976), Jensen & Murphy (1990), Mirrlees (1976), Murphy (1986a, 1986b), Ross (1973), Schaefer (1998), Starks (1987), Stiglitz (1974), and Tehranian & Waegelien (1985) are a sampling of the articles that demonstrate a long and enduring history of academic interest in compensation in its various forms. Some investors, government officials, and academicians believe compensation is too high, some that it is improperly structured, others that it is inequitable and/or unethical, and still others that it provides the wrong incentives. In short, compensation is an issue of controversy. Understanding the role of compensation in the business framework is the key to the controversy. THE PRINCIPAL-AGENT MODEL Agency models generally address the problem of moral hazard. This problem occurs when a decision made by one individual, striving to satisfy personal desires, affects the welfare of others. Furthermore, those so affected cannot observe or directly control the choice made by the individual. In an agency model, the principal is the owner of a business who, for some reason, (2) chooses not to be directly involved in the management of the firm; instead, the principal hires an agent and delegates decision-making authority for the enterprise to that agent. The owner of the firm might choose not to be involved in the operation of the business because of a desire not to expend effort or because the agent has a comparative advantage (either in resources or ability) in the management of the firm or because of a desire to diversify personal and capital resources. If the principal and agent have different goals, if it is too costly to monitor the behavior of the agent, and if both of the parties seek to meet their own goals, the agent won't act in the best interests of the principal. If the agent has decision-making authority and the agent's choices are not easily observed and controlled, the choices he/she makes are unlikely to be consistent with the objectives of the principal. Suppose the agent expends effort to improve the outcome of the business. The principal receives the net profit of the operation of the business less the fee paid to the agent. (3) Thus, the principal may receive the benefit of the agent's expenditure of effort through the increase in the profitability of the enterprise. However, the agent is assumed to have some, as yet unspecified, level of disutility associated with the expenditure of effort. Because the agent may or may not, depending on the compensation scheme, receive the full benefit of any increase in effort, the agent may choose a level of effort less than the principal would like. The problem of the principal is to motivate the agent to act in a manner that will be mutually satisfying. The contract that leads to the highest level of expected utility (4) for the principal may be relatively simple or may be quite complex. If the actions of the agent are perfectly and costlessly observable, the principal can merely reward the agent for the correct action and punish the agent for the incorrect action. …