Managerial reputation and corporate investment decisions - Corporate Investments Special Issue

Financial Management (Financial Management Association), Summer, 1993 by David Hirshleifer

conclusion about the market for takeovers and other forms of corporate control.

What we do see is that a large variety of managerial investment policies are influenced by the manager's incentive to build his personal reputation and that of his firm. Reputation affects the firm's risk-taking, what projects it undertakes and when it terminates them, whether it tries to obtain resolution of its project uncertainty early or late, and whether the firm's investment policy conforms to others in the industry or diverges. Thus, the analysis of managerial reputation-building is crucial for a scientific understanding of how firms make During the 1980s, General Motor's Chairman and CEO Roger Smith undertook vast capital expenditures, and pursued his vision of GM as a leader in new production techniques and labor management. This included $40 billion in new equipment between 1979 and 1987 (see Business Week, May 18, 1987), the self-consciously innovative development of the Saturn line of cars, and the introduction of robotic production methods. In hindsight, the disastrous consequences of these policies are evident to all. At the time, however, there was more room for controversy. It was plausibly argued by some that massive investment and innovative expenditure was needed to meet the competitive challenge of the Japanese car manufacturers. And as GM's market share and productivity fell, it was pointed out that radical change is costly, that the payoff to innovation often does not arrive in the short-term, and that courage was needed to revolutionize the American car industry. As Roger Smith put it, "Don't write the book on me until I've been gone at least ten years. It's too early. You've got to wait and see." (Lee |30~)

Although Smith made the wrong call, Smith's reputation as a manager benefited from the fact that he was following a very long-term investment strategy. As a consequence, early signs of failure (declining market share, low profitability) were not judged as harshly as they would have been if his policies were designed to generate immediate performance, and still failed. Since his strategy arguably had great long-term promise, not everyone knew just how badly things would turn out.

This case leads one to suspect that managers will sometimes intentionally choose investment strategies that take a long time to evaluate fairly.(1) In some cases, this may be because long-term investments are the most efficient for the firm. In others, it may be that long-term investments are inefficient for the firm, but they are chosen because they afford the manager protection from the risk of being viewed as a failure early on.

This example is a special case of a more general point. This article is based on the fundamental fact that a manager's investment decisions affect his reputation. Even President Clinton has staked his reputation on the strategy he is designing for U.S. government spending and investment. Because of a concern for reputation, managers sometimes make investment choices that are bad for shareholders but good for the manager -- because they make the manager look good in the short run.

Managers have good reason to be concerned with maintaining their reputations for high ability, both in the short run and the long run. Apart from direct value of prestige, high reputation gives the manager better bargaining power to increase his pay. Even if a manager's sole purpose were to maximize shareholder value, he may be concerned with the firm's reputation. Investors' beliefs about his ability and his firm's assets and capacities will affect the price at which the firm can raise capital, hire employees and sell its products.

Managers often have information about the profitability of alternative investment decisions that is unavailable to outside investors. Furthermore, investors cannot perfectly observe the manager's investment choices. This gives the manager leeway to follow policies that do not maximize profitability in the long run, but improve the manager's immediate reputation. For example, the manager of a pharmaceutical firm may invest heavily to accelerate approval of a medication, if testing and FDA approval will reflect well on him. This can hurt shareholders if the cost is disproportionate. Another example is a consumer retail chain cutting investment in store quality and customer service in order to make earnings seem high in the short run.

This article reviews research on the manipulation by managers of investment decisions owing to a desire to influence perceptions about a manager or firm, and in particular, with reputational effects on investment decisions.(2) The term "reputation-building" is more general than the concept of "signalling" introduced in academic models of capital structure in the 1970s. One could define signalling as any action taken by a manager that conveys information to others, but this does violence to the term. The basic notion of signalling is taking a visible action (such as choosing a capital structure) for the primary purpose of conveying information to others. More generally, even hidden actions have consequences that are eventually visible, so reputational considerations affect firms' hidden investment decisions (such as customer service activities) even though these decisions are not used as signals. Also, reputational considerations affect important decisions, such as whether to undertake a major new project, even though the primary motivation for the project may be profitability.