Managerial reputation and corporate investment decisions - Corporate Investments Special Issue

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

Consider a manager who decides today whether to invest or not to invest.(3) Investors do not know whether the manager (or his firm) is of high or low quality, so his action will, in general, affect his reputation and that of his firm. After the decision is made, public news may arrive that will affect investors' beliefs about the manager and his firm. This is the "short-run" reputation he will be concerned about. Long-run profitability also matters to the manager, but not as much as to a shareholder planning to buy and hold.

Only in the last decade have academic researchers begun to explore the more general consequences of managerial reputation-building. This recent interest has been led by Bengt Holmstrom in two important papers (Holmstrom |25~ and Holmstrom and Ricart i Costa |26~). Holmstrom and Ricart i Costa |26~ point out that the manager's freedom to quit a firm to get higher pay elsewhere gives him an incentive to build his reputation in the short run. This contrasts with a more traditional analysis of agency problems that assume that the manager and the firm are inseparably bound together.(4)

It is worth pointing out that shareholders may actually want the manager to invest in a way that improves the firm's short-run reputation, even if this is at the expense of long-run profitability, for at least three reasons (see Harris and Raviv |20~, Thakor |46~, and Trueman |47~). First, some shareholders may expect to be selling their shares at the current market price before the long term happens. Second, if the firm plans to issue new equity, a better reputation allows it to do so at a higher price, to the benefit of current equityholders. Third, the price at which the firm is sold in a takeover contest can be improved by maintaining a good reputation (Stein |43~).

As an example of reputation-building, a firm may act to boost its current cash flows at the expense of reducing future cash flows by a greater amount. It can do so by failing to make a desirable investment, or even by liquidating an investment. Advancing cash flows incurs real costs in an attempt to redistribute wealth from new share purchasers to old. This is a trap, because if investors have rational expectations, they will not be fooled, on average, about the value of the firm. But the firm still needs to manipulate its investment policy (boost current cash flows). If it were to fail to do so, its cash flows would look low, and investors would wrongly believe the firm was worse than it really is.

In economic jargon, reputation-building creates dead-weight costs. These costs are ultimately borne by the firm's founder when he initially sells his equity in the firm. Buyers will pay less for his equity since they can foresee that resources will be wasted on reputation-building.

In principle, it would be desirable to eliminate these deadweight costs by paying the firm's manager only for long-term performance, not short-term reputation (Dybvig and Zender |15~). Unfortunately, this is not as easy as it looks, for several reasons. First, a manager whose reputation is riding high has a credible threat to leave for another firm, so it may be impossible to hold his pay down while waiting to learn the long-term outcome. Second, the manager needs to consume while he is young. Although some of his compensation can be long-term, much of it must be paid before his long-term performance is known. Third, as pointed out by Pound |38~, there is a temptation on the part of the manager and the board to renegotiate contracts later, so that a manager with favorable information can increase his pay by conveying favorable information about the firm.