Firm Performance and Mechanisms to Control Agency Problems between Managers and Shareholders

This paper examines firms' choice of the mix of mechanisms used to reduce agency problems between managers and shareholders. We empirically address two questions. First, is there interdependence between the use of the various quot;control mechanismsquot;? Second, does cross-sectional evidence suggest that firms fail to adjust their use of these control mechanisms optimally? We consider the use of seven control mechanisms in a sample of nearly 400 large U.S. firms. These mechanisms are: shareholdings of insiders, institutions, and large blockholders; use of outside directors; debt policy; the labor market for managers; and the market for corporate control. We present two main empirical findings. First, there is evidence of interdependence among the use of these mechanisms. Second, given this interdependence, cross-sectional OLS regressions of single mechanisms on firm performance can be misleading. Like prior studies, we find a positive effect of insider shareholding on firm performance when insider shareholding is examined alone. However, this effect disappears when all of the mechanisms are included in an OLS estimation and when the relation is estimated within a simultaneous equations framework. We also find a negative effect of a larger fraction of outside directors, greater debt, and more activity in the market for corporate control on firm performance in OLS estimations, but only the negative effect of board composition persists in the systems framework. The lack of a relation between insider shareholding and firm performance in the more inclusive estimations is consistent with the argument in Demsetz and Lehn (1985) that firms choose ownership structures optimally. By contrast, the persistent negative relation between board composition and firm performance suggests that boards contain too many outsiders