Relational Investing And Agency Theory, 15 Cardozo Law Review 1033 (1994) (with Peter Cramton)
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INTRODUCTION ............................................................. 1033

  1. DISTORTIONS AND DEFICIENCIES IN MANAGERIAL DISCIPLINE ............... 1036
    1. Relational Investing as a Response to Distortions in the Capital Market ................................................................. 1037
    2. Negotiated vs. Non-Negotiated Relational Investing ............... 1038
  2. RELATIONAL RESPONSES TO DISCIPLINARY FAILURE ........................ 1039
    1. Deficient Discipline ............................................. 1043
      1. Enhancing Internal Discipline ................................. 1043
      2. Enhancing External Discipline ................................. 1045
        1. Ex Post Free-Riding ....................................... 1046
        2. Insufficient Ex Ante Inducements .......................... 1048
        3. Moral Hazard Inefficiency ................................. 1052
    2. Distorted Discipline ............................................. 1057
      1. Inadequate Measures of Managerial Quality ..................... 1057
      2. Capital Market Prices Assets Below Fundamental Value .......... 1058
      3. Opportunistic Redistribution of Rents ......................... 1059
      4. Insulating Managers from Distorted Discipline ................. 1060
  3. WHEN IS RELATIONAL INVESTING MOST LIKELY TO BE SUCCESSFUL? .......... 1061
    1. Rationales for Relational Investing .............................. 1061
    2. The Venture Capitalist as a Relational Investor .................. 1063
    3. Debt vs. Equity .................................................. 1064
CONCLUSION ............................................................... 1065

INTRODUCTION

This Article analyzes how, and when, corporate governance could be improved by utilizing "relational investing." The term relational investing is just coming into vogue and there does not yet seem to be a consensus on what it means. Although the term has been trumpeted on the cover of Business Week, before the Conference on Relational Investing at Columbia University, relatively little legal writing had been published on the subject.

For the purposes of this Article, we define relational investing to encompass commitments to buy and hold significant blocks of a corporation's stock. And it is particularly important that the relational investors commit not to tender their shares to hostile bidders. Using our definition, relational investing is used to foreclose or reduce hostile takeover threats, replacing this form of external discipline with enhanced internal discipline by the relational investors. The long-term investment induces the relational shareholders to invest more in acquiring information about the effectiveness of management. To be effective internal monitors, however, relational investors must be able to use this information to influence corporate policy. At a minimum, relational investors must be "provocable"--they must be able to increase the likelihood that poor management or poor policies will be changed.

Relational investors might accomplish these changes through either internal (informal negotiation or proxy contest) or external (tender offer) means.

Although we will often assume that relational investors are committed to patient oversight, it is important to remember that these commitments are usually noncontractual, suggesting that an implicit commitment to buy and hold stock must be self-enforcing. This self-enforcement constraint might be especially useful in determining when relational investing is likely to arise. For example, the short-term illiquidity of large blocks of stock might make the buy and hold commitment more credible. Moreover, large block holders often will lack an incentive to reduce the size of their holdings. The 13(d) filing requirements of the Securities Exchange Act could also facilitate relational investing, because unfulfilled representations to buy and hold stock can give rise to legal liability. Using the minimalist definition that relational investors commit not to tender a large block of shares, it is possible that relational investing could reduce agency costs by providing a more effective form of corporate governance. This is far different from arguing that, as an empirical matter, relational investing is superior to more traditional forms of corporate governance. Indeed, some theorists suggest that with "friendly" relational investing, there is a substantial risk of entrenched managers and exacerbated agency costs. Without adjudicating the ultimate efficacy of relational investing, our analysis illuminates how relational investing might create value and highlights the contexts in which it is most likely to be effective.

We generate three main conclusions from our analysis of relational investing: First, relational investing can reduce agency costs, both by increasing the principal's incentive to acquire information, and by improving the principal's ability to foster a monitoring reputation through a long-term relationship with the firm's management. Large block holders have a greater incentive to monitor than do "rationally ignorant" atomistic shareholders. In addition, the commitment to hold for long periods of time permits relational investors to enter more credibly into self-enforcing implicit contracts that discipline poor managerial decisions and abilities.

Second, relational investing may be better suited to mitigating "moral hazard" problems than traditional types of monitoring. In particular, potential third-party bidders are less likely to respond to problems of moral hazard than to problems of adverse selection. Even in a strong form efficient capital market, external monitors may not have an adequate incentive to discipline managers who have succumbed to moral hazard and caused the corporation to bear an inefficient sunk cost. Relational investors, in contrast, have a multiperiod incentive to respond.

Third, relational investing can be rationalized by either of the following theories: (1) the threat that managers will lose their jobs is minimal; or (2) managers face too great a threat of losing their jobs.

Distinguishing between excessive and inadequate discipline leads us to predict that negotiated and non-negotiated relationships are likely to occur in different settings. Hostile (non-negotiated) relational investments are likely to produce larger gains when managers face too little pressure from internal or external markets. Friendly (negotiated) relational investments produce larger gains when managers face too much pressure from external markets to take inefficient actions. But friendly investments are also more likely to displace valuable external discipline and lead to a reduction in shareholder value. Hence, it is possible that non-negotiated investments would produce more uniformly positive results, while negotiated investments may be consistent with value creation or entrenchment.

This Article is divided into three sections. The first section distinguishes between two different types of "governance failure," which we characterize as distortions and deficiencies in managerial discipline. This section then explores the possibility that poor managers face too low a probability of firing and that good managers face too high a probability of firing. The second section provides a preliminary framework to analyze: (1) why managers may be subject to too much or too little discipline; and (2) whether relational investing can mitigate each type of disciplinary error. In the last section, we explore the characteristics of a market which would make relational investing more likely to add value. This section includes a cursory analysis of two settings where relational investing has already flourished: venture capital investments and certain leveraged buyouts ("LBOs").


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