The paper demonstrates that the optimal incentive contract generates short- or long-termism in corporate policies, defined as short- or long-term investment levels above the levels attainable in the absence of agency frictions. In other words, short- or long-termism can be an optimal response to the dual agency problem over the short and long run. Long-termism arises because the investors find it optimal to expose the manager excessively to long-term shocks. This can be necessary because, with low exposure, the manager’s stake in the firm is diluted by positive shocks to firm value: the manager’s value changes little relative to firm value, so her stake is diluted and, under some conditions, becomes insufficient to run a bigger firm. Our analysis demonstrates that long-termism is more likely to arise when cash flows are more volatile or when the investment technology is less efficient. A key result of the paper is to show that short-termism is more likely to occur when the agent’s stake in the firm is low, and the risk of termination and agency costs are high. Indeed, in such instances, the benefits of long-term growth are limited. By contrast, stimulating short-term investment increases earnings and reduces the risk of termination and agency costs. Interestingly, a recent study by Barton, Manyika, and Williamson (2017) finds using a data set of 615 large- and mid-cap US publicly listed companies from 2001 to 2015 that “the long-term focused companies surpassed their short-term focused peers on several important financial measures.” While our model does indeed predict that firm performance should be positively related to the corporate horizon, it, in fact, suggests the reverse causality. A distinctive feature of our model is that the optimal contract introduces exposure to permanent shocks (via exposure to the firm’s stock price) that is not needed to incentivize investment. In particular, the agent is provided minimal long-run incentives when the firm is close to financial distress and higher-powered long-run incentives after positive past performance when sufficient slack has been accumulated. In this region, incentives have option-like features and increase after positive performance. In other words, positive permanent shocks lead to additional pay-for-performance, and negative permanent shocks eventually eliminate this extra sensitivity to performance implied by the optimal contract. Our model, therefore, provides a rationale for the asymmetry of pay-for-performance observed in the data (see, e.g., Garvey and Milbourn, 2006; Francis et al., 2013).The full paper is available here.
Our view is that there is no single answer here. Each company’s board should clearly and explicitly disclose what its goals are and how the incentive compensation is tied to them, both upside and downside, and then let investors decide which companies are best aligned with their investment priorities.