The Dynamics of the Management-Shareholder Conflict
Posted: 15 Sep 1999
This paper analyzes the dynamics of the interaction between internal control and outside equityholders and the timing of corporate control contests and management buyouts. The model provides a particularly useful framework to investigate corporate decisions with a dynamic perspective. There is a trading-phase with a rational expectation model of security markets followed by a dynamic game model of a corporate phase in which payout policies and corporate control contests are decided. Internal control shareholders sustain their control by regular dividend payments in equilibrium. The equilibrium dividend policy is supported by the threat of a corporate control contest; a takeover, a directorial challenge or a proxy flight, to remove internal control shareholders from their control over the operation of the assets. When the real cost of capital is very low, then shareholders have long time horizon and they are willing to discipline unsuitable management no matter how costly it is in the short run. Unexpected rises in the cost of capital shift shareholders' time preference toward the present and make them less willing to undertake a control challenge that is costly in the short run. Since a control challenge is likely to cost more to win the larger the management ownership is, management may preempt the threat of their dismissal by increasing their equity stake in their company. The model predicts that when the real cost of capital is low then management holds a negligible stake in their company. When there is an unexpected, significant rise in the real cost of financial capital, a shift that is likely to last long, then internal control shareholders may suddenly and massively increase their stake in their company or take their company private. The implications of the theory are consistent with empirical facts concerning movements of the real cost of capital and the pattern of management buyouts and reverse buyouts in the United States in the 1980s.
JEL Classification: L14, G34
Suggested Citation: Suggested Citation