N. K. Chidambaran, John Kose
ABSTRACT
We characterize conditions under which a large institutional
shareholder and the manager of a firm will establish relationship
investing, wherein the manager actively cooperates with the institution in
the monitoring process, to resolve agency problems. The setting of our
model is that of a privately informed manager choosing between a project
that has a faster resolution of uncertainty and a project that has a
delayed resolution of uncertainty. The agency problem arises because the
manager has incentives to focus on the firm's perceived market value,
rather than its true long-term value, through his compensation contract
and leads to investment distortions. We show that relationship investing
solves the agency problem and reduces the free-riding problem associated
with large shareholder monitoring. We also show that under some
conditions it is optimal for shareholders to make the manager's
compensation more distortionary by increasing the manger's incentives to
focus on the firm's perceived market value, in order to induce him to
cooperate in the monitoring process.
John: (212) 998-0337 kjohn@stern.nyu.edu
Chidambaran: (504) 865-5479 chiddi@mailhost.tcs.tulane.edu
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