Over the long pull, there is one simple criterion for the survival of a business enterprise: Profits must be nonnegative. No matter how strongly managers prefer to pursue other objectives [...] failure to satisfy this criterion means ultimately that a firm will disappear from the economic scene (Scherer, 1980).The hypothesis that competition mitigates managerial slack is important, should it turnout to be true.
In a new NBER Working Paper, Xavier Giroud and Holger M. Mueller try to test whether or not it is true. Their paper asks "Does Corporate Governance Matter in Competitive Industries?" Giroud and Mueller test the hypothesis that competition mitigates managerial slack by using exogenous variation in corporate governance in the form of what are called business combination (BC) laws. BC laws impose a moratorium on certain transactions, especially mergers and asset sales, between a large shareholder and the firm for a period ranging from three to five years after the large shareholder's stake has passed a prespecified threshold. Importantly such a moratorium hinders corporate raiders from gaining access to the target firm's assets for the purpose of paying down acquisition debt, thus making hostile takeovers more difficult and often impossible. By reducing the threat of a hostile takeover, BC laws thus weaken corporate governance and increase the opportunity for managerial slack. There were 30 such laws passed between 1985 and 1991 on a state-by-state basis in the US.
When summarising the results of their research Giroud and Mueller write
Using the passage of BC laws as a source of identifying variation, we examine if these laws have a different effect on firms in competitive and non-competitive industries. We obtain three main results. First, consistent with the notion that BC laws increase the opportunity for managerial slack, we find that firms’ return on assets (ROA) drops by 0.6 percentage points on average. Given that the average ROA in our sample is about 7.4 percent, this implies a drop in ROA of about 8.1 percent. Second, the drop in ROA is larger for firms in non-competitive industries. While ROA drops by 1.5 percentage points in the highest HHI (Herfindahl-Hirschman index) quintile, it only drops by 0.1 percentage points in the lowest HHI quintile. Third, the effect is close to zero and statistically insignificant for firms in highly competitive industries. Thus, while the opportunity for managerial slack increases equally across all industries, managerial slack appears to increase only in non-competitive industries, but not in highly competitive industries, where competitive pressure enforces discipline on management. It is in this sense that our results suggest that competition mitigates managerial slack.Giroud and Mueller go on to point out that while their results suggest that competition mitigates managerial agency problems, they do not say which agency problem is being mitigated. Does competition curb managerial empire building? Or does it prevent managers from enjoying a “quiet life” by forcing them to “undertake cognitively difficult activities”? Giroud and Mueller explain
We find no evidence for empire building. Capital expenditures, asset growth, PPE growth, the volume of acquisitions made by a firm, and the likelihood of being an acquirer are all unaffected by the passage of the BC laws. In contrast, we find that input costs, overhead costs, and wages all increase after the laws’ passage, and only so in non-competitive industries. Our results are broadly consistent with a “quiet life” hypothesis, whereby managers insulated from hostile takeovers and competitive pressure seek to avoid cognitively difficult activities, such as haggling with input suppliers, labor unions, and organizational units within the company demanding bigger overhead budgets.Giroud and Mueller also wonder if the effect shows up in stock prices. To test this they conduct event studies around the dates of the first newspaper reports about the BC laws. Their results show that
Across all industries, we find a significant cumulative abnormal return (CAR) of −0.32%. When we compute CARs separately for low- and high-HHI portfolios, we find that the CAR for the low-HHI portfolio is small and insignificant, while the CAR for the high-HHI portfolio is large (−0.54%) and significant. Similarly, if we compute CARs for low-, medium-, and high-HHI portfolios, we find that the CAR for the low-HHI portfolio is small and insignificant, while the CARs for the medium- and high-HHI portfolios are large (−0.44% and −0.67%) and significant.So overall Giroud and Mueller find that, consistent with the notion that competition mitigates managerial slack, while firms in non-competitive industries experience a significant drop in operating performance after the laws' passage, firms in competitive industries experience no significant effect. When they examine which agency problem competition mitigates, the evidence is in support of a "quiet-life" hypothesis. Input costs, wages, and overhead costs all increase after the laws' passage, and only so in non-competitive industries. Similarly, when they conduct event studies around the dates of the first newspaper reports about the BC laws, their results find that while firms in non-competitive industries experience a significant stock price decline, firms in competitive industries experience a small and insignificant stock price impact.