Agency costs: what shareholders pay when someone else makes the decisions

Agency costs are the loss of value that arises when capital is controlled not by its owner but by a hired manager with interests of their own. They are not a line in the income statement. They are made up of the cost of monitoring management, the cost management itself incurs to prove its good faith, and a residual loss: the part of value that could not be preserved even after all those efforts. For an investor in the Russian market this is a practical matter. Two stocks with the same underlying economics trade at different valuations precisely because the market has different degrees of confidence about where the cash flow a company earns will end up.

Where the conflict of interests comes from

The framework was set out by Jensen and Meckling in 1976, and its substance has not changed since. The principal (the shareholder) hires an agent (the executive) and cannot observe the agent's effort directly, only the outcome, which is also shaped by market conditions. The agent receives fixed pay and reputation, while the risk of a bad decision is borne mainly by the principal. This produces systematic distortions.

One of them is a bias towards growth for the sake of size. A manager's status and pay are usually tied to the scale of the business rather than to the return on invested capital, so the temptation to put free cash flow into a low-return deal is stronger than the temptation to return it to shareholders. Another is consumption at the company's expense: from facilities and entertainment spending to non-core assets that are convenient for management and useless to the owner. The third distortion runs in the opposite direction: excessive caution. A manager has no diversification; their human capital is tied to a single company, and they may turn down a risky project with a positive expected value that a shareholder holding a portfolio would welcome.

What the costs themselves consist of

Monitoring costs are borne by the owner: the board of directors and its independent members, external audit, the disclosure system, internal control, committees, and valuation by an independent appraiser. Bonding costs, the cost of demonstrating good faith, are borne by the agent and the company: voluntary disclosure beyond what is required, an adopted and published dividend policy, covenants in loan agreements, and long-term incentive plans linked to per-share metrics. The residual loss is what remains after the first two: suboptimal decisions that no procedure caught. It can never be reduced to zero, and the attempt to do so becomes a cost in its own right: beyond a certain level of oversight, every additional rule costs more than the damage it prevents.

The conflict is not just manager versus shareholder

For the Russian market a different axis matters more. Where ownership is concentrated, the main conflict lies between the controlling shareholder and minority shareholders. The controlling owner directs both decisions and cash flows and can extract benefits in ways that are not shared in proportion to stakes: related-party transactions, transfer pricing within the group, moving the profitable part of the business to a level minority holders cannot reach, a reorganisation at an unfavourable valuation, or taking a subsidiary out of consolidation. The Federal Law "On Joint-Stock Companies" responds procedurally: liability of executives and board members for losses (Art. 71), the regime for interested-party transactions (Chapter XI), the mandatory offer when a controlling stake changes hands (Art. 84.2), and the right to demand a buyback of shares following certain decisions (Art. 75). These procedures reduce the costs but do not eliminate them.

There is also a third axis: shareholders versus creditors. The holder of an equity instrument benefits from additional risk, keeping the upside while sharing the downside with creditors. Hence asset substitution, large dividends funded with borrowed money, and the build-up of senior debt. Creditors respond with covenants, collateral and restrictions on payouts, and these are exactly the bonding costs that show up in the cost of servicing debt. Comparing yields on corporate issues with the OFZ curve and other debt instruments is, among other things, the market's assessment of a particular issuer's agency risk.

Where it shows up in the data

There is no direct metric for agency costs, only indirect signs, and they need to be read in primary documents rather than in second-hand summaries. Look in issuers' financial statements for: the relationship between capital expenditure and return on invested capital, growth in non-core assets, the volume and terms of related-party transactions in the notes, compensation of key management personnel, and movements in working capital that operations do not explain. Set this against what the company returns to its owners: the history and terms of payouts and the upcoming dates:

Decisions that change the balance of interests pass through shareholder meetings and boards, and their schedule is in the corporate events calendar.

Regular, predictable payouts and share buybacks act as a discipline: they take free cash flow out of the company before it can be invested in a weak project. Moderate debt works the same way, since mandatory payments narrow the room for discretionary decisions. This explains a well-known effect: the market usually greets a higher payout or an announced buyback positively, and a large cash acquisition warily, even without knowing the details of the deal.

What a private investor should do about it

Agency risk cannot be eliminated, but it can be assessed and a premium can be demanded for bearing it. In practice this means: building an adjustment for the quality of management into a valuation, not just relying on a multiple; reading the notes to the financial statements rather than the press release; voting your shares rather than ignoring the meeting; and tracking changes of control and reorganisations as events that alter your position. Collective investment vehicles add another layer of the same conflict, this time between you and the management company; its price is examined in hidden fund costs. Agency costs should not be confused with execution costs: the former arise from the structure of ownership and governance, the latter from the mechanics of a trade on the exchange. Other definitions are in the glossary.