Centralization of Decision-Makingin the Top Management Team

Heitor Almeida

New Ideas and Open Issues in Corporate Finance

Amsterdam, June 15, 2003

Two Notions of Centralization

1 Where in organization should decisions be made2 Centralization of decisions at a given level of the

organization - opening up the boxes

Top Management Team (CEO)

Division Managers

These are Two Different Questions • Examples

– HP until the 80s: decision-making highly concentrated in the hands of founders, but company was a “ loose federation of far flung divisions each finding its own way to contribute to the greater good” (Anders, 2003)

– News Corp.’s magic circle (FT May 20, 2003): office of the chairman is a group of 5 people which meet every Monday to consider “every acquisition and item of capital expenditure”

• Augustin will talk about 1), I will talk about 2)

The Role of Top Managers

• Focus on decision-making at the top level of the organization

• Why is this an important/relevant question for a presentation on centralization?– Decision-making power could have been sent

down the hierarchy

– Isn’t the CEO alone at the top of the hierarchy?

Do Top Managers Matter?

• Question has a long intellectual history in management– No: Lieberson and O'Connor (1972), Hannan and

Freeman (1977)– Yes: Weiner and Mahoney (1981), Hambrick and

Mason (1984), Finkelstein and Hambrick (1996)

• More recent finance and economics literature arguing that managers matter– Malmendier and Tate (2001), Bertrand and Schoar

(2002), Adams et. al (2002)

Is the CEO alone at the top?

• No, or at least not always (Top management team)– FH (1996) loosely define TMT as top 3-10 executives in the

organization such as CEO, Chairman, President, COO, Senior Vice-President, Executive Vice-President, etc.

• TMT also interacts with the board, and with markets (at least when company needs funds)

• Behavioral theory of senior leadership must extend beyond considering executives in isolation

“ Decision-makers are informed, influenced, and sometimes constrained by others, both inside and outside the organization ” (FH 1996)

A View from the Top

CEO Other managers

TMT

board

markets proposed decision

represents an exchange of opinion about decision

final decision

market’s opinion carries more weight when company needs to raise funds - implications for financial policy

A Key Ingredient - Differences of Opinion

• Justifications for disagreement– costly communication– differences in ability to process information– differences in priors– managers are overconfident, or they have “vision”

• Disagreement especially likely for types of decisions made by TMT– weak situation (Mischel, 1977)– for many industries in modern economies there is

uncertainty about logical implications of information and actions (Allen, 1993, Radner, 1997)

Disagreement Implies Fallibility

• When people disagree, some (or all) should be wrong, even when they have common goals (no agency problem required)

“... biases, egos, aptitudes, experiences...greatly affect what happens to companies. This is not to say that managers are weak and sinister, only that they are human and limited.” (FH, 1996)

• With disagreement, issue is not how to give shareholders control, but who should be given control (Allen and Gale, 2000)

Roadmap for Discussion• Simple model of decision-making with disagreement based

on Sah and Stiglitz (1985, 1986, 1988)

• Introduce effect of groups and group interaction

• Applications– Interactions within TMT and optimal design and distribution of

power in the TMT

– Role of corporate boards in decision-making

– Potential implications for behavioral corporate finance

– Managers vs. markets: implications for financial policy

• Caveats– Many more questions than answers

– I will use management and social psychology ideas that are not formally modeled

Simple Model Based on Sah and Stiglitz

• CEO and other top managers face decision of whether or not to implement a given project

• Good projects have NPV of G, bad projects have NPV of -B. Fraction of projects are good

• Fallible decision-making– CEO judges a good project to be good with probability pG

CEO < 1, and he judges a bad project to be good with probability pB

CEO > 0

• Expected output when CEO is deciding aloneYCEO = pG

CEO G - (1 - ) pB

CEO B

• CEO makes two types of mistakes– Type I: reject good project

– Type II: accept bad project

Introducing a Second Member in the TMT• Second member is subject to similar bias as CEO (pG

M < 1, pBM

> 0 )

• Disagreement: second manager might have a different opinion about the project (even after communicating with the CEO)– opinions are not perfectly correlated. Assume they are uncorrelated

– SS never modeled communication explicitly. They assume managers only observe whether the other wants to accept or reject, and do not update

• How will group decision-making affect the final decision?– Suppose that both the CEO and the manager have to accept the project

in order for it to be implemented

• This will lead to the following expected outputYTMT = pG

CEO pGM

G - (1 - ) pBCEO pB

M B

• Group will decrease probability of type II but increase probability of type I error

Optimal Distribution of Power in the TMT

• Decentralizing decision-making power pays off when– CEO is more fallible (low pG

CEO, high pBCEO )

– Manager is less fallible (high pGM, low pB

M )

– Proportion of good projects is low (low )

– Cost of accepting bad projects is high relative to benefit of accepting good ones (high B, low G)

• Notice that when decentralization pays off, it does so because of disagreement– No benefit when opinions are perfectly correlated

– It may be important to incorporate opinions of both managers in the final decision

• See Sah (JEP, 1991) for a summary of other implications of the Sah and Stiglitz’s framework

The Role of TMT Heterogeneity• Management literature has also argued for need to have diverse

top management team in some circumstances– Focus on demographic heterogeneity, i.e. dispersion in age, tenure,

educational and functional background

• Basic idea– Firms in “complex” and “unstable” environments require more diverse

TMT

– Benefits of broader range of skills, diverse interpretations, more debate and questioning, i.e. promotion of disagreement

– In “simpler” environments heterogeneity may be dysfunctional because it promotes conflict and hinders communication

• This idea might already be in the SS model – “Complex” environments might be those where CEO is more likely to

make mistakes, and where cost of type II errors is high

– But I think they are talking about real exchange of information

The Role of Group Interaction• Decision-making group in Sah and Stiglitz is not a truly

interacting group– Nothing is really exchanged, or at least the exchange of information is

not modeled

• TMT heterogeneity idea suggests that group members with diverse perspectives can influence each other and mitigate all types of individual biases– In this case a “complex” environment can simply be one where

fallibility is more important

• Large social psychology literature characterizing exchange of information in groups, and processes by which group members adjust priors following group discussion– Groupthink (Janis, 1972)

– Group polarization (Moscovici and Zavalloni, 1969)

Groupthink

• “...dysfunctional mode of group decision-making characterized by a relentless striving for unanimity, resulting in a reduction in independent critical thinking” (Forbes and Milliken, 1999)

• Fewer options are considered in the discussion preceding a decision because members seek concurrence (they dislike disagreement)– In the model, manager M says that she always agrees with the CEO

even when she does not

– Groupthink reduces benefit of decentralization when it is optimal

• Janis (1972) used this notion to try to understand some famous policy fiascoes such as invasion of Bay of Pigs by US in 1961 (a “perfect failure”)

• GT could be important in TMTs, but I am unaware of any empirical work exploring that

Group Polarization• Tendency for group judgment to deviate significantly from

average of the pre-discussion individual judgements, in the direction of higher “extremity”

– Extremity of a judgment is a measure of its deviation from some neutral point in a scale, such as not agreeing nor disagreeing with a particular statement

– Evidence that group consensus is more distant from the neutral point of the scale than the preconsensus mean

– Individuals seem to change their priors in the direction of higher extremity

• Unlike GT, it is unclear whether this is a bad thing

• Experimental evidence based on laboratory experiments with college students in artificial contexts - unclear whether this is relevant for top executives

Economics Literature on Communication and Exchange of Information

• In my view, what is missing from the SS model is an explicit modeling of communication and exchange of information among group members– Effectiveness of communication will affect optimal structure of

decision-making

– Model could use some of the management and social psychology ideas that I presented for motivation

• Economics’ literature on communication– Radner (1992), Bolton and Dewatripont (1994) - not very relevant for

problems proposed here (I think). More about how to process a given batch of information in the fastest and cheapest way, than about minimizing costs of decision-making errors

– Krishna and Morgan (2001), Dessein (2002), Harris and Raviv (2002) - focus on quality of decision and allocation of decision-making authority under “cheap talk”

Cheap Talk Models

• Models based on Crawford and Sobel (1982)– Strategic communication of information by an “expert” to a decision-

maker

– Decision-maker makes decision that affects utility of both, but the expert has a taste for size (empire builder)

– This agency problem prevents full communication and decreases quality of decision

• Krishna and Morgan (2001) consider multiple biased experts

• Dessein (2002) considers possibility of delegating decision to expert (this turns out to be always better than communicating information to top level decision-maker)

• Harris and Raviv (2002) consider possibility that top level decision-maker also has private information

Cheap Talk Models and Top Management Teams• These papers are more about structure of hierarchies, than

about distribution of decision-making power in a given level of the hierarchy

• Usually agent (division manager) has more information (with the exception of Harris and Raviv) but is biased towards larger investments

• In the TMT – CEO also has information (perhaps he has the best information)

– If there are agency problems these should be similar for all top managers

• Still, it is possible that managers behave strategically when they have biased opinions (if they are aware of other people’s biases)– i.e, they might exaggerate opinions when they interact in a group (group

polarization?)

The Role of Boards

• The established view in corporate finance“Boards are an economic institution that in theory helps to solve

the agency problems inherent in managing an organization” (Hermalin and Weisbach’s survey, 2002)

• Problems– Weak link between board structure and performance (i.e.

insiders vs. outsiders, CEO = Chairman not robustly related to performance)

– Board composition seems inconsistent with pure agency view• CEOs make up largest single slice of outside directors among the

SP500 (20%)

• Very few institutional investors, or other direct representatives of SH

• SH have very little influence over who fills board seats

What do Boards Really Do?• The cynical view - nothing

– Boards don’t matter because they are captured by the CEO

– Boards are just a product of regulation

– Outside directors are carefully chosen so as to be overcommited (thus CEOs)

• Is there an alternative view?– Perhaps boards are an additional “tool” to help the CEO’s

decision-making - a “supra top” management team (FH, 1996)

• Example of an active board doing more than just monitoring on behalf of SH– HP’s board after Fiorina took over (Anders, 2003)

Ideas From Management Literature (FH, 1996)

• External and internal roles for board– external: linking organization to critical

resources/information that reside in the outside environment

– internal: setting strategy and monitoring management

• Limited empirical evidence that boards are systematically involved in setting strategy, and conditions that make this more/less likely– Boards more likely to be advising/evaluating than forming

strategy

– Top managers more likely to have influence on CEO, and thus literature has focused more on them

Interactions Between Monitoring and Advising

• Key difference between boards and other top managers is that boards have (formal) authority over CEO and other managers– Boards can fire CEO/other top managers

– Hiring/firing might be the key monitoring role of board

• Interesting effects to model - complementarities and trade-offs between monitoring (firing/hiring) and advising (direct participation in decision making) by the board– Such a model might help uncover roles that are particular to

corporate boards

Adams and Ferreira (2003)• Key idea: information between CEO and board flows

both ways– Board needs information from CEO to perform advising role.

Advising is a suggestion to accept or reject a project (like in SS)

– But information provided by the CEO also allows board to update prior about CEO’s ability

– CEO cares about being fired and thus may not provide information if board uses the information to update

• Main result is that board may commit not to monitor in order to encourage the CEO to share information– A theory of “friendly” boards. In equilibrium boards may

participate in decision-making but not monitor much

Some Ideas for Behavioral Corporate Finance

• Behavioral corporate finance is about the impact of managerial biases on firm policies and performance (i.e., Malmendier and Tate, 2001)

• Managerial discretion idea (FH, 1996)“...discretion attenuates the relationship between executive

characteristics (values, experiences and so on) and organizational outcomes. Namely, if high discretion exists, executive orientations become reflected in organizational outcomes; if low discretion exists, they do not”.

• Discretion is related to– Distribution of power in the TMT, and between the TMT and

the board

– Environmental factors such as industry and financial slack

Power Levers Up Overconfidence

• In the SS model, we can represent an overconfident (or more precisely, an optimist) CEO as one who holds a stronger belief that the project is good– Optimist CEO judges a good project to be good with probability qG >

pGCEO, and he judges a bad project to be good with probability qB > pB

CEO

• The optimist CEO will clearly overinvest relative to the “rational” CEO (Malmendier and Tate)

• However, tendency to overinvest will also depend on the distribution of power in the TMT– Optimist deciding alone invests with probability qG + (1 - )

qB = x

– Optimist deciding in group invests with prob. qG pGM +

(1 - )qB pBM < x

Optimal Bias and Centralization

• It might be optimal to have an optimist CEO– Even in basic SS model, rational CEO makes more type I

errors (rejects good projects more often)

– Optimality of bias even more likely if we introduce “motivating” effects of optimism (vision), as in Rotemberg and Saloner (2000) and Van den Steen (2001)

• If it is optimal to have a visionary CEO it might also be optimal to centralize top-level decision making (within TMT, and perhaps also weak boards)– No dilution of vision with decentralized decision-making

– Example: CEO = Chairman is required to “ensure existence of illusion of strong leadership in a firm” (Finkelstein and D’Aveni, 1994)

Empirical Measures of CEO Power and Discretion• It is possible to construct proxies for the distribution of

power in the TMT, and between TMT and boards (Adams

et al. 2002, Haleblian and Finkelstein, 1993)– Formal titles of CEO (President, Chairman, etc.);

– Founder status;

– TMT executive’s membership on the board;

– Number of boards where executive is member;

– Compensation ratios in the TMT;

• It is also possible to construct environmental measures of managerial discretion based on industry (Adams et al, 2002,

Hambrick and Abrahamson, 1995)• These measures can help sharpen tests of behavioral

hypotheses!

Managers and Markets

• Compared to top managers and boards, outside investors are farther away from corporate decision-making– And boards do not seem to represent their interests that much

• Still, outside investors will have their own opinions about optimal actions and consequences of actions taken by management– Ex: HP & Compaq merger

Disagreement Between Managers and Markets

• What is the nature of this disagreement?– Allen (1993): because many investors are computing values,

on average mistakes cancel out and markets end up more precise than managers

– Allen and Gale (1999): markets may allow for matching between opinions of investors and managers

– Behavioral finance sometimes assumes that markets are right and managers are biased (i.e. Malmendier and Tate), sometimes that managers are right and markets are wrong (i.e. Baker and Wurgler)

• Given possibility of disagreement, question is when will outside investors have discretion to influence firm policies

Disagreement and Financial Policy

• The most obvious effect– Outside investors will have more discretion when firms need

to raise funds

• One of the primary purposes of corporate financial policies might be to determine the extent to which firms (managers) can rely on their own perception of the world (Allen, 1993)

• Theories based on disagreement and discretion might help explain some of the main facts of corporate finance– Firms dislike external finance

– Financial slack matters for investment and financial policies

Why not Focus on Cash Policy ?• There are already some papers relating disagreement

and discretion (flexibility) to financial policy– i.e., Boot and Thakor, 2002

• Focus is on effects of disagreement and flexibility on optimal security design and issuance– This might be a secondary concern: cash (internal finance)

gives you maximum flexibility. The main issue might be how to avoid raising external finance

– A framework to think about optimal cash policies: Almeida et al, 2003

• The empirical challenge will be how to differentiate such a theory from existing arguments– Financial constraints, agency

Conclusions• Behavioral theory of senior leadership should

incorporate role of other constituencies that might have discretion to influence top-level decision making– Top management teams, boards and markets

• Questions– When do they have discretion?

– What is the optimal level of discretion?

– What is their effect on the quality of corporate decisions and corporate performance?

• These research questions might generate insights about important unsolved issues in corporate finance, such as the role of boards and optimal financial policy