EMPIRE-BUILDING: countering inefficient business expansion

In the popular imagination, managers often suffer from a predilection for “empire building” – that is, growing their firms inefficiently large through expansion and wasteful acquisitions.

We generally attribute this tendency to an excessively ambitious personality, but over-investment is a common phenomenon among managers. New research by Matthias Fahn and Florian Englmaier, published in the November 2019 issue of The Economic Journal, looks at how managers’ over-investment affects performance and damages economic growth.

The authors argue that, since an increase in “standard” investment may at the same time necessitate a reduction of R&D spending and potentially harm economic growth in a wider context, the reasons behind the ‘over-investment’ phenomenon must be well-understood before suggesting effective countermeasures.

Contrary to the usual tenor in the literature that over-investment results from frictions in the relationship between manager and shareholders, the research suggests that it may serve as a means of mitigating issues of both commitment and liquidity.

In multiple entrepreneurial settings, managers cannot verify their employees’ effort and must therefore promise bonus payments in order to sufficiently motivate their workforce. Since these incentives often cannot be established in formal contracts, managers may be tempted to deviate from the deal if they find it profitable to do so.

The commitment problem of keeping this promise becomes particularly pressing if the value of expected future profits is low – either due to low output or high impatience on the manager’s side, implying that she values revenues generated in the future (much) less than those closer to the present.

While previous literature has mostly focused on this “personal” friction only, the authors of this new paper have developed an approach which also takes into consideration possible liquidity constraints.

Plausibly, the bonus payments a manager promises her employees cannot exceed the cash generated by output sales; hence, the manager is restricted in choosing the height of the payments. In our complex political and economic world, demand has proven to be rather volatile which in turn results in varying amounts of available cash on the side of the firms.

It is therefore anything but unlikely that managers may find themselves restricted by liquidity considerations in times of low demand. This then has a decisive impact on the height of the bonuses a manager can pay her workforce and consequently, in the level of effort she can induce.

The authors explain over-investment as a measure taken by the manager to relax the constraints of commitment and limited cash flow: additional investment, though it may be beyond the point of maximum profitability, yields an increase in output and hence increases the firm’s cash base. Therefore, the manager can promise higher bonus payments which in turn promotes employees’ motivation and eventually results in their showing higher (future) effort levels. Not only is the liquidity constraint consequently less of an issue for the manager but her commitment problem is mitigated as well: as her future expected profits become larger due to an increase in both capital investment and effort, she finds herself less tempted to deviate from the deals struck with her employees.

Even when amending the basic setting and allowing for more complex financial interactions, the conclusion remains unchanged. Alleged over-investment can mitigate commitment and liquidity issues. This is a crucial finding for corporate finance since the established general solution of reducing a firm’s free cash-flow in case of over-investment must be critically reflected upon. New recommendations of which actions are to be taken must consider the potentially beneficial effects of this presumed ineffective practice.

Size Matters: How Over-Investments Relax Liquidity Constraints in Relational Contracts is published in the November 2019 issue of The Economic Journal

Matthias Fahn

Assistant Professor at Johannes Kepler University Linz

Florian Englmaier

Professor of Organizational Economics at University of Munich