Agency theory is the branch of financial economics that looks at conflicts of interest between people with different interests in the same assets. This most importantly means the conflicts between:
- shareholders and managers of companies
- shareholders and bond holders.
Agency theory explains, among other things, why:
- companies so often make acquisitions that are bad for shareholders.
- convertible bonds are used and bonds are sometimes sold with warrants
- capital structure matters.
Agency theory is rarely, if ever, of direct relevance to portfolio investment decisions. It is used to by financial economists to model very important aspects of how capital markets function. However, investors gain a better understanding of markets by being aware of the insights of agency theory.
One particularly important agency issue is the conflict between the interests of shareholders and debt holders. In particular, following a more riskier but higher return strategy benefits the shareholders to the detriment of the debt holders.
It can easily be seen why debt holders lose out: a more risky strategy increases the risk of default on debt, but debt holders, being entitled to a fixed return, will not benefit from higher returns. Shareholders will benefit from the higher returns (if they do improve), however if the risk goes bad, shareholders will, thanks to limited liability, share a sufficiently bad loss with debt holders.
This conflict can be addressed by the use of debt covenants, or by providing debt holders with a hedge against such action by the shareholders by issuing convertible debt or debt bundled with warrants.