Long-Term Bias

Michal Barzuza is Nicholas E. Chimicles Research Professor of Business Law and Regulation at the University of Virginia School of Law and Eric Talley is Isidor and Seville Sulzbacher Professor of Law at Columbia Law School. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); The Uneasy Case for Favoring Long-Term Shareholders by Jesse Fried (discussed on the Forum here); and The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here).

The perceived dangers of “short-termism” in public capital markets have come to occupy center stage as a chief concern for corporate America. During the last decade, an emerging conventional wisdom has taken root among lawyers, business commentators, judges, policymakers and (at least some) investors, asserting that managers of public companies are too often pressured to pursue short-term gains at the expense of managing for long-term value. Although concerns about short-termism are hardly new (recurring for over a quarter century), the recent rise of hedge fund activism and corporate governance intermediation has added a sense of urgency—if not emergency—to the critical chorus warning of the perils of myopia.

Much of the ensuing debate about short-termism has tended to revolve around competing claims concerning the phenomenon in isolation. Many skeptics, for example, have rejoined that arbitrage activity in efficient capital markets should create a natural corrective mechanism that eviscerates (or substantially dampens) most short-term biases. Others have questioned the magnitude of the phenomenon, or argued that claims about short-termism are little more than disingenuous apologies for managerial agency costs and empire building. Nevertheless, manifest concerns about the perils of short-termism—and the existential threat it poses for long-term value creation—persist in both public discourse and some influential corners of academic research. The kerfuffle over short-termism has attracted passionate adherents on both sides, with the resulting battlefield resembling something close to a standoff.

In a recent working paper, we argue that the stalemate over short-termism might be due (at least in part) to the failure of advocates from both sides to confront seriously two curious paradoxes about their own debate. First, even if episodic short-term bias might conceivably emerge in appropriate capital market settings, its persistence over time is difficult to explain. Why would sophisticated market participants, for example, deliberately and repeatedly leave money on the table during both economic upturns and downturns, eschewing superior long-term investments in order to extract a quick payout? The conventional response that hedge fund managers are compensated to think in like short-termists rings particularly hollow: nothing requires the persistence of standard “two and twenty” compensation packages; and yet, hedge funds have generally not backed away from it (doing the opposite if anything). The second puzzling aspect of the current debate concerns the concept of long-term value creation itself, and its seemingly “deified” status as the consensus gold standard for corporate governance. In other words, while the clash over the existence and/or magnitude of short-term bias has raged on, most seem willing to stipulate that long-term value maximization remains a paragon objective (quibbling only about how best to realize it).

Our paper attempts to gain some traction on this debate by introducing a novel notion of long-term bias: namely, an inclination for managers to favor inferior long-term projects over short-term alternatives that have superior returns. While short-term bias typically originates from external  sources in the capital markets, long-term bias emerges internally, from managers’ assessments about their own long-term projects. Long-term bias, we argue, is likely to be particularly salient for managerial decisions makers, because (1) managers are inclined to be highly optimistic in general; (2) they tend to discount feedback and relevant data; and (3) they tend to receive such feedback more sporadically for long-term endeavors. Consequently, we argue, mangers’ long-term projects are particularly prone to persistent overestimation. Our analysis of how and why long-term investments are systematically prone to overestimation draws primarily on extensive literatures in psychology and behavioral finance, but we also buttress it with three extended case studies from mainstream companies (Yahoo, AOL and Navistar), where managerial overconfidence about long-term investments seem to have thrived, only to be disrupted by hedge fund activism.

To the extent that our account of long-term managerial bias is persuasive, it holds several implications for corporate law and policy. Most directly, it suggests that external pressures by activists can have some positive ramifications, even if they tend to overemphasize short-term performance, since such myopia may place an institutional damper on at least certain forms of long-termist overinvestment. Moreover, short-term pressure to unlock cash increases the frequency of external feedback and benchmarking for managers, since it requires them to draw more regularly on external sources to finance their projects. It is well known that overconfidence tends to feed on a surplus of internal funds (e.g., retained earnings) to underwrite projects. If overconfident managers are required to raise capital externally (because activists keep capital margins thin), they will have to subject their strategies more frequently to outside assessment.

Our analysis bears on several current reform proposals to re-shape doctrines, laws and regulations in order to protect long-termism management from short-term demands. The proposed Brokaw Act, for example, intends to limit hedge fund activists through a variety of disclosure and liability measures. The SEC (prompted by a Presidential tweet) is investigating the elimination quarterly reporting requirements. And, a series of recent Delaware Chancery Court opinions (see, e.g., here, here, and here) have held that a director nominee of a short-term investor or hedge fund might breach fiduciary duties by pursuing strategies that appear to disregard the firm’s long-term equity value. Our analysis counsels some degree of caution in pursuing these legal and regulatory interventions: If such interventions do not account for the possibility of value-reducing long-termism too, the results could miss their mark by focusing on only half the problem.

Our argument also bears (among other things) on the phenomenon of dual-class IPOs. Despite a potential discount to the IPO price, overconfident managers, who believe that the market is likely to undervalue their long-term project, may embrace a dual-class structure to protect their projects from subsequent shareholder revolts. While our strong intuition is to leave such capital-structure decisions up to the promoters (who must internalize the discount, after all), long-termism may well imply that at least some fraction of dual-class structures is unwise or inefficient.

While our paper focuses on establishing that long-term bias exists and can distort corporate decision making, we do not aspire to displace or refute the prevailing narrative about the dangers of short-term bias. Quite to the contrary, a key puzzle surrounding short-termism—its stubborn persistence over time—becomes far less paradoxical when short-termism is viewed as an institutional “chaperone” to long-termism. Because the two biases affect managers in opposing directions, they tend to counteract one another’s most glaring shortcomings. Once one relaxes utopian assumptions about the sacrosanctity of long-term value, persistent and durable short-termism among sophisticated investors becomes both more plausible and symbiotic. Viewed thusly, long-term bias is the yin to short-termism’s yang.

Finally, even if one accepts our constructive argument, it concededly comes straight out of the “shareholder primacy” handbook, equating firm welfare to shareholder welfare. While this normative frame is now well established, the relative merits of long-term versus short-term management could easily change when reckoned against alternative objectives. One important and re-emerging dialogue within corporate law concerns the extent to which fiduciaries do (or should) accord weight to a broader set of constituencies beyond stockholders. Creditors, employees, customers, suppliers, and surrounding communities may also have a stake in company decisions, yet are rarely accorded the same status under corporate law that shareholders receive. And, it seems plausible that many overconfident long-term strategies might also bestow collateral benefits on non-shareholder constituencies (e.g., aggressive R&D programs that increase the company’s workforce). Thus, even if our arguments are correct, long-term value maximization could still emerge attractive precisely because it endows managers with the equanimity to pursue strategies that are both overconfidently sanguine and stakeholder friendly. While we welcome this dialogue, we also submit that a host of alternative mechanisms exist for ensuring stakeholder-friendly governance, including public benefit corporate structures, alternative financing arrangements, tax incentives, and even top-down regulation. Some of these alternatives could well outflank managerial long-termism in harmonizing the interests of multiple stakeholders. Some will not. But at the very least, the relevant comparisons deserve to be made transparently, and upon equal footing.

The complete paper is available here.

Both comments and trackbacks are currently closed.

One Comment

  1. reader
    Posted Friday, March 8, 2019 at 12:06 am | Permalink

    Thoughtful, common-sense piece.