The Lessons of Michael C. Jensen

From the 1950s to the middle of the 1970s, a few scholars built the foundations for a new field of scholarship, the field of financial economics. Michael C. Jensen, who died last April, is one of these scholars. He has the distinction of having written the most highly cited paper in financial economics. This paper has been hugely influential not only in financial economics, but in other business fields, in economics, and in corporate law. His most important lesson for corporate finance is that the productivity of firms depends directly on corporate finance, so that corporate financial policy is not a side-show but a critical factor in the success of corporations.

In my paper titled “The Lessons of Michael C. Jensen,” I assess how Jensen impacted the field of financial economics and academia more broadly, as well as the world outside academia. Jensen was controversial throughout his career. The New York Times published an article following his death that highlighted both his accomplishments and the controversy that followed him. The article was titled “Michael C. Jensen, 84, who helped reshape modern capitalism, dies.” The title captures his enormous influence, but then the article blames him for the “greed-is-good era.”

The central idea that motivated him was that individuals pursue their own objectives, so they have different interests. These different interests create conflicts that impose costs on organizations. Organizations must manage these conflicts to minimize their costs. Different organizational forms have a different impact on the costs of conflicts of interest, so that different activities are organized using different organizational forms. His most famous article, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” co-authored with William Meckling, shows how financial policy helps corporations reduce the costs of conflicts of interest. The article focuses on conflicts of interest between the manager of a firm and its shareholders, as well as conflicts of interest between bondholders and shareholders. It calls the costs of these conflicts of interest agency costs.

Theory of the Firm helps explain the existence of debt and the role of managerial ownership of shares. This was a seminal contribution as it showed that there is an optimal level of debt even in the absence of corporate taxes. Previous theories of an optimal level of debt were tradeoff theories, which traded off the tax benefit of debt against the costs of financial distress potentially resulting from leverage. Tradeoff theories have no explanation for why firms have debt even when there are no corporate taxes.

Much of the subsequent work of Jensen points out instances where agency costs are poorly controlled and actions that can control them better. Poorly managed agency costs make corporations less efficient through misallocation of resources. Hence, to make corporations more efficient, obstacles to controlling agency costs must be removed and solutions must be found to reduce agency costs. Throughout his career, Jensen studied agency costs caused by a variety of factors, such as entrenched management, free cash flow, and overvalued equity. He also investigated how agency costs could be controlled through devices internal to the corporation such as the choice of capital structure, the choice of payout policy, the distribution of ownership, corporate boards, and compensation policy, as well as through devices external to the corporation, such as the market for corporate control.

An important theme in Jensen’s work is the role of the market in controlling agency costs. He argued forcefully that the market for corporate control has to be left to do its work, so that capital is not wasted by being put to suboptimal uses. Mergers and acquisitions are valuable in allocating resources to the firms that have the best use for them. They also play an important role in disciplining management. Eventually, one expects firms with incompetent or entrenched management to fail, but this process can take a very long time for firms that have a cash cow, a set of assets that produces high cash flows. Managers can use these high cash flows wastefully with little risk of having their firm fail during their tenure. In one of his most famous papers, Jensen calls this issue the agency costs of free cash flow. He points to the example of oil companies that, when the paper was written in the 1980s, earned large cash flows because of high oil prices and used these cash flows to make unrelated acquisitions that destroyed shareholder wealth. He argues that such companies should be forced to pay out their free cash flow.

One way to have such firms commit to paying out free cash flow is to have them issue large amounts of debt, so that they have to use the free cash flow for debt service. Leveraged buyouts lever up firms, so that managers cannot waste free cash flow and must focus on generating enough cash flow to service the debt. These buyouts also make it possible to have concentrated equity ownership, which facilitates monitoring of managers by shareholders. This led Jensen to argue for the benefits of leveraged buyouts and private equity at a time when these practices were under attack. He concluded that the public firm organization form is not well suited to allocate resources efficiently for some types of firms, namely those that have potentially high agency costs that could be reduced through monitoring of management and with sharper constraints on management through debt. His presidential address to the American Finance Association shows that firms in markets that are in decline are especially vulnerable to agency costs.

The paper is available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5159093