The Benefits of Over-investment in volatile Market Conditions. Evidence from Research.
Updated: May 11
A theoretical study shows that over-investment into liquidity-generating capital can increase the value of a company in volatile market conditions by making it easier to motivate the company’s workforce. The findings of the study have implications for the optimal design of incentives and management practices in companies in times of crisis.
Over-investment - An Agency Problem
A prominent fact in corporate finance is that managers tend to over-invest, i.e. marginal costs exceed (direct) marginal benefits of an investment. Numerous theories have been developed to explain this pattern, including managers’ taste for empire building, short-termism of managers, managerial over-confidence, or asymmetric information with respect to new investment opportunities.
All of these theories share the perception that over-investments are caused by agency problems between a firm and its management. Hence, mechanisms to reduce free cash-flow — and consequently the management’s ability to invest — have been suggested as optimal responses to this perceived fundamental agency problem. However, there is no clear evidence that reducing a firm’s free cash-flow and restricting a manager’s investment opportunities increases the firm’s value — on the contrary, investors often assess capital investments positively. Evidence from Research
In their study "Size Matters: How Over-investments Relax Liquidity Constraints in Relational Contracts" Florian Englmaier and Matthias Fahn investigate how over-investments relate to a firm's workforce in volatile market conditions.
To conduct the study the researchers setup a theoretical model in a setting where firms face varying cash-flow streams, and where the firm cannot rely on court-enforceable contracts to motivate their workforce, but has to use relational contracts instead.
The study finds that over-investments are not necessarily the (negative) consequence of agency problems between shareholders and managers but that over-investments might be a second-best optimal response to contracting frictions like limited commitment and limited liquidity. Moreover, the study finds that over-investments into liquidity generating capital can increase the efficiency of a firm’s labor relations, if a firm has to rely on relational contracts to motivate its workforce and if it faces a volatile environment.
In relationships with employees, firms generally face an intertemporal trade-off: Treating their employees well comes with costs but has (future) benefits such as higher motivation and loyalty. When a firm faces volatile market conditions and commitment problems because it cannot use formal, court-enforceable contracts to provide incentives the firm can choose to over-invest to motivate their workforces.
Over-investment prior crisis: If the investments make it easier to compensate workers also in difficult times, they ease the burden for workers in times of a crisis and make it easier for firms to treat employees well in good times. Moreover, firms that have treated their employees well prior to the crisis can benefit from it in these times because employees are more willing to carry some of the burden the crisis brings with it.
Over-investment during crisis: Higher investments help because they increase rents as soon as the situation has again improved. Furthermore, these rents can only be captured by a firm if it keeps its relationships with workers alive. Keeping employees in times of crisis is a particularly strong signal for a firm's commitment towards its employees and will also have a huge effect on their employees's future loyalty.
Reference: Englmaier, Florian, and Matthias Fahn. "Size Matters: How Over-Investments Relax Liquidity Constraints in Relational Contracts."The Economic Journal 129, no. 624 (2019): 3092-3106.