Relationship Investing: Large Shareholder Monitoring with Managerial Cooperation

Abstract

We characterize conditions under which a large institutional shareholder and the manager of a firm will establish relationship investing, wherein the manager actively cooperates with the institution in the monitoring process, to resolve agency problems. The setting of our model is that of a privately informed manager choosing between a project that has a faster resolution of uncertainty and a project that has a delayed resolution of uncertainty. The agency problem arises because the manager has incentives to focus on the firm's perceived market value, rather than its true long-term value, through his compensation contract and leads to investment distortions. We show that relationship investing solves the agency problem and reduces the free-riding problem associated with large shareholder monitoring. We also show that under some conditions it is optimal for shareholders to make the manager's compensation more distortionary by increasing the manger's incentives to focus on the firm's perceived market value, in order to induce him to cooperate in the monitoring process.