Financial Management Association International

Managerial Reputation and Corporate Investment Decisions Author(s): David Hirshleifer Source: Financial Management, Vol. 22, No. 2 (Summer, 1993), pp. 145-160 Published by: Blackwell Publishing on behalf of the Financial Management Association International Stable URL: . Accessed: 18/02/2011 17:23 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at . . JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at . . . Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@.

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ManageriaRl eputationand Corporate Investment Decisions

DavidHirshlelfer

David Hirshleiferis an AssociateProfessorof Financeat theAndersonGraduateSchool of Management,Universityof Californiaat LosAngeles,LosAngeles, California.

0 Duringthe 1980s,GeneraMl otor'sChairmaanndCEO RogerSmithundertookvast capitalexpendituresa,nd pursuedhis visionof GMas a leaderin newproduction techniqueasndlabormanagemenTt.hisincluded$40billioninnewequipmenbtetween1979and1987(seeBusinessWeekM, ay18,1987),theself-consciousliynnovative developmenotftheSaturnlineofcars,andtheintroduction ofroboticproductiomn ethodsI.nhindsight,hedisastrous consequenceosf thesepoliciesareevidentto all. At the time,howevert,herewasmoreroomforcontroversIyt.was plausiblyarguedby some thatmassiveinvestmenat nd innovativexpenditurwe asneededto meetthecompetitivechallengeof theJapanesecarmanufacturerAs.ndas GM'smarkesthareandproductivitfyell,itwaspointedout thatradicacl hangeis costly,thatthepayoffto innovation oftendoesnotarrivein theshort-terma,ndthatcourage wasneededtorevolutionizteheAmericancarindustryA. s RogerSmithputit,"Don'twritethebookonmeuntilI've

I thankTarunChordiaandespeciallytheeditor,AnjanThakor,forhelpful comments.

beengoneat leastten years.It'stoo early.You'vegot to waitandsee."(Lee[30])

AlthoughSmithmadethewrongcall,Smith'sreputation as a managerbenefitedfromthe fact thathe was followinga verylong-terminvestmensttrategyA. s a consequence,earlysignsof failure(decliningmarketshare, lowprofitabilityw)erenotjudgedasharshlyastheywould havebeenif his policiesweredesignedto generateimmediateperformancea,ndstillfailed.Sincehis strategy arguablhyadgreatlong-termpromisen, oteveryoneknew justhowbadlythingswouldturnout.

Thiscaseleadsonetosuspecthatmanagerws illsometimesintentionallcyhooseinvestmensttrategietshattake a longtimetoevaluatefairly1. Insomecases,thismaybe

'If a managercan avoid looking bad by following a long-termstrategy, why don't all managersdo it? For one thing, a superiormanagermay want his projectoutcome to be resolved early,which demonstrateshis high ability to investorssooner.Given thatmanagerswho believe they aresuperiorpreferearly-resolvingprojects,a managerwho knowshe is not superiorfaces a toughchoice. By choosinga long-termstrategylike RogerSmith's,he can avoida visible earlyfailure.Butsince topmanagers

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because long-terminvestmentsare the most efficient for the firm. In others,it may be that long-terminvestments are inefficient for the firm, but they are chosen because they affordthe managerprotectionfromthe riskof being viewed as a failureearlyon.

This exampleis a specialcase of a moregeneralpoint. This article is based on the fundamental fact that a

manager'sinvestmentdecisionsaffecthisreputationE. ven PresidentClintonhas stakedhis reputationon the strategy he is designingfor U.S. governmentspendingandinvestment. Because of a concern for reputation,managers sometimesmakeinvestmentchoices thatarebadforshareholdersbut good for the manager- because they make the managerlook good in the shortrun.

Managershavegood reasonto be concernedwithmaintainingtheirreputationsfor high ability,bothin the short runandthe long run.Apartfromdirectvalue of prestige, highreputationgives themanagerbetterbargainingpower to increasehis pay.Even if a manager'ssole purposewere to maximizeshareholdervalue,he maybe concernedwith the firm's reputation.Investors'beliefs about his ability andhis firm'sassets andcapacitieswill affectthe priceat which the firmcan raisecapital,hire employees and sell its products.

Managersoftenhaveinformationabouttheprofitability of alternativeinvestmentdecisions that is unavailableto

outside investors.Furthermorei,nvestorscannotperfectly observethe manager'sinvestmentchoices. This gives the managerleeway to follow policies thatdo not maximize profitabilityin the long run, but improvethe manager's immediate reputation.For example, the manager of a pharmaceuticaflirm may investheavily to accelerateapprovalof a medication,if testing andFDA approvalwill reflect well on him. This can hurtshareholdersif the cost

is disproportionateA. notherexampleis a consumerretail chain cutting investmentin store quality and customer service in orderto make earningsseem high in the short run.

This article reviews researchon the manipulationby managersof investmentdecisions owing to a desire to influence perceptionsabout a manageror firm, and in

particular,with reputationaleffects on investmentdeci-

tryto choose projectswhose outcomesarevisible early,the verylack of earlyresolution,atleastto someextent,tipsinvestorsoff thatthemanager is inferior.Still, as will be discussedlater,evena good managercan have good reasonto pick a long-term,late-resolvingproject.In otherwords, promisinga rosy future is the last refuge of incompetence;but some managerswho promisea rosy futureare, in fact,telling the truth.

sions.2 The term "reputation-building"is more general than the concept of "signalling"introducedin academic modelsof capitalstructurein the 1970s.One coulddefine signallingas any actiontakenby a managerthatconveys informationto others,but this does violence to the term. The basic notion of signalling is taking a visible action (such as choosing a capital structure)for the primary purposeof conveyinginformationto others.Moregenerally,even hiddenactionshaveconsequencesthatareeventuallyvisible, so reputationacl onsiderationsaffect firms' hidden investmentdecisions (such as customer service activities) even though these decisions are not used as signals.Also, reputationacl onsiderationsaffectimportant decisions, such as whether to undertakea major new project,even thoughthe primarymotivationfor the project may be profitability.

The main lessons of the papercan be summarizedas follows. Managershave an incentive to use investment choices as a tool for buildingtheirpersonalreputationsor the reputationof their firms. These incentives come in threemainforms:visibilitybias,whichencouragesa manager to try to make short-termindicatorsof success look better;resolutionpreference,whichencouragesa manager to try to advancethe arrivalof good news and delay bad news; and mimiciy and avoidance, which encourages a managerto taketheactionsthatthebestmanagersareseen to take, and to avoid the actions the worst managersare seen to take.

These incentivesimply a varietyof investmentbiases. Theseinclude:secretlysqueezinginvestmentso thatshortterm cash flows look higher; liquidatingassets prematurely to reveal that they are worth a lot; undertaking unprofitableinvestmentsto tryto makeit seem likea firm with good projects available; undertakinginvestments whose outcomeswill be resolvedsoon, to revealthatyou are a good manager;undertakinginvestmentswhose outcomes will be resolvedin thedistantfuture,to concealthe

fact thatyou area mediocremanager;avoidingprofitable projectsthathave a high risk of early failure,to protect short-termreputation;hedging on corporateaccount, to reduce reputationalrisk; avoiding marginallyprofitable

newprojects,sinceinvestorswill attributelow profitability to a lack of managerialtalent;escalatingbad projects,to avoid concedingthatfailurehas occurred;conformingto the decisions of othermanagers,to avoidseeming unreliable,or in orderto bejudgedagainsta comparablebench-

2Fora briefexpositionof how otherdecisions areinfluencedby reputation, see Hirshleifer[211.

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mark;anddeviatingfromothermanagers,in orderconceal

mediocrity. Thus,reputation-buildingaffectsthe firm'sattitudeto-

ward risk, what projects it undertakesand terminates, whetherit obtainsresolutionof projectoutcomeearly or late, andwhetherit chooses the sameprojectsas ordifferent projectsfromindustrycompetitors.Some researchers have developed models of reputation-buildingwith implicationsthatseem consistentwithrecentallegationsthat U.S. businessunderinvestsa, voidsriskexcessively,andis too conformist.However,takenas a whole, thetheoretical andempiricalresearchon this topic neithersubstantiates nordisprovesthese claims.

The remainderof the paper is structuredas follows. Section I discusses the motives for a manager to use investmentpolicy as a tool for buildingreputation- of himself or his firm. Section II provides a taxonomy of differentkinds of reputationaldistortionsthat can arise fromreputation-buildingincentives.Section IIIthen analyzes four differentkinds of applications:cash flow manipulation (Section III.A.), risk manipulation(Section III.B.),projectstransitions(Section III.C.),andconformism/fads in investment(Section III.D.). Section IV concludes andprovidesrecommendationsfor investmentpol-

icy.

I.WhyManagersWantto BuildTheir Reputations

Consider a manager who decides today whether to investor notto invest.3Investorsdo notknow whetherthe

manager(orhisfirm)is of highorlow quality,so his action will, in general,affect his reputationand thatof his firm. Afterthedecisionis made,publicnewsmayarrivethatwill affect investors'beliefs about the managerand his firm. This is the "short-run"reputationhe will be concerned about.Long-runprofitabilityalso mattersto themanager, but not as much as to a shareholderplanningto buy and hold.

Only in the last decade have academic researchers begunto explorethe moregeneralconsequencesof managerialreputation-buildingT. his recent interesthas been led by Bengt Holmstrom in two important papers (Holmstrom[25] andHolmstromandRicarti Costa[26]). Holmstrom and Ricart i Costa [26] point out that the manager'sfreedomto quit a firm to get higherpay else-

3Thealternativesmayalsobewhetherto investalargerorsmalleramount, whetherto invest in a high- or low-riskproject,whetherto follow the investmentpolicy of othermanagersor to deviate,and so on.

wheregives him an incentiveto buildhis reputationin the shortrun.This contrastswith a more traditionalanalysis of agencyproblemsthatassumethatthe managerandthe firm are inseparablyboundtogether.4

It is worthpointingoutthatshareholdersmay actually want the managerto invest in a way that improves the firm'sshort-runreputation,evenif this is attheexpenseof long-runprofitabilityf,or atleastthreereasons(see Harris and Raviv [20], Thakor[46], and Trueman[47]). First, some shareholdersmayexpect to be selling theirsharesat the currentmarketprice before the long term happens. Second, if the firm plans to issue new equity, a better reputationallowsit to do so ata higherprice,to thebenefit of currentequityholders.Third,thepriceatwhichthe firm is sold in a takeovercontestcanbe improvedby maintaining a good reputation(Stein [43]).

As an exampleof reputation-buildinga, firmmay act to boost its currentcash flows at the expense of reducing future cash flows by a greateramount.It can do so by failingto makea desirableinvestment,orevenby liquidating an investment.Advancingcash flows incursrealcosts in an attemptto redistributewealth fromnew sharepurchasers to old. This is a trap,because if investorshave rationalexpectations,they will not be fooled, on average, about the value of the firm. But the firm still needs to

manipulate its investment policy (boost current cash flows). If it wereto fail to do so, its cashflows wouldlook low, and investorswould wrongly believe the firm was worse thanit really is.

In economicjargon,reputation-buildingcreatesdeadweightcosts.Thesecostsareultimatelyborneby thefirm's founder when he initially sells his equity in the firm. Buyers will pay less for his equity since they can foresee thatresourceswill be wastedon reputation-building.

In principle, it would be desirable to eliminate these deadweightcosts by paying the firm'smanageronly for long-termperformancen, otshort-termreputation(Dybvig and Zender [15]). Unfortunately,this is not as easy as it looks, for severalreasons.First,a managerwhose reputation is ridinghighhas a crediblethreatto leaveforanother firm, so it may be impossibleto hold his pay down while waitingto learnthe long-termoutcome.Second,the man-

agerneedsto consumewhile he is young. Althoughsome of his compensationcan be long-term,muchof it mustbe

4Bethel[4] hasextendedthese ideasby pointingoutthatthepressureon the managerto buildhis short-termreputationdependson the extentto which his decisions and performanceat one firm can be observedat anotherfirm.

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paidbeforehis long-termperformanceis known.Third,as pointedoutby Pound[38],thereis a temptationon thepart of themanagerandtheboardto renegotiatecontractslater, so thata managerwithfavorableinformationcan increase his paybyconveyingfavorableinformationaboutthefirm.

Thisessay doesnotfocus on designingcontractstodeal withreputationalincentives.Generally,one wouldexpect thatcompensationschemes could be designedto mitigate unfortunatereputationalproblemspartially,but not perfectly (e.g., Hagerty,Ofer,andSiegel [17]).Reputationhas itsgood side as well, since a majormotivationforworking hardis tomaintainagoodreputationG. ibbonsandMurphy [16] point out that a managerhas a greaterincentive to workharderwhenfarfromretirementbecausehe will bear the reputationalconsequences of his effort for a longer time. Thus, compensationcontractsshould be more performnnance-sensitfiovremanagersclose to retirementT. hey provideevidence supportingthis prediction.

II.ATaxonomyof Reputational Pressures

This sectionprovidesa taxonomyof thedifferentkinds of reputationalpressuresthatmanagersface. It also analyzes how thesedifferentkindsof pressuresinteract;these interactionsshow up repeatedly in the applicationsof Section III.

A. Distortions

There are three main ways in which managers can manipulateinvestmentdecisions to improvetheirreputations. First,managerscan takeactionsthatmakethe current or short-termnews about project outcome appear more favorable- risibility bias. Second, managerscan tryto acceleratethearrivalof newsthatis likelyto turnout good, anddelaythearrivalof newsthatis likelyto turnout bad- resolutionpreference.Third,managerscan try to imitatetheinvestmentchoices expectedof goodmanagers, anddivergefromthechoices expectedof badmanagersmlimi'cryand avoidance. Let us consider each of these points in turn.5

1. Visibility Bias Visibilitybias is defined as improving what is im-

mediately visible, at the expense of what is not immediatelyvisible. Whendressingfor a formaldinner,we spendmore time choosing our pantsthanour underwear.

5Thiscategorizationis also discussedin Hirshleifer121].

This makes what is visible look good. This can be profitableevenif itoccursatthecost of whatis notvisible(fancy tie, cheapunderwear)C. osmeticsurgeryandsteroidmuscle buildingare otherexamples. These improveappearances, at the expense of a less visible substance(future health).A similarpointappliesmoremildlyto highheels, cosmetics, andshoulderpads.And wearingfine suitsand fashionabledressesconveysanimpressionof the wearer's wealth,while at the sametimereducingit. Thesebehaviors areall examplesof visibilitybias.

Visibilitybias appliesto investmentdecisions as well. Considera projectabout which public news is about to appear,such as early sales figureson a new product.The managerhas an incentiveto improveappearancesby increasingthefavorabilityof morevisible events,forexample, by offering hiddendiscountson the new productto boost initialsales. He will tryto distortearlynews reports favorably,even if this leads to an equal decrease in the favorabilityof permanentperformance.To see why, suppose thatno one butthe manageris awareof his abilityto offer hidden discounts.Then he receives a benefit from

improvedreputationnow. The ultimatereductionin his reputationlateris to the correctlevel. Thus,he receivesan early reputational benefit without paying any later reputationalcost.

2. ResolutionPreference

(i) PuttingYourBest Foot Forward.On an interview or a date,one alwaysputsone's best foot forward. Andalthoughthe sayingdoesn'tmentionit, this is the sameas puttingone's worstfoot backwards.A projectmanagershould do likewise. Thus, other thingsequal,if he expects good news to arrive(he maynotbe sure),he shouldtryto advancethedate at which thatnews will arrive.If he expects bad news, he should delay resolution of the project. This "puttingyourbest foot forward"effect is an example of resolution preference, because the managerwants to shift resolutionof uncertainty aboutthe projectforwardor back(see Hirshleifer andChordia[22]).

(ii) RiskAvoidance.If the managerdislikes personal risk,then thereis an advantageto deferringresolution of uncertainty.Even for a good manager, thereis anappealtonotbeingjudgeduntiltenyears after retirement(as is suggested by the Roger Smith quote at the beginning of this article). By deferringthe resolutionof uncertainty,the manager temporarilymaintainshis reputationat the

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currentlevel, andreapsthe rewardsat the current level. His currentreputationis basedonthecurrent assessment of his ability. Deferred resolution makeshis lifetime incomemorecertainthanif his reputationandpay were to jump up or down with an immediatenews event.

3. MimicryandAvoidance

If peopleexpecta high-qualityfirmto undertakeambitiousinvestments,thena low-qualityfirmcantrytomimic. Consequently,a high-qualityfirmmay be led to exaggerate those investmentsthatare difficultor costly for lowqualityfirmsto mimic. Trueman[47] has pointedout that firmswith low-qualityinvestmentopportunitiesmay overinvest in order to seem to be firms with high-quality investments.Firmswith high-qualityinvestmentsalso invest too much, in orderto avoidbeing identifiedwith the lower-qualityfirms! All firms are forced to overinvest. Since everyoneknows this, they are not actuallyfooling anyonebydoingso. Butif afirmwereto investatthelower scale thatis optimalfor shareholdersi,nvestorswouldnot give it anycreditfordoing so. Instead,theywouldassume thatthe firmhad verypoorinvestmentopportunities.

Even if the investmentchoices arenot visible to financial markets(suchasexpendituresoncustomerserviceand maintenance),mimicry and avoidancecan be important. These will still occur, because the consequences of the investmentdecision(e.g., howfavorableearlynewsevents are, or how early or lateruncertaintyaboutthe projectis resolved) are visible.

B. How Reputational Pressures Interact

Visibility bias and resolution preference should be viewed as the more fundamentalmanagementpressures, with mimicry and avoidance acting as a modifier. For example,supposethatsome firms(efficientorganizations) can providehiddenservice to customersmoreeffectively than others(inefficientorganizations).For eithertype of firm, visibility bias leads to a temptationto secretly cut costsbyreducingthequalityof service.Thisboostscurrent net cash flows, and the long-runcost to the firm is not immediately visible. Suppose, however, that there is a positive probabilitythat customerdissatisfactionwill be discoveredearlyby analystsandpublicizedwidely. Then an efficient organizationmay maintaina superblevel of servicein orderto demonstrateitshighefficiency.If mimicry is too costly, an inefficient firm may still have low levels of service. On the other hand, the inefficient firm

may also maintain customer service in order to avoid appearingeven worsethanit reallyis.

A wise epigramstatesthat"Itis betterto be silent,and be thoughta fool, than to speak and remove all doubt.'' Investmentchoices can also speakor remainsilent, in the sense of leadingto earlynews arrivalor latenews arrival. Resolution preference can pressure managers to make investmentchoices thateitherdeferoradvanceresolution

of uncertainty(SectionII.A.2(i)above).A clevermanager, who can reasonablyexpect his investmentsto succeed, may well want to "speak up" by undertakingprojects whose outcomeswill beresolvedearly.A foolishmanager, whose projectsare likely to fail, may do best with longterm,visionaryprojectswhose outcomeswill take a long time to resolve (as with the case of Roger Smith at the beginningof this article).

If this were the whole story,then managerswould be treatedextremelyskepticallywhen news arriveslate, because investorswould know that news arrivesearly for good managersand late for bad managers.Supposethat managersperfectlycontrolthe timing of arrivalof news. Thenmimicryrearsits ugly head,because lateresolution of uncertaintywill provokesuch intense skepticismthat even a bad manageror firm will be forced to advance resolutionof uncertaintyj,ust likegood managers.Inother words,a good managerputshis bestfoot forward.Thebad managerhas a bad foot, but if he doesn't step up, he is known to be bad. The best he can do is step up (with an early-resolvingproject)andhopeto be luckyenoughto get a good outcome.

Moregenerally,however,managersdo nothaveperfect controloverwhennews arrives.Evena good managerwho tries to advanceresolutionof uncertaintywill sometimes findthatit remainsunresolvedfora long periodof time.A pharmaceuticalcompanydeveloping a blockbusterdrug may find that the FDA insists on additionalcontrolled studiesbeforeit will decide whetherto approve.Alternatively, there may be strong business reasons to pick a projectwith long-termresolution.A pharmaceuticaflirm may takea long time to findout whetherit is successfulif it is trying to develop a new class of drugs or a new

approachto findingdrugs.Butthismaybe moreprofitable

for shareholdersthanto focus on developingroutinevari-

ationson currentdrugs.Outsiderscan'tbe sureif thefirm's

late resolutionof uncertaintyis because expected profits

arehigherfromthe late-resolutionproject,or becausethe

firmwantsto concealitsincompetence.Thus,a low-ability

managercan intentionallydeferresolutionwithoutbeing unambiguouslyexposed.Externalfactorsthataffectreso-

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