Principal-agent problem


There is an age old saying - If you want it done, then go, And if not, then send - Julius Caesar.


Private individual investors who are working in isolation will know the depth of this mental model.


What's the Principle agent problem ? When you are the Principal ( business owner, a start up founder ) your vision and your ideas are totally different from the agent ( persons working under you) their priorities are mismatched and vision may be completely different from yours.


Lets connect this with companies we invest in


Investing in the public markets shows companies that have grown big which makes capital allocation mistakes. Lets talk about the cigarette manufacturer in India, The company's strength is its cash flows, but when viewed closely as to where the cash flows are being allocated we could see that the company has mismanaged with its capital allocation.


Capital allocated to projects earning below its Cost of capital, although its debt free the capital allocation isn't prudent.


Why is there such a problem in capital allocation ?


The owners of the business are not incentivized based on the projects and capital allocation. The persons running the business are free to allocate capital and also enjoy their incentives uninterrupted even if the performance of the company is deteriorating this is a value destroying move. The Principal in this problem are the owners who are not directly controlling the company and the Agent has the authority to allocate capital.


The owners who own a major share of the business and also run the business and make capital allocation decisions have a more prudent approach to this problem, The owner/ CEO who holds skin in the game like Warren buffet has always kept the capital allocation to himself and delegated all the other day to day operations to people who are better than him.


Some of the best capital allocators are people who are owners and executors, they have high accountability and high stakes in their decisions which makes them think and make capital allocation decisions more prudently. In companies with high promoter holding and most of their net worth tied to their decisions people tend to be more careful in their decisions.


In Indian context lets consider ITC and its capital allocation, when we think of ITC from principal agent problem we can see though the problem where the company is allocating capital and resources to areas like hotels where the ROC isn't high as compared to its cigarette business. Also the capital allocation decisions are made by CEO's who are not owners but have high incentives. When incentives are not tied to their decisions and its outcomes peoples behavior tends to vary widely.


Escorts is another example where the Principle agent problem has remarkably turned around the company with good capital allocation. The company was struggling with huge debt in 1980's with unrelated diversifications into asset heavy businesses like healthcare, telecom which did not turn out well for the company and when NIKHIL NANDA visited his factory at Faridabad he was shocked to learn that the electricity was cut due to non payment of bills. It was the worst time the company had to go through which made Nanda take things seriously in his hands. From then on Escorts started to exit non-core businesses selling its motorcycle JV with Yamaha which made Rajdoot cruisers, auto components JV with Mahle group and construction equipment JV with JCB of UK. In 2004 the debt was hovering around 1200 Cr. The company needed a strategic vision to make a come back.


In 2000's it sold Escotel and Escorts heart institute which reduced the debt and freed up capital for the company, Nanda was then JMD and after these moves the company had cash flows to divert to its core business of Tractors.. The company between 2008-2020 invested 986cr in product development which led to FARMTRAC, the range of high power tractors. Domestic sales doubled from 21011 units in FY03 to over 80000 units by FY 2018. These efforts were well rewarded with EBIDTA margins expansion to 11% and they have targeted to take it to 15%. In FY19 the tractor s sales reached 100000 mark, the revenues in last 5 years have grown at 22%.


" We sunk in a lot of investments in research and development. The products needed to speak for itself on the farm. Our motto was simple, don't overpromise, but overdeliver" - Nikhil Nanda

Nanda has tied up with Kubota of japan and which has invested 10% in escorts for 1042 Cr. The company also expanded its agri-led business such as seeding, planting and harvesting equipment. In 2017 it unveiled its Electric tractor and in 2019 they have launched Digitrac brand of high power tractors. The outcomes of all these efforts are stunning, the stock price has moved from 130Rs in 2010 to 1300 in 2020 which is a remarkable 10x in 10 years at a 26% CAGR.


Escorts is a remarkable study about Principal agent problem, when your company is struggling or when you need to pursue a growth strategy you have 2 choices either to delegate or to take up things in your own hands and turn them around. Its well worth recalling that " If you want to get it done, then go or delegate". Start ups have high autonomy and flexibility earlier where the owner (Principal) and executors (agents) are closely kinit which reduces friction in decision making.






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