The Principal-Agency Problem

Are you an agency or a consultancy? A principal or an agent? Does it matter? Faris Yakob goes in search of the fundamental building blocks of the advertising business.

In the broad set of professional service providers to businesses, there are different terms for different services. One set of such service providers are known as agencies, one set are known as consultancies, and then there are manifold financial, legal and technology providers of endlessly esoteric flavors. Agencies now compete directly with consultancies in various areas.

Agencies have positioned themselves as ‘creative transformation’ companies. Publicis recently acquired a consultancy called Spinnaker SCA to “expand its supply chain expertise and capabilities”, which is pretty far beyond the traditional purview of advertising or marketing services. Consultancies have ingested creative agencies and built programmatic media trading arms to position themselves as end-to-end solution providers outside of their historic domain. Usually for the aforementioned, and apparently always urgently necessary, corporate transformation.

What makes agencies and consultancies different? I doubt most people share my obsession with semantics but there are essential differences worth considering. Consultancies provide advice to and agents act on behalf of clients. Historically, agencies also provide business advice but never had to monetize it directly due to production margins. Consultancies charge and receive significantly higher fees per employee partially because strategic products are very high margin, but now they operate across supply chain implementation, marketing, technology and beyond and still command better rates.

Do the terms matter? Perhaps. In the last few years advertising holding companies haven’t been performing apiece. As analyst Brian Wieser has explained, a few have pulled away from the others and are performing financially better over the last few years. Looking at balance sheets and statements such as the one from the CEO of Publicis explaining that creative agencies are no longer “accretive to growth” suggests that the holding company structure is currently being sustained by growth in media, data and digital services. Signs of this are everywhere. For example, IPG for recently sold creative agencies Hill Holliday and Deutsch NY.

Agents act on behalf, and fiduciarily in the best interests, of their client. Consultants sell advice. Ultimately, since both are providing growth driving services to companies (because that is the only thing companies want), the majority of the value of their actions accrues to the client because that is literally the point. We, all of us, regardless of skill set or discipline, help clients make more money, for which we charge them money. If we charge them more money than we make them, they will tend to look elsewhere, unless there is a promise of outsized returns in the future. This is the heart of the hedge fund proposition, that in return for the classic “2 and 20*” you will make significant alpha (above market returns) eventually.

*(2% of assets as fee and 20% of any gains, which is certainly one way to do performance based remuneration. This seems outlandish now but is also reminiscent of the original commission based trading model margins in advertising that supported the entire industry…)

The fact that some of the biggest holding companies of creatively related professional services are outpacing the others requires deeper examination. Which is partly why these analyses, by Wieser and others, have led to some discourse.

In modern finance, there is an important construct known as the ‘principal-agent problem’. It is the source for what has been called the “the dumbest idea in the world” by one of its most famous former proponents, storied GE CEO Jack Welch.

In essence, Milton Friedman et al proposed that the owners of the business have different priorities than the executives of the business, because they get paid differently.

The shareholders are the owners…

(sort of, this is complex, but the ‘ownership’ you get from buying stock is conditional and primarily applies to a securitized asset that can be traded and paid discretionary dividends against. The difference being if you own a share of Apple you don’t get to walk into Apple headquarters and demand a tour, despite being an ‘owner’)

..and the executives work on their behalf in their best interests.

Therefore, the executives tasked with running the business have to not focus on what makes them individually more money in order to make sure they deliver the greatest return to shareholders. Weirdly, as this idea gained prominence, executive remuneration grew astronomically, despite the idea that paying executives in conditional stock based on share price targets was designed to align the interests of the agent with the principal. It more accurately aligned the interests of the executives with the stock price within bounded time horizons, which they are uniquely positioned to manipulate in the same time frame. And so it goes. Incentives matter and when a measure becomes a target, Goodhart’s Law applies.

One very useful source in this emerging discourse topic is Nick Manning, the co-founder of MG OMD who went on to be CSO at Ebiquity, a media investment consultancy. He really knows the media business and he is concerned about what is happening:

“Holding companies are increasingly using “principal-based” media trading models to inflate their media margins. Also known as “inventory media”, this involves the groups purportedly buying up media inventory wholesale and selling it on to clients at a higher price. Broking by any other name.”

See? Here is where language becomes important. A broker is not an agent, because they are diametrically opposed concepts. One is working for you, the other is selling you something. That’s why we have independent financial advisors and why Naked Communications made a point of the objective neutrality of their recommendations, because when you mingle advice and selling things get a little messy.

This is why media agencies aggregate the buying power of their clients’ money – they are agents, not principals. Or were. But now the ones that are making enough money to appease the market are involved in both sides of many media deals. Principal based trading means that the holding company is, allegedly, buying media inventory in advance, leveraging its scale, as always, but staking its own money. It then re-sells the media to its clients at an undisclosed markup creating margin.

“They are taking the easier and quicker route to more profit. They are doubling down on the lack of transparency that makes it harder for clients to measure effectiveness.” (Manning)

This is troubling because it’s happening when increased attention is being paid to effectiveness, especially profitability, because the economic climate for capital has changed.

You may have been in the industry long enough to remember the mediapocalypse when various exposures of undisclosed rebates around the world and other kinds of double-dealing triggered a spate of global media pitches. That also seemed to trigger an investigation into how creative agencies leverage production companies in order to manage spend into their own new vertically integrated content studios by the DOJ.

All of which eventually blew over, but interestingly Mark Read recently announced a WPP business ambition to grow their production arm Hogarth into a billion dollar business. “Our production capabilities are both strong and also have significant growth opportunities. Clients spend roughly the same on production as they do on creative fees, and today we capture only a small part of that”, which also seems to suggest they no longer want to function purely as agencies in order to capture more from the surrounding value chain, but this seems to create the same inherent conflict of interest.

Historically, creative agencies don’t make television commercials, they choose from a number of directors and production partners. The selection and management process is baked into their business model but how does that work when there is now a stated commercial mandate to push production budgets back towards their own bottom line?

Despite the bad press that certain consultancies have brought upon themselves working for authoritarian governments and super-charging opioid sales whilst also consulting with the FDA on the terms of opioid regulation, despite all that, companies seem to trust consultancies more than advertising agencies and pay them accordingly.

So, are you an agency or a consultancy? A principal or an agent? Does it matter? Without trust business cannot function. Money is a form of reified trust. For now clients seem to be willing to accept principal trading conflicts of interest to get what they believe are cheaper rates overall but the business model and technological underpinnings of this system feel awfully familiar, something like high-frequency financial trading or front-running, and disturbingly opaque.

Complexity and opacity create friction and arbitrage opportunities. The global media trading system has never been more complex or opaque, that’s why clients come to agencies in the first place, but an agency cannot be a principal, as a matter of principle.

About the author

Faris Yakob – Co-founder, Genius Steals