Tournament incentives, firm risk, and corporate policies

This paper tests the proposition that higher tournament incentives will result in greater risk-taking by senior managers in order to increase their chance of promotion to the rank of CEO. Measuring tournament incentives as the pay gap between the CEO and the next layer of senior managers, we find a significantly positive relation between firm risk and tournament incentives. Further, we find that greater tournament incentives lead to higher R&D intensity, firm focus, and leverage, but lower capital expenditures intensity. Our results support the hypothesis that option-like features of intra-organizational CEO promotion tournaments provide incentives to senior executives to increase firm risk by following riskier policies. Finally, the compensation levels and structures of executives of financial institutions have received a great deal of scrutiny after the financial crisis. In a separate examination of financial firms, we again find a significantly positive relation between firm risk and tournament incentives.     

The Relationship Between Equity-Based Compensation and Managerial Risk Taking: Evidence from China

The authors analyze the impact of equity-based compensation on managerial risk-taking behavior in Chinese listed firms from January 2006 to July 2011. They find that greater risk-taking incentives lead executives to invest more in research and development (R&D) projects and less in capital expenditures. Greater managerial risk-taking incentive increases firm focus. Managerial risk-taking incentives have positive effects on firms' leverage. Overall, increasing the sensitivity of chief executive officers' portfolio value to stock return volatility helps incentivize executives to work harder, as sharing gains and losses with shareholders aligns the interests of executives and shareholders. In addition, the results indicate that state control of firms has a negative effect on R&D investment, and this suggests that state-controlled firms should take more initiative to innovate.     

Managerial foreign experience and corporate risk-taking: Evidence from China

This study investigates the relationship between managerial foreign experience and corporate risk-taking. We find that foreign experienced managers in Chinese firms are positively associated with corporate risk-taking and that this mainly exists in private firms rather than in state owned enterprises (SOEs). In privately owned firms, the degree of corporate internationalization and operating leverage are potential channels through which foreign experienced managers affect corporate risk-taking. Moreover, the positive association is more pronounced for managers' practical, rather than educational foreign experience and for managers who gain their foreign experience from countries or regions with advanced management practices and better corporate governance. Short-term visits overseas has no impact on corporate risk-taking. Additionally, the relationship is more persistent among private firms with better corporate governance and those operating in weak local economy. Finally, we find evidence that the risk-taking behaviour from foreign experienced managers is an important mechanism for companies to enhance their value.     

CEO risk-taking incentives and corporate social responsibility

We examine how firms adjust CEO risk-taking incentives in response to risk environments associated with their corporate social responsibility (CSR) standing. We find strong evidence that as a firm's CSR status improves (declines), increasing (decreasing) its risk-taking capacity, the firm responds by adjusting compensation contracts to increase (decrease) CEO risk-taking incentives (Vega). One channel of the adjustment is through stock option grants. Further analyses indicate that the positive CSR-Vega association is stronger in firms with better corporate governance and in industries where riskiness is more important. Our evidence indicates that firms are not passive in response to changes in CSR status and firm risk.     

Managerial risk-taking behavior and equity-based compensation

Equity-based compensation affects managers’ risk-taking behavior, which in turn has an impact on shareholder wealth. In response to an exogenous increase in takeover protection in Delaware during the mid-1990s, managers lower firm risk by 6%. This risk reduction is concentrated among firms with low managerial equity-based incentives, in particular firms with low chief executive officer portfolio sensitivity to stock return volatility. Furthermore, the risk reduction is value-destroying. Finally, firms respond to the increased protection accorded by the regime shift by providing managers with greater incentives for risk-taking.     

Good for managers,bad for society? Causal evidence on the association between risk-taking incentives and corporate social responsibility

Using FAS 123R as an exogenous shock to stock options, I provide evidence that equity-based risk-taking incentives discourage corporate social responsibility (CSR). This finding suggests that compensation incentives can motivate managers not to pursue CSR strategies because CSR reduces firms’ risk and provides insurance-like benefits. Firms with a greater demand for CSR's risk reduction are more sensitive to changes in risk-taking incentives. I triangulate my results by confirming that CSR weaknesses are positively related to subsequent stock return volatility. Overall, using a robust empirical design, I find that risk-taking incentives are a determinant of firms’ CSR.     

Leverage,executive incentives and corporate governance

This paper analyses the effect of executive incentives and internal governance on capital structure. Using a large sample of non‐financial US‐listed firms over the period 1999–2005, it is found that managers have different attitudes towards leverage when offered different incentive schemes; leverage initially decreases in bonuses and stock incentives and then increases in these incentives after a certain incentive level, suggesting the existence of the entrenchment–alignment effects under these incentive schemes. In contrast, leverage initially increases in option incentives and then decreases after a certain option incentive level. When all of these incentive schemes are combined together into a single incentive package, the entrenchment–alignment effects prevail. It is also found that leverage increases in internal governance and managers behave differently under different governance regimes such that the entrenchment–alignment effects prevail under weak governance firms, whereas the alignment–entrenchment effects prevail under strong governance firms. The results also suggest that managers’ target leverage ratio is less than the one predicted by theory or preferred by firm shareholders.     

Does freezing a defined benefit pension plan affect firm risk?

This paper examines the impact of a defined benefit (DB) pension plan freeze on the sponsoring firm's risk and risk-taking activities. Using a sample of firms declaring a hard freeze on their DB plans between 2002 and 2007, we observe an increase in total risk (proxied by the standard deviation of EBITDA and asset beta), equity risk (standard deviation of returns), and credit risk following a DB-plan freeze. The increase in credit risk is reflected in a decline in credit ratings and an increase in bond yields for freezing firms. When we examine investment strategies, we observe a shift in investment from capital expenditures before the freeze to more-risky R&D projects after the freeze, and an increase in leverage. These strategies (increased focus on R&D and higher leverage) increase the operating and financial risk the firm faces. Overall, we observe an increase in risk-taking following DB plan freezes, consistent with theories that DB plans act as “inside debt” that aligns managers’ interests with bondholders’.     

Proxy contests and debt contracting behavior: The interplay of managerial,shareholder and creditor incentives

We evaluate how heterogeneity in the strategic interplay among shareholder, creditor and manager incentives influences debt contracting behavior around proxy contests. We find that, after proxy contests, new loan originations have significantly higher spreads and more stringent non-pricing contracting terms. The effect, however, occurs largely in contest firms where Chief Executive Officers (CEOs) are provided with risk-taking incentives. Further, creditors’ simultaneous equity holdings and credit default swaps (CDS) trading attenuate the impact of proxy contests on debt contracting costs. Finally, proxy contests that culminate in voting and dissident victory experience the largest increase in loan pricing. Overall, our results suggest an increase in the agency cost of debt occurs after proxy contests, particularly when managerial risk-taking incentives are high, and when creditors do not simultaneously hold target firms’ equity or CDS.     

Corporate cash holdings and CEO compensation incentives

We examine the effect of chief executive officer (CEO) compensation incentives on corporate cash holdings and the value of cash to better understand how compensation incentives designed to enhance the alignment of manager and shareholder interests could influence stockholder-bondholder conflicts. We find a positive relation between CEO risk-taking (vega) incentives and cash holdings, and we find a negative relation between vega and the value of cash to shareholders. The negative effect of vega on the value of cash is robust after controlling for corporate governance, is stronger in firms with high leverage, is reversed for unlevered firms, and is not present in financially constrained firms. We also find that the likelihood of liquidity covenants in new bank loans is increasing in CEO vega incentives. Our evidence primarily supports the costly contracting hypothesis, which asserts that bondholders anticipate greater risk-taking in high vega firms and, therefore, require greater liquidity.     

Female CFOs,leverage and the moderating role of board diversity and CEO power

This paper investigates the extent to which female Chief Financial Officers (CFOs) affect corporate leverage. We examine female CFOs in UK firms and find that they significantly reduce the leverage of the firm; however, a female CFO's ability to influence corporate leverage is moderated by the senior decision-making environment in the firm. In particular, female CFOs are more effective in reducing leverage in firms with boards that are diverse with respect to gender, nationality and age, and in firms where the Chief Executive Officer (CEO) is not overly powerful. In addition, we find that externally appointed female CFOs reduce leverage more, in line with them having less allegiances to other top managers and greater scope to deviate from existing policies. Our work contributes to the literature by examining the conditions under which gender-specific risk-taking preferences lead to observable effects on corporate outcomes.     

The unintended consequence of collateral-based financing: Evidence from corporate cost behavior

This paper examines how real estate appreciation correspondingly changes collateral value, which affects debt structure choices and consequent operating decisions. Specifically, we explore whether collateral-based financing provides a link between real estate values and corporate cost behavior. Our baseline results show that an appreciation of a firm’s real estate assets alleviates its cost stickiness. A further analysis shows that this influence is stronger for firms with less prior bank debt, less dependence on external financing, and a lower leverage ratio. We also observe that the impact of collateral shocks on cost stickiness is more pronounced when selling, general and administrative (SG&A) costs create less future value for mature firms and for firms with weaker external governance. Collectively, our results support the argument that an increase in bank debt arising from collateral value appreciation mitigates agency problems and thus lessens cost stickiness.     

Managerial incentives to take asset risk

We argue that incentives to take equity risk (”equity incentives”) only partially capture incentives to take asset risk (“asset incentives”). This is because leverage, while central to the theory of risk-shifting, is not explicitly considered by equity incentives. Employing measures of asset incentives that account for leverage, we find that asset risk-taking incentives can be large compared to incentives to increase firm value. Stock holdings can induce substantial risk-taking incentives, contrary to the assumption that only stock options drive risk-taking. Finally, asset incentives help explain asset risk-taking of U.S. financial institutions before the 2007/08 crisis.     

The differential effects of classified boards on firm value

Classified boards actually benefit firms that have low monitoring costs and greater needs for advisory services. Previous literature has emphasized the entrenchment effect of classified boards. However, we find that this adverse impact of classified boards can be offset or even superseded by the potential benefits of board classification for firms who hope to benefit from the advisory services of their independent directors. We show that firms with greater advising needs appoint more outside directors with diverse attributes and expertise, qualifications that enhance the ability to provide useful advice to managers. Furthermore, in such firms, board classification is associated with higher performance sensitivity of forced CEO turnover and better acquisition performance. Conversely, in firms with high monitoring costs, board classification hurts managerial equity-based incentives and risk-taking incentives. These findings suggest how and through which channels classified boards engender the differential effects on firm value.     

Shareholder governance, bondholder governance, and managerial risk-taking

We examine the relation between the overall corporate governance structure and managerial risk-taking behavior. We find that the overall governance structure has a significant impact on how managers make decisions on investment policy: strong bondholder governance motivates more low-risk investments such as capital expenditure and lower high-risk investments such as R&D expenditures, whereas weak shareholder governance (entrenched managers) leads to more R&D expenditures. Moreover, we find that the effects of governance on investment policy differ significantly between speculative and investment-grade firms. For speculative firms, strong bondholder or shareholder governance leads to more capital expenditures and low R&D investments. For investment-grade firms, strong bondholder or shareholder governance leads to low capital expenditures and an insignificant impact on R&D investments. Furthermore, financing and investment covenants exhibit strong binding power to deter risky investments. Finally, a more dependent (or a less independent) board is associated with low capital expenditures and high R&D investments.     

Interest Rates and Credit Risk

This paper explores the effects of shifts in interest rates on corporate leverage and default in the context of a dynamic model in which the link between leverage and default risk comes from the lower incentives of overindebted entrepreneurs to guarantee firm survival. The need to finance new investment pushes firms' leverage ratio above some state‐contingent target toward which firms gradually adjust through earnings retention. The response to interest rate rises and cuts is both asymmetric and heterogeneously distributed across firms. Our results help rationalize some of the evidence regarding the risk‐taking channel of monetary policy.     

CEO risk incentives and firm performance following R&D increases

In this study we analyze how CEO risk incentives affect the efficiency of research and development (R&D) investments. We examine a sample of 843 cases in which firms increase their R&D investments by an economically significant amount over the period of 1995–2006. We find that firms with higher sensitivity of CEO compensation portfolio value to stock volatility (vega) are more likely to have large increases in R&D investments. More importantly, we find that high-vega firms experience lower abnormal stock returns and lower operating performance compared to their low-vega counterparts following the R&D increases. Our main results hold in a variety of robustness tests. The results are consistent with the conjecture that high-vega compensation portfolios may induce managers to overinvest in inefficient R&D projects and therefore hurt firm performance.     

Fund ownership,wealth, and risk-taking: Evidence on private equity managers

Private equity (PE) managers are required to invest their own money in the funds they manage. We examine the incentive effects of this ownership on the delegated acquisition decision. A simple model shows that PE managers select less risky firms and use more debt, the higher their ownership. We test these predictions for a sample of Norwegian PE funds, using managers’ wealth to capture their relative risk aversion. As predicted, the target company’s cash-flow risk decreases and leverage increases with the manager’s ownership scaled by wealth. Moreover, the overall portfolio risk decreases with ownership, mitigating widespread concerns about excessive risk-taking.     

Do firms lease to hedge? CEO risk-taking and operating lease intensity

Operating leases are used extensively for financing, but their ability to separate ownership and use also creates hedging opportunities. We investigate whether firms recognize such opportunities by examining the relation between chief executive officer (CEO) risk-taking incentives and the use of operating leases. Consistent with firms using operating leases to hedge, we find higher CEO risk-taking incentives lower operating lease intensity. To address endogeneity, we use the adoption of Statement of Financial Accounting Standards 123R as an exogenous shock to option compensation, dynamic panel generalized method of moments, simultaneous equations, and change regressions. Our results are robust to placebo and alternative tests.     

Share‐pledging and the cost of debt

We examine how corporate insiders pledging their equity stakes to collateralise personal loans influences firm cost of debt. Pledging enables managers to diversify personal holdings, potentially increasing risk‐taking incentives. However, exposure to contingent risks creates potentially stronger risk‐reducing incentives. Using hand‐collected data with OLS, difference‐in‐differences, and instrumental variables models, we find significant decreases in yield spreads associated with executive share‐pledging. Reductions in spreads surrounding share‐pledge disclosures suggest investors update their risk assessment to reflect pledging managers’ risk‐taking incentives. Consistent with risk‐reducing incentives, firms with share‐pledging executives subsequently reduce leverage.