The relation between equity incentives and misreporting: The role of risk-taking incentives

Prior research argues that a manager whose wealth is more sensitive to changes in the firm?s stock price has a greater incentive to misreport. However, if the manager is risk-averse and misreporting increases both equity values and equity risk, the sensitivity of the manager?s wealth to changes in stock price (portfolio delta) will have two countervailing incentive effects: a positive “reward effect” and a negative “risk effect.” In contrast, the sensitivity of the manager?s wealth to changes in risk (portfolio vega) will have an unambiguously positive incentive effect. We show that jointly considering the incentive effects of both portfolio delta and portfolio vega substantially alters inferences reported in prior literature. Using both regression and matching designs, and measuring misreporting using discretionary accruals, restatements, and enforcement actions, we find strong evidence of a positive relation between vega and misreporting and that the incentives provided by vega subsume those of delta. Collectively, our results suggest that equity portfolios provide managers with incentives to misreport when they make managers less averse to equity risk.     

Fund managers' herding and the sensitivity of fund flows to past performance

This study provides a new explanation for the weak sensitivity of investors' flows to poor fund performance based on fund managers' incentives to herd from career concerns. We show that a manager's decision to trade with (against) the herd decreases (increases) significantly investors' willingness to redeem capital from underperforming funds. We argue that this differential investor reaction to poor performance conditional on herding explains the lower termination risk identified among herding managers. We also find that financial intermediaries do not mitigate this sub-optimal investors' response. Our findings support the view that underperforming funds can retain larger payoffs if they herd.     

The Moderating Effect of Relative Performance Evaluation on the Risk Incentive Properties of Executives’ Equity Portfolios

We offer evidence that the use of relative performance evaluation (RPE) in CEOs’ incentive contracts influences the effect of risk‐taking incentives on both the magnitude and composition of firm risk. We find that, when the incentive design lacks RPE features, the incentive portfolio vega motivates CEOs to increase total risk through the systematic component because it can be hedged. In contrast, when the incentive design includes RPE features, CEOs prefer idiosyncratic risk because RPE filters out the systematic component of firm performance. We also document that the use of RPE reinforces the incentive portfolio vega's effect on the total risk.     

Executive stock options,differential risk-taking incentives,and firm value

The sensitivity of stock options' payoff to return volatility, or vega, provides risk-averse CEOs with an incentive to increase their firms' risk more by increasing systematic rather than idiosyncratic risk. This effect manifests because any increase in the firm's systematic risk can be hedged by a CEO who can trade the market portfolio. Consistent with this prediction, we find that vega gives CEOs incentives to increase their firms' total risk by increasing systematic risk but not idiosyncratic risk. Collectively, our results suggest that stock options might not always encourage managers to pursue projects that are primarily characterized by idiosyncratic risk when projects with systematic risk are available as an alternative.     

Managerial personal diversification and portfolio equity incentives

This paper examines the diversification choices of top managers and their implications for the levels of portfolio equity incentives as well as for firms' financial policies. Standard portfolio theory should also apply to corporate managers and therefore excessive risk exposures to the firm should create portfolio diversification incentives for the managers. We use a unique dataset from the Taiwan tax data center and construct the measures of the degree of diversification in a manager's equity portfolio that is made up of equities of other firms to capture his motives for diversifying his risk exposure to his own firm. We provide empirical evidence supporting the view that managers have a risk-reduction motive when they trade in the equities of other firms besides their own. Moreover, we document evidence that the degree of diversification in such equity portfolios also significantly affects managerial equity incentives as well as firms' financial policies. Overall, our findings confirm that managers' personal diversification can help make up for the diversification that the managers would otherwise have lost, thereby reducing the agency cost of equity incentive contracts.     

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.     

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.     

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.     

High‐Water Marks: High Risk Appetites? Convex Compensation,Long Horizons,and Portfolio Choice

We study the portfolio choice of hedge fund managers who are compensated by high-water mark contracts. We find that even risk-neutral managers do not place unbounded weights on risky assets, despite option-like contracts. Instead, they place a constant fraction of funds in a mean-variance efficient portfolio and the rest in the riskless asset, acting as would constant relative risk aversion (CRRA) investors. This result is a direct consequence of the in(de)finite horizon of the contract. We show that the risk-seeking incentives of option-like contracts rely on combining finite horizons and convex compensation schemes rather than on convexity alone.     

Tournament incentives and firm credit risk: Evidence from credit default swap referenced firms

In this paper, we evaluate the impact of managerial tournament incentives on firm credit risk in credit default swap (CDS) referenced firms. We find that intra‐firm tournament incentives are negatively related to credit risk. Our results suggest that tournament incentives reduce credit risk by alleviating the potential for underinvestment when managers are concerned about exacting empty creditors. Further, we find that tournament incentives decrease credit risk when internal governance is strong or product market competition is intense. Taken together, our results suggest that creditors perceive senior manager tournament incentives (SMTI) as a critical determinant of a firm's credit risk, particularly in settings where managerial risk aversion is high.     

Market share and risk taking: the role of collateral asset managers in the collapse of the arbitrage CDO market

Asset pricing theory predicts that if credit ratings do not reflect all relevant aspects of a CDO debt tranche’s risk profile (i.e., its total and systematic risk), then ratings-based tranche pricing by some naïve investors creates incentives for CDO arrangers to take excessive non-priced risk. CDO managers’ desire for repeat issuance makes them part of this risk taking strategy to exploit naïve investors. The implication is that the credit quality of CDOs run by large market share managers has a higher tendency to deteriorate in bad times. This paper finds empirical evidence for large market share manager’s conflicts of interest.     

Managerial hedging,equity ownership,and firm value

Suppose risk‐averse managers can hedge the aggregate component of their exposure to firm's cash‐flow risk by trading in financial markets but cannot hedge their firm‐specific exposure. This gives them incentives to pass up firm‐specific projects in favor of standard projects that contain greater aggregate risk. Such forms of moral hazard give rise to excessive aggregate risk in stock markets. In this context, optimal managerial contracts induce a relationship between managerial ownership and (i) aggregate risk in the firm's cash flows, as well as (ii) firm value. We show that this can help explain the shape of the empirically documented relationship between ownership and firm performance.     

Tournament-based incentives and mergers and acquisitions

This research examines the relation between tournament-based incentives, which are proxied by the difference between a firm's CEO pay and the median pay of the senior managers, and mergers and acquisitions (M&As). We find that tournament-based incentives are positively related to firm acquisitiveness and acquiring firms' stock and operating performance. Further analysis indicates that positive acquisition performance increases the likelihood of the CEO being promoted from inside the acquiring firm. Our evidence is consistent with the view that tournament-based incentives motivate acquiring firms' managers to make greater efforts and take more risk that result in superior acquisition performance.     

Sustaining implicit contracts when agents have career concerns: the role of information disclosure

Firms often augment career concerns incentives with implicit incentive contracts. I formalize the interaction between these two incentives, and highlight its implications on a firm's decision to disclose its workers' productivity information. Disclosure enhances career concerns but inhibits implicit contracts. I show two main results. First, implicit contracts weaken (i.e., substitute) career concerns if the prior belief about the worker's ability is low, and vice versa. Second, when these incentives are substitutes, the optimal disclosure policy follows a cutoff rule: patient firms are opaque, and transparent firms never offer implicit contracts. These results need not hold if the incentives are complements.     

The impact of performance-based compensation on misreporting

This paper examines the effect of CEO compensation contracts on misreporting. We find that the sensitivity of the CEO's option portfolio to stock price is significantly positively related to the propensity to misreport. We do not find that the sensitivity of other components of CEO compensation, i.e., equity, restricted stock, long-term incentive payouts, and salary plus bonus have any significant impact on the propensity to misreport. Relative to other components of compensation, stock options are associated with stronger incentives to misreport because convexity in CEO wealth introduced by stock options limits the downside risk on detection of the misreporting.     

Optimal hedge fund portfolios under liquidation risk

We use an expected utility framework to integrate the liquidation risk of hedge funds into portfolio allocation problems. The introduction of realistic investment constraints complicates the determination of the optimal solution, which is solved using a genetic algorithm that mimics the mechanism of natural evolution. We analyse the impact of the liquidation risk, of the investment constraints and of the agent's degree of risk aversion on the optimal allocation and on the optimal certainty equivalent of hedge fund portfolios. We observe, in particular, that the portfolio weights and their performance are significantly affected by liquidation risk. Finally, tight portfolio constraints can only provide limited protection against liquidation risk. This approach is of special interest to fund of hedge fund managers who wish to include the hedge fund liquidation risk in their portfolio optimization scheme.     

Offsetting the implicit incentives: Benefits of benchmarking in money management

Money managers are rewarded for increasing the value of assets under management. This gives a manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. The misaligned incentives create potentially significant deviations of the manager’s policy from that desired by fund investors. In the context of a familiar continuous-time portfolio choice model, we demonstrate how a simple risk management practice that accounts for benchmarking can ameliorate the adverse effects of managerial incentives. Our results contrast with the conventional view that benchmarking a fund manager is not in the best interest of investors.     

How Control System Design Influences Performance Misreporting

This paper investigates reporting honesty when managers have monetary incentives to overstate their performance. We argue that managers who report about their performance will take into account how their report affects their peers (i.e., other managers at the same hierarchical level). This effect depends on the design of the organization's control system, in particular, on the reward structure and the information policy regarding individual performance reports. The reward structure determines if peers’ monetary payoff is increased or decreased when managers claim a higher level of performance. The information policy determines if managers will be able to link individual peers to their reports and affects the nonmonetary costs of breaking social norms. We present the results of a laboratory experiment. As predicted, we find that participants are more likely to overstate their performance if this increases the monetary payoff of others than if their reported performance decreases others’ monetary gains. In addition, overstatements are lower under an open information policy, where each individual's reported performance is made public, compared to a closed information policy, where participants only learn the average performance of the other participants. Our findings have several important implications for management accounting research and practice.     

Portfolio size and information disclosure: An analysis of startup accelerators

We study the information-gathering role of a startup accelerator and consider the accelerator's incentives to choose a portfolio size and disclose information about participating ventures. We show that in a rational-expectations equilibrium, the resultant portfolio size is smaller than the first-best (efficient) level, consistent with some real-world observations. We further show that when some signals are uninformative and the portfolio consists of mostly high-quality ventures, the accelerator may choose to disclose only positive signals (and conceal negative signals) about its portfolio firms — a strategy we refer to as partial disclosure. Moreover, coupled with pursuing this strategy of partial disclosure, we demonstrate that the accelerator may possess incentives to exit its portfolio firms early.     

Do Portfolio Manager Contracts Contract Portfolio Management?

Most mutual fund managers have performance‐based contracts. Our theory predicts that mutual fund managers with asymmetric contracts and mid‐year performance close to their announced benchmark increase their portfolio risk in the second part of the year. As predicted by our theory, performance deviation from the benchmark decreases risk‐shifting only for managers with performance contracts. Deviation from the benchmark dominates incentives from the flow‐performance relation, suggesting that risk‐shifting is motivated more by management contracts than by a tournament to capture flows.