Managerial incentives and risk-taking

We provide empirical evidence of a strong causal relation between managerial compensation and investment policy, debt policy, and firm risk. Controlling for CEO pay-performance sensitivity (delta) and the feedback effects of firm policy and risk on the managerial compensation scheme, we find that higher sensitivity of CEO wealth to stock volatility (vega) implements riskier policy choices, including relatively more investment in R&D, less investment in PPE, more focus, and higher leverage. We also find that riskier policy choices generally lead to compensation structures with higher vega and lower delta. Stock-return volatility has a positive effect on both vega and delta.     

The Impact of Ambiguity on Managerial Investment and Cash Holdings

Standard finance theory suggests that managers invest in projects that, in expectation, produce returns that justify the use of capital. An underlying assumption is that managers have the information necessary to understand the distributional properties of the pay‐offs underlying the decision. This paper examines firm investment behavior when managers are likely to find it more challenging to develop expectations of pay‐offs, namely during periods of increased macroeconomic ambiguity. In particular, we examine how macroeconomic ambiguity – proxied by the variance premium (Drechsler, 2010 ) and the dispersion in forecasts of corporate profits from the Survey of Professional Forecasters (Anderson et al., 2009 ) – impacts managerial capital investment and cash holdings. Consistent with ambiguity theory, we find that macroeconomic ambiguity is negatively associated with capital investment and positively associated with cash holdings. These results are robust to alternative explanations related to risk, investor sentiment and economic conditions. Moreover, consistent with recent theoretical real options literature, we find that ambiguity reduces the value of investment opportunities, while risk increases the value of such opportunities. Overall, these findings provide initial empirical evidence on the economic distinction between ambiguity and risk with respect to managerial investment and cash holdings.     

Investor ambiguity,systemic banking risk and economic activity: The case of too-big-to-fail

This paper examines the relationship between investors' ambiguity in the financial options market and systemic banks' risk. Eliciting ambiguity information from option pricing data on the twelve major U.S. banks between 2003 and 2010, we show that higher behavioral deviations from risk-neutral and Bayesian valuation (i.e., investor ambiguity) are associated with higher systemic banks' downside, market and credit risks. Consistent with behavioral explanations, we confirm the detrimental effect of ambiguity on financial market outcomes and find strong evidence of ambiguity among call and put option holders. Variance decomposition indicates that such a pattern of behavior explains a significant proportion of U.S. banking risk variance. This effect is more pronounced during periods of economic turbulence and bank stress (i.e., the 2007–2009 crisis), and holds after controlling for size, tail risk, implied volatility, and volatility of volatility dynamics. We also document that ambiguity from the financial market has a depressing impact on real economic activity, including capacity utilization, non-farm payrolls and overall economic performance. Our findings are robust to alternative specifications of ambiguity such as multiple priors and expected utilities with uncertain probabilities.     

Executive Compensation and the Maturity Structure of Corporate Debt

Executive compensation influences managerial risk preferences through executives' portfolio sensitivities to changes in stock prices (delta) and stock return volatility (vega). Large deltas discourage managerial risk‐taking, while large vegas encourage risk‐taking. Theory suggests that short‐maturity debt mitigates agency costs of debt by constraining managerial risk preferences. We posit and find evidence of a negative (positive) relation between CEO portfolio deltas (vegas) and short‐maturity debt. We also find that short‐maturity debt mitigates the influence of vega‐ and delta‐related incentives on bond yields. Overall, our empirical evidence shows that short‐term debt mitigates agency costs of debt arising from compensation risk.     

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.     

Performance of closely held firms in Russia: evidence from firm-level data∗

This paper evaluates the impact of ownership concentration on firm performance in a weak institutional environment. Specifically, using new survey evidence, we seek to appraise quantitatively the performance of block-holder-controlled firms in Russia and to identify, within the domain of corporate governance theory, factors that may explain such performance. We find evidence of negative association between the size of the dominant owners’ shareholding and performance parameters such as investment, capacity utilization, and profitability. At the same time, we establish that control structures with multiple, large shareholders increase efficiency. The ambiguity of the effects of ownership concentration suggests that country-specific factors play an important role.     

How do auditors perceive CEO's risk‐taking incentives?

Prior literature documents that executive compensation influences managerial risk preferences through executives’ portfolio sensitivities to changes in stock prices (delta) and stock‐return volatility (vega). Large deltas discourage managerial risk‐taking, while large vegas encourage risk‐taking. Theory suggests that auditors charge higher audit fees when standard audit procedures do not allow auditors to reduce audit risk including the risk arising from higher business risk. We posit and find evidence of a negative (positive) relation between CEO portfolio deltas (vegas) and audit fees. We also find a negative relation between CEO portfolio deltas and the issuance of going‐concern audit opinions (GCO).     

The influence of product market dynamics on a firm's cash holdings and hedging behavior

Prior work suggests that if a firm shares a larger proportion of its growth opportunities with rivals, an inability to fully invest in these opportunities leads to predatory behavior on the part of rivals and losses in market share. We examine whether firms manage this predation risk. We find inter- and intra-industry evidence that the extent of the interdependence of a firm's investment opportunities with rivals is positively associated with its use of derivatives and the size of its cash holdings. Moreover, an analysis of investment behavior provides evidence that if this interdependence is high, the management of predation risk provides strategic benefits. Our results indicate that predation risk is an important determinant of corporate financial policy choices and investment behavior.     

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.     

The joint influence of Sarbanes-Oxley and FAS123R on financial misreporting

Prior research reports that a manager's equity risk-taking incentive (vega) is positively associated with financial misreporting. FAS 123R led to a significant decrease in vega while SOX increased the cost of financial misreporting. Consistent with the original intent of the legislation, we find that SOX contributed to significant decreases in both fraud restatements and AAERs. Importantly, our results suggest that the SOX-induced decreases in fraud restatements and AAERs have endured to more recent years. On the other hand, while we find evidence that equity-incentive-motivated financial misreporting ceased to exist in the immediate years after FAS 123R, we also find that this was only temporary. In particular, we find strong evidence of a significantly positive association between vega and accrual misreporting in more recent years.     

Alpha or beta in the eye of the beholder: What drives hedge fund flows?

Capital Asset Pricing Model (CAPM) alpha explains hedge fund flows better than alphas from more sophisticated models. This suggests that investors pool together sophisticated model alpha with returns from exposures to traditional (except for the market) and exotic risks. We decompose performance into traditional and exotic risk components and find that while investors chase both components, they place greater relative emphasis on returns associated with exotic risk exposures that can only be obtained through hedge funds. However, we find little evidence of persistence in performance from traditional or exotic risks, which cautions against investors’ practice of seeking out risk exposures following periods of recent success.     

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.     

Explicit relative performance evaluation in performance-vested equity grants

Using data from FTSE 350 firms, we examine factors influencing explicit relative performance evaluation (RPE) conditions in performance-vested equity grants. We provide exploratory evidence on whether the use or characteristics of RPE are associated with efforts to improve incentives by removing common risk, other economic factors discussed in the RPE literature, or external pressure to implement RPE. We find that many of these economic factors, including common risk reduction, are more closely related to specific relative performance conditions than to the firm-level decision to use RPE in some or all of their equity grants. We also find that greater external monitoring by institutional investors or others is associated with plans with tougher overall RPE conditions. The relative performance conditions are binding in most RPE plans, with nearly two-thirds of the grants vesting only partially or not vesting at all. Further, we find evidence that vesting percentages vary in RPE and non-RPE plans.     

How do ‘busy’ and ‘overlap’ directors relate to CEO pay structure and incentives?

We examine how CEO compensation is affected by the presence of busy and overlap directors. We find that CEOs at firms with more busy directors receive greater total pay, fixed salary and equity‐linked pay and exhibit higher pay‐performance (delta) and pay‐risk (vega) sensitivities. Our results also suggest that CEOs at firms with more overlap directors take smaller total pay and equity‐linked pay and reveal lower delta and vega. We further show that the impact of busy and overlap directors on CEO pay is more visible for firms with less complexity and low information acquisition cost.     

The Effect of Executive Stock Options on Corporate Innovative Activities

This study investigates whether the implicit optionality of executive stock options (ESOs) induce managers to undertake innovative activities associated with various types of risk. We find ESO risk incentive (vega) to be positively correlated with all types of corporate innovations. We also find greater ESO risk incentive effects for the product‐related innovative activities that are associated more with systematic risk than idiosyncratic risk. Finally, we document the following pecking order for the ESO risk incentive effects: improved product, new product, alliance, and new research and development. Our results suggest that executives have more incentive to invest in projects with higher systematic risk.     

Equity‐Based Incentives,Risk Aversion,and Merger‐Related Risk‐Taking Behavior

We find that post‐merger equity risk is negatively related to the sensitivity of CEO wealth to stock return volatility (vega), but is concentrated in CEOs with high proportions of options and options that are more in‐the‐money. The probability of industrial diversification also increases in vega. Additional tests show that the decline in post‐merger equity risk results in a significant decrease in shareholder wealth. This decrease is concentrated among firms with CEOs having the highest delta and the highest delta and vega. Our results suggest that the increased convexity provided by option‐based compensation does not necessarily increase risk‐taking behavior by CEOs.     

Heterogeneity in the Effect of Managerial Equity Incentives on Firm Value

We document significant heterogeneity in the relation between chief executive officer (CEO) equity incentives and firm value using quantile regression. We show that CEO delta is more effective in the presence of ample investment opportunities, while CEO vega is more beneficial for firms lacking investment opportunities. Further, Tobin's Q increases in CEO delta for more risk‐tolerant firms but increases in CEO vega for more risk‐averse firms. We also observe that higher monitoring intensity after the Sarbanes‐Oxley Act reduces CEO delta's role in compensation. Risk aversion alters the optimal incentive‐value relation, and the nature of this relation also depends on the level of Tobin's Q.     

The Effects of Downsizing on Operating Performance

We examine the performance of 118 firms that downsized between 1989–1993. We find that downsizing firms experience declines in operating performance prior to the downsizing announcement. Operating performance improves significantly following the downsizing. These firms are able to reduce the cost of sales, labor cost, capital expenditures and R&D expenditures. We also find that firms that perform poorly in their industries prior to the downsizing and have increases in assets following the downsizing have larger improvements in performance. There is some evidence that the improvements are greater for firms that increase their focus.     

Are target leverage ratios stable? Investigating the impact of corporate asset restructuring

If firms balance the benefits and costs of leverage, then we might expect corporate asset shocks to trigger a change in corporate target leverage. We investigate the impact of corporate asset restructuring and find that target leverage after restructuring is reduced for downsizing firms and increased for upsizing firms. Changes in target leverage are stabilized by the second year after the restructuring event and are monotonic relative to the degree of restructuring. Decomposition analysis shows that corporate asset restructuring directly and significantly affects target debt ratios. Compared to control firms, downsizing firms adjust claims by repurchasing debt while upsizing firms issue debt securities. As expected, debt repurchases are associated with lower tax liabilities while debt issuance decisions correspond to lower growth proxies and are consistent with a higher adverse selection cost of issuing equity, positive leverage deficit, higher tax liabilities, and lower bankruptcy risk.     

Does Firing a CEO Pay Off?

We examine whether involuntary chief executive officer (CEO) replacements pay off by improving firm prospects. We find CEO successors’ acquisition investments to be associated with significantly higher shareholder gains relative to their predecessors and the average CEO. This improvement in postturnover acquisition performance appears to be a function of board independence, hedge fund ownership, and the new CEO's relative experience. CEO successors also create sizable shareholder value by reversing prior investments through asset disposals and discontinuing operations and by employing more efficient investment strategies. Our evidence suggests that firing a CEO pays off.