Risk aversion and career concerns are pushing managers to play it safe, reducing the shareholder value of their companies — and the incentive compensation structures meant to motivate managers often have the opposite effect.
Many previous studies have examined how personal benefits or the refusal to exert the required effort (also known as ‘enjoying the quiet life’) can lead managers to take actions that hurt their companies. The recent research by Todd Gormley of Olin and David Matsa of Kellogg focuses on an overlooked third motivation for managers acting against their company’s interests: risk aversion.
To assess the impact of risk aversion on manager performance and shareholder value, Gormley and Matsa compared managerial actions in states where hostile takeovers are limited or hampered by state laws to managerial actions in states where companies are more at risk of such takeovers.
Hostile takeovers, the researchers explain, usually involve a change of top management. Thus in states in which the laws are more friendly to hostile takeovers, managers have an incentive to increase shareholder value — an incentive that translates in the prudent risk-taking required to improve corporate results.
In states where hostile takeovers are more constrained — and thus, managers are less likely to be replaced — corporate managers will tend to take less risks, leading to lower corporate performance and the destruction of shareholder value.
One way in which managers reduce their risk taking, according to the researchers, is through diversifying acquisitions — that is, acquisitions of firms that are in industries different from the acquiring firm’s industry. In addition to seeking out new industries, risk averse managers (for example, younger managers afraid to risk their future careers) will seek out target firms that will likely reduce stock volatility and distress. In addition, these acquisitions will be financed by equity rather than cash, further reducing the risk of distress.
However, such acquisitions tend to reduce shareholder value — in fact, the downturn often begins with the announcement of the acquisition (which, according to the research, sees an average decrease of 5.6% in stock value).
Traditional compensation structures used to motivate managers, such as increased equity ownership in the firm, can have unintended consequences when managerial risk aversion is involved, according to Gormley’s and Matsa’s research.
For example, managers with a larger ownership stake in the company play it even more safe since they don’t want to risk their wealth that is tied up in the company. This is borne out by the results of the study: when new anti-hostile laws protecting managers are passed, companies with above average share of inside ownership are 28% more likely to launch diversifying acquisitions than companies with the same ownership structure but unprotected from hostile takeovers.
Managers in companies in less solid positions economically — that is, companies with greater leverage and greater distress risk (e.g. operating asset volatility, cash flow volatility and cash holdings) — are even more motivated to play it safe: the distress of their companies is putting their wealth at risk.
To explore the interrelationships described in the study, the researchers used data from a variety of sources, including Compustat for financial information, and the Securities Data Company Mergers and Acquisitions Database for histories on acquisitions. The research was based on data from the years 1976 – 2006.
This research does not argue that leverage or ownership equity are consistently poor choices for directing a manager’s motivation. The research does argue, however, that incentive structures must take into account a manager’s risk aversion and the motivation behind that aversion.
For example, if the manager is unwilling to undertake risky investments because they entail exerting costly effort, increasing the manager’s ownership stake will have the desired effect of motivating the manager to exert more effort and increase the company’s value.
However, if the manager’s risk aversion stems from fearing the loss of personal wealth — including the loss of his or her job — that might result from failure, then a greater ownership stake will have an impact opposite to the one intended: the manager will become even more risk averse. In this case, a better design is a compensation plan with greater convexity (that is, with a motivating upside, but limited or no downside).
A further complication is that manager motivations are not static. For example, a manager may exert too little effort in good times, and be overly active in times of distress.
The bottom line: boards must design the compensation package that motivates a manager to take the risks necessary to maximize shareholder value — a task even more complicated than it seems.
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