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E-MailTodd Gormley is Associate Professor of Finance at Washington University in St. Louis Olin Business School; and David A. Matsa is Associate Professor of Finance at Northwestern University Kellogg School of Management. This post is based on their recent article. Related research from the Program on Corporate Governance includes The Costs of Entrenched Boards by Lucian Bebchuk and Alma Cohen; and How Do Staggered Boards Affect Shareholder Value? Evidence from a Natural Experiment by Alma Cohen and Charles C. Y. Wang.
There is not one conflict between managers and shareholders. Various different underlying frictions create many manager-shareholder agency conflicts. Understanding the relevance of these various conflicts and how they vary across firms is crucial for designing incentive and governance structures that mitigate the impact of these conflicts on shareholder value and potentially the aggregate economy. For example, if a manager fails to make risky investments out of a reluctance to exert costly effort and a desire to pursue the “quiet life”, then shareholders might wish to increase the manager’s ownership stake to better align their interests and encourage risk taking. On the other hand, if the manager forgoes these investments because of risk aversion and the potential impact of failure on his or her income and wealth, then increasing the manager’s ownership stake in the firm will only worsen the agency conflict. Understanding the source of the agency conflict also has important implications for a firm’s optimal leverage and cash management policies.
In our article, Playing it Safe? Managerial Preferences, Risk, and Agency Conflicts, which was published in the current issue of the Journal of Financial Economics, we illustrate the importance of managers’ risk preferences in agency conflicts. Although risk-related conflicts are pervasive in agency theory, their empirical relevance was unclear. Building upon the literature’s workhorse empirical setting for establishing agency conflicts, we assess the importance of agency conflicts arising from managers’ risk preferences by exploiting anti-hostile takeover laws as a source of variation in external shareholder governance (e.g., see Bertrand and Mullainathan (2003), among many others). By making it more difficult to remove a manager who engages in value-destroying activities, these laws weaken shareholder governance and increase the scope for agency conflicts. Moreover, because more than 60% of U.S. firms are incorporated in one state but located in another, we can control for potential confounding state-level trends by comparing the differential response of two firms that operate in the same state but where only one of these firms is incorporated in a state that adopts an anti-takeover law (and hence is affected by the law).
We find that weakened governance leads many managers to take value-destroying actions that reduce their firms’ stock volatility and risk of distress. We call these actions “playing it safe,” and to illustrate one such action, we show that managers protected by antitakeover laws undertake diversifying acquisitions that target firms likely to reduce risk. These acquisitions have negative announcement returns and are concentrated among firms whose managers (personally) gain the most from reducing risk. For most corporate outcomes (including stock volatility and R&D expenditures), pursuing the quiet life and playing it safe lead to observationally equivalent outcomes. Our analysis focuses on acquisitions because they provide evidence of managers playing it safe in a way that can be distinguished empirically from them pursuing the quiet life. These findings confirm that motivating managerial effort is not the only challenge shareholders face and provide a new perspective on what motivates managerial responses to these laws.
Consistent with theory, we show that inside ownership, financial leverage, volatility, and corporate distress exacerbate risk-related agency conflicts. We also explore the underlying sources of managers’ preference to play it safe. In theory, such preferences could be motivated by both risk aversion and career concerns, and we find evidence for both mechanisms. Consistent with managerial risk aversion, we find that holding a large ownership stake makes managers more likely to play it safe, because managers of these firms have more of their financial wealth tied to the firms’ success. Consistent with career concerns also being an important factor, we find that younger managers, who have stronger career-related incentives, are more likely to play it safe. The increase in diversifying acquisitions is strongest among CEOs who are under 55 years old when a BC law is adopted in their firm’s state of incorporation.
Our analysis points to the importance of managerial preferences aside from a desire to avoid costly effort or take private benefits. The findings offer explanations for puzzles in the literature. Managers’ incentive to play it safe could explain why firms often don’t risk shift in distress (e.g., Andrade and Kaplan, 1998; Rauh, 2009; Gilje, 2014); although risk shifting is in shareholders’ interest, managers’ self interest in playing it safe could dominate. Our findings also provide an explanation for the long-term decline in risk taking among U.S. firms. While multiple factors surely contribute to this trend, the decrease in risk taking interestingly coincides with increases in equity-based compensation and the sensitivity of CEO turnover to corporate performance (Jenter and Lewellen, 2014), both of which give corporate leaders incentives to tread carefully.
The full article is available for download here.
