The Effect of Managerial Traits on Corporate Financial Policies

The following post comes to us from Ulrike Malmendier of the Economics Department at the University of California, Berkeley, Geoffrey Tate of the Finance Department at UCLA, and Jon Yan of Stanford University.

In our forthcoming Journal of Finance paper, Overconfidence and Early-life Experiences: The Effect of Managerial Traits on Corporate Financial Policies, we provide evidence that managers’ beliefs and early-life experiences significantly affect financial policies, above and beyond traditional market-, industry-, and firm-level determinants of capital structure. We begin by using personal portfolio choices of CEOs to measure their beliefs about the future performance of their own companies. We focus on CEOs who persistently exercise their executive stock options late relative to a rational diversification benchmark. We consider several interpretations of such behavior — including positive inside information — and show that it is most consistent with CEO overconfidence. We also verify our measure of revealed beliefs by confirming that such CEOs are disproportionately characterized by the business press as “confident” or “optimistic,” rather than “reliable,” “cautious,” “practical,” “conservative,” “frugal,” or “steady.”

This form of belief makes specific capital structure predictions: Overconfident CEOs overestimate future cash flows and, therefore, perceive external financing — and particularly equity — to be unduly costly. Thus, they prefer internal financing over external capital markets and, conditional on raising risky capital, debt over equity. We find strong evidence that, conditional on accessing public securities markets, overconfident CEOs are less likely to issue equity than other CEOs. We also find that, to cover an additional dollar of external financing deficit, overconfident CEOs issue about 33 cents more debt than their peers. Managerial overconfidence is also positively related to debt conservatism, measured using the kink variable from Graham (2000). This debt conservatism is not driven by an increased propensity to issue equity. Instead, overconfident CEOs who are debt-conservative are also equity conservative and rely excessively on internal funds. Finally, overconfident managers choose higher leverage ratios than predecessors or successors in their firms.

Second, we consider early-life experiences which are likely to shape beliefs and choices later in life. Guided by prior psychology and management literature, we focus on two major formative experiences which affect our sample CEOs: growing up during the Great Depression and serving in the military. We find that CEOs who experience the Great Depression early in life display a heightened reluctance to access external capital markets. World War II CEOs, on the other hand, choose more aggressive corporate policies, including higher leverage ratios. The effects are distinct from the effect of overconfidence on financial decisions. Though the specific shocks which guide belief formation may differ in other samples of CEOs, our methodology for identifying those shocks is easily generalized.

Our results have several implications. First, our findings help to explain the strong time-invariant component of firm capital structure identified in recent studies. Though our identification strategy requires us to establish the effect of managerial beliefs using within-firm variation, the significance of our measures suggests that variation in managerial beliefs may account for a significant portion of the (co-determined) between-firm variation. Managerial beliefs may be particularly important in firms with long-serving managers, family ownership, or a preference for hiring managers with a particular “style.”

Second, our results have distinct implications for contracting practices and organizational design. To the degree that boards do not anticipate or desire bias-driven policies, standard incentives, such as stock- and option-based compensation, are unlikely to offset fully the effects of managerial overconfidence on investment and financing decisions. Biased managers believe they are choosing value-maximizing policies, and boards may need to use different tools, such as cash dividend payment and debt overhang, to constrain overconfident CEOs. Similarly, financial incentives will be miscalibrated if they do not account for financial conservatism or financial aggressiveness arising from the CEO’s past experiences.

Third, our findings on the financial decision-making of Depression and military CEOs provide evidence that major personal events can have a life-long effect on risk attitudes and choices. Macroeconomic shocks, such as the current financial crisis, are likely not only to have an immediate impact on corporate financial policies (e.g. through de-leveraging and a shift toward self-sufficiency), but also to affect future policies as today’s young investors, who are being introduced to financial markets during a time of crisis, become the next generation of corporate leaders. Thus, the Depression Baby results not only document a pattern of historical interest, but also suggest how financial choices may play out over the coming decades.

Finally, exposure to a military environment may affect corporate decision-making more broadly than just financial policy. For example, military CEOs may implement a more command-based corporate culture. An interesting topic for future research is to test whether CEOs with military experience create a more hierarchical structure in their firms and, conversely, to test for an effect of private-sector experience on the decisions of government, military, or non-profit leaders.

The full paper is available for download here.

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