Creditors’ Incentives to Monitor: The Impact of CEO Compensation Structure

Francesco Vallascas is Chair in Banking at Leeds University Business School. This post is based on a recent paper by Professor Vallascas; Borja Amor-Tapia, Professor at Universidad de León; Paula Castro, Professor at Universidad de León; Kevin Keasey, Head of the Accounting and Finance Department at Leeds University Business School; and Maria T. Tascón at Universidad de León.

The presence of equity-based incentives in executive pay, by linking the value of compensation to stock return volatility and to stock price, are seen as aligning the interests of managers with those of shareholders (Brockman et al. [2010]; Coles et al. [2006]; Dow and Raposo [2005]; Lo [2003]).

Another effect of these incentives is, however, the potential increase in the agency costs of debt related to asset substitution problems, with managers being tempted to replace safe activities with riskier ones, thus transferring wealth from debtholders to shareholders. Nevertheless, creditors understand the risk-taking incentives in executive pay and the related potential negative effects for their wealth. In this regard, Brockman et al. [2010] show that the debt maturity shortens when the risk-taking incentives in CEO pay are larger.

In our paper, The Incentives of Creditors to Monitor via Debt Concentration: The Impact of CEO Compensation Structure and Horizon, which was recently made publicly available on SSRN, we show that the relationship between CEO compensation and a firm’s debt structure extends beyond debt maturity to debt concentration by debt type. Furthermore, we demonstrate that not simply the magnitude of the risk-taking incentives in CEO pay but also their time horizon matter for debt concentration.

In general, the view of debt concentration as a monitoring tool is theoretically motivated by more concentrated debt structures (by debt type) being associated with a lower number of creditors with potentially conflicting interests (Li et al. [2016]; Lou and Otto [2016]). A more concentrated debt structure is expected to alleviate information collection problems for creditors (and the related agency costs), reduce free-rider problems amongst creditors and the risk of duplicating monitoring effort (Allen [1990]; Diamond [1984]; Platikanova and Soonawalla [2014]).

We base our analysis on a sample of publicly traded US non-financial firms for the period 2001-2012 and rely on the sensitivity of compensation to stock return volatility, commonly known as Vega, as our primary measure of the risk-taking incentives embedded in executive pay.

We first investigate whether an increasing presence of risk-taking incentives in executive compensation impacts on the degree of debt concentration by debt type. Debt concentration has been shown to be significantly higher in companies where creditors have more incentives to monitor—(Colla et al. [2013]; Li et al. [2016]; Platikanova and Soonawalla [2014]). This implies that a concentration of debt claims should be preferable to creditors when they have stronger incentives to effectively monitor managerial actions, as is the case of when managers receive high risk-taking incentives in their compensation package. We show that, given the level of risk-taking incentives in CEO compensation, creditors identify an increase in debt concentration as an alternative mechanism to a reduction in debt maturity to facilitate the monitoring of managers.

We then examine whether the time horizon of risk-taking incentives influences the potential effect of executive pay-incentives on debt concentration. Numerous studies suggest that short-term incentives induce short-termism in the performance of CEOs (Bolton et al. [2006]) that might generate myopic behavior (Bebchuk and Fried [2010]; Gopalan et al. [2014]). Furthermore, short-term incentives are expected to make it attractive for managers to choose riskier projects that boost short-term performance and enhance manager reputation (Gopalan et al. [2014]; Thakor [1990]). We argue, therefore, that debt concentration as a monitoring tool for creditors emerges especially in the presence of a shorter time horizon of risk-taking incentives.

To examine the above argument, we quantify the potential short-term benefits that a CEO might obtain by increasing firm risk on the basis of the vesting period of his/her portfolio of stock options that allows us to compute two components of Vega. Specifically, we compute a proxy for short-term compensation benefits produced by an increase in volatility by using only vested options and a proxy for the long-term benefits by focusing on unvested options. Our results show that only increases in the component of Vega linked to vested options lead to a rise in the degree of debt concentration in a firm’s debt structure.

We then extend the analysis by investigating how the relationship between debt concentration and equity-based incentives, and the related impact of the incentive time horizon, is influenced by a firm’s default risk. We posit that there could be at least two reasons that motivate greater debt concentration by debt type in more risky companies when CEO pay might generate more severe asset-substitution problems. First, in the presence of a default, a dispersed group of creditors tends to be inefficient in organizing and coordinating negotiation efforts (Bolton and Scharfstein [1996]; Hart and Moore [1995]; Hubert and Schfer [2002]; Ivashina and Scharfstein [2010]). Second, asset substitution problems are also more likely to occur when firms are closer to financial distress (Black and Scholes [1973]; Gavish and Kalay [1983]; Leland [1998]). We find that an increase in Vega raises the degree of debt concentration significantly more in riskier firms and furthermore, we also show that the effect of Vega is generally driven by its short term component.

Finally, by comparing the impact of Vega on the percentage change of the market value of debt in firms with low and high degree of debt concentration, we find that the negative influence of equity-based incentives on debtholder wealth is limited to the group of firms with less concentrated debt structures, especially in the presence of short-term incentives. This result implies, therefore, that debt concentration is an effective tool to curtail asset substitution problems.

The complete paper is available for download here.

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