Industry Tournament Incentives and the Product Market Benefits of Corporate Liquidity

Recent research suggests that the inherent optionality present in intra-firm rank-order tournaments provides senior managers with distinct and incremental career-enhancing incentives from option-based compensation schemes to implement riskier but value-enhancing firm policies (Kale, Reis, and Venkateswaran (2009) and Kini and Williams (2012)). Extending the notion of tournaments beyond the top management team to focus on the CEO, Coles, Li, and Wang (2017) find that CEO industry tournament incentives (henceforth ITI), as captured by the pay differential between the firm’s CEO and the maximal industry CEO pay, encourage the adoption of riskier but value-enhancing corporate investment and financing policies. In our article, Industry Tournament Incentives and the Product Market Benefits of Corporate Liquidity, forthcoming in the Journal of Financial and Quantitative Analysis, we add to the literature on managerial tournaments by examining whether and how ITI shape corporate cash policy. To shed light on this issue, we empirically examine the impact of ITI on the: (i) level of cash holdings, (ii) marginal value of cash holdings, and (iii) strategic actions that entail the use of excess cash to obtain competitive benefits in the firm’s product markets.

In evaluating whether and how CEO industry tournaments shape corporate cash policy, we draw on two alternative theoretical viewpoints with regard to the value to shareholders of maintaining balance sheet liquidity. On the one hand, the dominant agency theory view suggests that excess cash in the hands of management reduces shareholder value. The overarching concern with regard to greater managerial access to liquidity arises largely from the flexibility it provides them in making decisions related to its accumulation and dissipation. The pursuit of managerial self-interest can result in the unproductive utilization of cash holdings either due to overinvestment or underinvestment (Jensen (1986) and Bertrand and Mullainathan (2003)). Under the above-described agency theory view, allowing firms to become cash rich is value destructive and, consequently, incentive alignment mechanisms should result in CEOs pursuing actions that lead to the reduction of balance sheet liquidity. However, an alternative view in the literature, which we refer to as the product market benefit view, suggests that cash-rich firms are at a competitive advantage because cash can produce strategic and hedging benefits. Specifically, research suggests that cash-rich firms can secure a competitive advantage in their product markets by reducing the ability of rival firms to engage in predatory actions, imposing predation risks on rivals, and increasing the firm’s ability to withstand short-term shrinkages in profit margins in order to fund long-term market share building investments in advertising and promotions, development of supplier/customer networks, efficient supply chains, and R&D and capital expenditures (Benoit (1984), Bolton and Scharfstein (1990), Campello (2006), and Fresard (2010)).

The dichotomy arising from cash serving as a strategic resource capable of generating product market benefits versus its potential to promote inefficient investments underscores the importance of evaluating the efficacy of alternative incentive systems and/or governance mechanisms to not only alleviate agency conflicts but also incentivize managers to exploit the competitive benefits of cash. Drawing from the notion of tournament incentives, we argue that CEO industry tournament incentives have the potential to alleviate agency conflicts and provide CEOs with risk-taking incentives to exploit the product market benefits of cash holdings. For example, Lazear and Rosen (1981) and Prendergast (1999) contend that the effort exerted by economic agents will be higher if the size of the promotion prize is greater. In addition, the option-like features and convex payoff structure of tournament incentives will also increase managerial appetite for risk-taking in order to increase the probability of winning the tournament (see, e.g., Chen, Hughson, and Stoughton (2017), Coles Li, and Wang (2017), Goel and Thakor (2008), and Hvide (2002)). Thus, ITIs are likely to have a strategic component inherently built into them if they, in fact, motivate CEOs to win the industry tournament. Specifically, in the context of cash policy, the career-enhancing incentives provided by ITI can motivate managers to efficiently accumulate cash reserves and then strategically deploy it to reduce predation risk, deter aggressive investments by rivals, and/or await time-sensitive opportunities to invest cash strategically with the objective of gaining market share at the expense of rival firms.

Overall, our empirical analysis suggests that there is a consistently significant and positive relation between ITI and the level and marginal value of cash holdings. For example, for our main measure of ITI, our results suggest that high ITI firms hold 5.84%–11.16% more cash relative to low ITI firms. Similarly, for our main measure of ITI, we find that there is a $0.23–$0.34 difference in the marginal value of a dollar of cash for high ITI firms relative to low ITI firms. We further find consistent evidence to suggest that the market share gains arising from excess cash holdings increase with ITI. This result, however, only holds for firms facing significant competitive threats. In additional tests, we find that high ITI firms invest more in R&D expenses, capital expenditures, and acquisitions (especially focused acquisitions), and have lower shareholder payouts. Overall, our results suggest that ITI provide CEOs with incentives to aggressively build and then deploy excess cash reserves to pursue product market strategies that produce competitive benefits at the expense of industry rivals. Further, the positive relation between ITIs and the marginal value of cash suggests that these market share gains and related strategies are, on average, value enhancing.

Our article makes contributions to the following strands of research—corporate liquidity policies, tournament incentives, design of corporate compensation policies/incentive structures, and product market strategies. Our article is most closely tied to the literature on CEO industry tournament incentives and intra-firm tournament incentives which suggests that these tournament incentives lead to value enhancing risk-taking strategies by firms. Consistent with both the value creating and risk-taking incentives that arise from tournament incentives, we find ITI increase the marginal value of cash and enhance the strategic use of cash to gain market share. Our study also adds to a growing stream of research that suggests that governance quality can influence firm cash holdings as well as the marginal value of cash in the hands of management. In our article, we find that similar to good governance, ITI increase the marginal value of cash, but with the key difference that the value enhancement comes not from preventing inefficient investments, but rather from more efficient accumulation and subsequent deployment of excess cash to capture its competitive benefits. In addition, our results provide additional insights as to how alternative CEO incentive mechanisms differentially influence the level and value of cash. Our article also builds on the literature which views corporate cash holdings as a strategic resource by illustrating that CEO tournament incentives strengthen the link between cash holdings and subsequent market share gains. Finally, while boards can design CEO and top management incentive mechanisms and internal governance structures, they have little control over the design of the industry tournament and the setting of the CEO industry pay gap. Our results suggest that boards should take into account ITI in formulating mechanisms that are under their control to properly influence managerial behavior vis-à-vis liquidity policies.

The complete article is available here.