Managerial Duties and Managerial Biases

Ulrike M. Malmendier is the Edward J. and Mollie Arnold Professor of Finance at the Haas School of Business at the University of California, Berkeley; Vincenzo Pezone is Assistant Professor of Finance at the Goethe University in Frankfurt, Germany; and Hui Zheng is a PhD student at the University of California, Berkeley. This post is based on their recent paper.

One of the most striking developments in research on corporate finance and corporate governance over the last decade is the rise of behavioral finance. While earlier behavioral research had focused on psychological biases in the economic decision making of consumers or individual investors, the more recent research has provided evidence of their significant explanatory power even for top managers. Starting from virtually no published findings in finance until about 2000, Behavioral Corporate research now makes up a third to a half of the behavioral finance research in top finance and economics journals, with the majority focusing on the biases of top managers, as Malmendier (2018) documents (see Figure 3). Recent empirical work has established a significant role of managerial biases such as overconfidence, limited attention, or the sunk-cost fallacy in shaping investment, merger, and financing decisions (see, e.g., the overview in Günzel and Malmendier, 2020).

There is still one limitation to this existing research: Much of it focuses exclusively on the traits and biases of the chief executive officer (CEO). There are good reasons for this focus, namely, the central role of CEOs as the top decision makers and, more mundanely, data availability. In practice, however, other top managers, and especially other members of the C-Suite, significantly influence corporate decisions as well, and we know little about their biases and the interaction of their views and the CEO’s views.

In this paper, we take a step towards filling this gap. Specifically, we build on the existing literature on the role of CEO overconfidence in corporate finance decisions. The context of financial decisions provides for a good laboratory as we can easily identify the most relevant decision-makers: the CEO since she has the ultimate say and determines the riskiness of the firm’s projects, and the chief financial officer (CFO) since financial activities and operations are his core responsibility. We jointly assess the influence of CEO and CFO overconfidence on the choice of financing and on the financing conditions offered by investors.

Overconfidence is the most extensively researched and most robustly documented behavioral trait in corporate decision-making, and we are among the first to investigate its broader role beyond the CEO and apply the existing measures to the chief financial offer (CFO) as well. We define managerial overconfidence as managers’ overoptimistic belief about the future returns, or cash flows, accruing to their firms. Our empirical proxy is the widely used Longholder measure. It captures managers’ personal overinvestment in their firm in the form of delayed option exercise (see, e.g., Malmendier and Tate, 2015). The basic idea is simple: Managers who overestimate future returns to their firm believe that their firm’s value will increase in the future. In order to reap these future value increases, they delay exercise of their executive stock options while a rational manager would exercise.

We present a simple model that allows for the possibility of both the CEO and the CFO exhibiting overconfidence and that generates three main empirical predictions. First, holding constant the CEO’s type, overconfident CFOs exhibit a preference for debt over equity when accessing external finance. Intuitively, overconfident CFOs believe that the broader market underestimates the stream of future cash flows generated by the CEO’s investment choices and thus the value of their firm. Since equity prices are more sensitive to differences in opinions about future cash flows, overconfident CFOs find equity financing too costly and “even more overpriced” than debt.

Second, overconfident CEOs exert a significant indirect influence on financing as overconfidence can lower the cost of financing. The reason is that the CEO’s optimistic beliefs about the returns to effort induce higher effort. Even after a negative shock, when a rational CEO would not put much effort in a project any more, an overconfident CEO will be optimistic enough to work hard towards the good outcome regardless. Anticipating such behavior, investors “believe” in the overconfident CEO, and debtholders require a lower premium on debt than from a rational CEO. The model also reveals that the association between CEO overconfidence and the cost of debt should vary non-monotonically with the firm’s profit variability: Mild shocks to profits do not matter much for the effort choices of either type of CEO, and severe shocks diminish the incentives to work for both types of CEOs. For some intermediate range, however, a rational CEO anticipates the project to be under water and does not exert effort, while an overconfident CEO overestimates the return to effort enough to work hard.

The third prediction is that CEO overconfidence affects financing through hiring. When selecting a new CFO, an overconfident CEO is more likely to choose one who shares her views regarding the firm’s profitability.

All predictions find strong support in a sample of US companies for the period 1992-2015. We find that overconfident executives are reluctant to issue equity, but more inclined to increase leverage, conditional on choosing external financing. Importantly, CFO overconfidence is statistically and quantitatively more important than CEO overconfidence and, if analyzed jointly, CEO overconfidence is insignificant in our data. In other words, optimistic beliefs of both the CEO and the CFO predict that external financing is tilted towards debt, but the CFO’s beliefs strictly outweigh those of the CEO. Thus, the manager whose beliefs matter for capital budgeting decisions directly appears to be the CFO, which is consistent with the CFO’s core competency in designing the financing model.

With regard to our second prediction, we find that firms with overconfident CEOs obtain significantly better financing conditions, as measured by the interest rates on their corporate loans. Overconfident CEOs are charged significantly lower rates in a sample of syndicated corporate loans, controlling for known determinants of the cost of debt. This is consistent with investors being less worried about the investment “going under” even in the presence of negative shocks as the overconfident CEO will keep putting in effort regardless. Moreover, the effect is non-monotonic, following the pattern predicted by our model: It is significant only for firms characterized by medium earnings variability.

Third, we test who is likely to be chosen as CFO conditional on the beliefs of the CEO. We find that companies with overconfident CEOs are more likely to appoint like-minded CFOs, confirming the presence of assortative matching. Thus, CEOs exert indirect influence on corporate financing also via their influence on CFO selection.

In summary, our paper show that CFO beliefs and biases matter for corporate-finance outcomes and interact with those of the CEO. These new results help complete the literature on managerial overconfidence, which had focused on the CEO. Prior to our work, only few papers touch on the roles of other top managers, and even less research considers two or more top managers jointly. Going forward, empirical analyses of managerial traits and biases would benefit from more complete firm data sets that include all top managers who influence a specific firm outcome.

As a practical implication, the joint consideration of managerial biases is important for boards when composing the C-suite and when devising corporate-governance responses to biased managerial behavior.

The complete paper is available for download here.

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