A widely-held view in financial economics is that CEOs holding a non-diversified wealth portfolio tied to the firm are likely to be more risk-averse when making corporate decisions than what diversified shareholders would prefer. To reduce this divergence in attitude toward risk between CEOs and shareholders, equity-based compensation such as stock and stock option grants that offer payoff structures similar to what shareholders receive is often used in the CEOs compensation package. The purpose is to align the interests of CEOs with that of shareholders, and lead to corporate decisions consistent with shareholders’ interests.
In recent years, there has been an increase in the use of deferred compensation and pension benefits, often called “inside debt” in academic literature, in CEO compensation packages of U.S. firms. Deferred compensation and pension benefits are usually structured such that a firm promises to pay the CEO fixed amounts after retirement as long as the firm remains solvent, and in the case of insolvency, however, the CEO could lose these benefits as they are often unfunded and unsecured. In other words, the CEO’s inside debt is similar to the firm’s outside debt in payoff mechanism. Unlike equity-based compensation that creates risk-seeking incentives, inside debt compensation offers long-term incentives that might contain risk-seeking behaviors and align the interest of the CEO towards debtholders.
This suggests that CEOs receiving both equity-based compensation and inside debt compensation should consider the interests of both shareholders and debtholders when making corporate decisions that impact the risk level of the firm. In fact, some postulate that the CEO’s compensation structure would be optimal if it were identical to the firm’s capital structure. However, it is highly possible that compensating managers with inside debt could actually neutralize some of the risk-seeking incentives offered by equity-type compensation and exacerbate the divergence in attitude toward risk between CEOs and shareholders. As a result, CEOs having higher levels of inside debt would tend to adopt excessively conservative business policies that favor debtholders but compromise shareholders’ wealth, especially given that CEOs tend to be conservative even in the absence of inside debt.
To test this conjecture, we consider the impact that CEO inside debt has on the firm’s capital structure dynamics using a sample of U.S. firms included in the S&P 1500. The use of debt as part of the firm’s capital structure incurs the risk of bankruptcy that is often thought to increase exponentially with the debt-to-asset ratio. Risk-averse CEOs would naturally avoid lifting the debt ratio to shareholders’ desired level unless incentivized to do so. We hypothesize that CEO inside debt holdings, exacerbating the CEO’s risk aversion, negatively influence the firm’s debt ratio. Moreover, the more risk-averse a CEO is, the less likely he would adjust the debt ratio toward shareholders’ desired level if the firm is under-levered. In the over-levered firm case, however, both the CEO and shareholders would desire a lower debt ratio so the CEO’s risk aversion speeds up downward capital structure adjustments. Thus, our second hypothesis is that CEO inside debt holdings negatively impact the capital structure speed of adjustment toward shareholders’ desired levels for under-levered firms, but positively impacts the speed of adjustment for over-levered firms.
We first find that a firm’s debt ratio, on average, moves in the opposite direction as the CEO’s inside debt during the CEO’s tenure suggesting a negative correlation between CEO inside debt and the firm’s debt ratio. We then conduct several econometric tests that control for both firm and CEO characteristics including equity-based compensation, as well as potential endogeneity of CEO inside debt, in attempts to isolate the impact CEO inside debt holdings have on the firm’s debt ratio. Consistent with our first hypothesis, we find that the firm’s debt ratio is negatively associated with CEO’s inside debt holdings in the previous year, indicating that inside debt does indeed increase CEO risk-aversion in setting the firm’s capital structure policy.
To test our second hypothesis, we first estimate shareholders’ desired debt ratio for the firm where their wealth is maximized, and then determine the impact CEO inside debt has on the speed of adjustment of the debt ratio towards this estimated level for under- and over-levered firms, separately. We find that CEO inside debt holdings spur faster adjustments of under-levered firms toward shareholders’ desired debt ratios, but slow down the speed of adjustment for under-levered firms. Again, this suggests inside debt holdings aggravate CEO’s risk-aversion at the expense of shareholder wealth.
Finally, we attempt to identify the level of CEO inside debt holdings that is optimal for capital structure decisions. The optimal level of CEO inside debt would be the level that facilitates the fastest capital structure adjustment to shareholders’ desired levels for both over- and under-levered firms. We find the estimated optimal CEO inside-debt-to-total compensation ratio is very low, less than 10% of the firm’s debt-to-asset ratio, as conducive to optimal capital structure adjustment dynamics.
Our study provides two additional insights regarding the impact that inside debt compensation has on CEO incentives. First, in regards to capital structure decisions, our results indicate that inside debt can be used to align the interest of managers to debtholders, but only at the expense of shareholders’ interests. Second, since managers hold less diversified wealth, their interests are already more aligned with debtholders than shareholders to begin with. Firms do not need to offer much, if any, inside debt incentives to align manager’s interest with that of debtholders. It is perhaps more efficient to increase, or decrease, equity-based compensation only in order to incentivize managers to consider both shareholders’ and debtholders’ interests proportionately when making decisions that impact firm risk.
The preceding post comes to us from Eric R. Brisker, Assistant Professor in the Department of Finance at the University of Akron and Wei Wang, Assistant Professor of Finance at Monte Ahuja College of Business at Cleveland State University. The post is based on their working paper, which is entitled “CEO’s Inside Debt and Dynamics of Capital Structure” and available here.