In a new paper, we examine how tournament-based incentives affect corporate cash holdings and the value of those holdings for shareholders.
Before a firm selects a new CEO, it may run a tournament within the firm to rank its vice-presidents (VPs) as candidates. Because the actual ability of a VP is unobservable, the VP with the best performance relative to his peers will likely win the tournament. The payoff structure of tournament-based incentives is similar to that of stock options, in which the payoff is an increase in pay, perquisites, and prestige associated with being the CEO. This option-like feature of tournament-based incentives motivates senior executives to increase the risk of their activities whose outcomes are used to rank the candidates, leading to riskier corporate policies. In our research, we use CEO pay gap, measured as the difference between a company’s CEO pay and the median pay of the VPs, as the primary proxy for tournament-based incentives.
Tournament-based incentives can affect corporate cash policy in different ways. On the one hand, they may reduce corporate cash holdings, because the incentives encourage risky behavior, and cash is a safe investment. On the other hand, they might prompt shareholders to demand that the company hold more cash to avoid costly financing, because risky policies increase cash flow uncertainty that can create underinvestment and liquidity shortfalls in economic downturns. Furthermore, higher cash holdings may also be a result of creditors imposing restrictive liquidity covenants on firms as these lenders anticipate riskier behavior prompted by tournament-based incentives.
Our analysis of 2,683 firms over the period 1992–2014 indicates a positive relationship between tournament-based incentives and corporate cash holdings. This relationship is stronger for firms that have a lower correlation between investment opportunities and cash flow. We also find that the value of an extra dollar of cash is higher in firms that employ tournament-based incentives and this effect is more pronounced for financially constrained firms. Our further analysis of the link between tournament-based incentives and firm risks indicates that tournament-based incentives are associated with not only systematic but also idiosyncratic risk. The positive relationship between tournament-based incentives and idiosyncratic risk suggests that firms that run CEO tournaments hold larger cash reserves for hedging purpose. Overall, our findings suggest that, as tournament-based incentives induce risk-increasing investment and financing choices leading to increasing cash flow uncertainty, firms increase cash holdings to cushion potential liquidity shortfalls in order to maintain steady investment programs.
Our research adds to the debate over the efficiency of executive compensation. We show that, although tournament-based incentives and CEO compensation-based incentives, particularly CEO vega, which measures the sensitivity of CEO wealth to stock return volatility, exhibit similar effects on corporate cash holdings, their underlying motives and effects on shareholder value differ. The findings of our research can affect how firms compensate their executives and plan for liquidity and how regulators formulate policies on executive compensation. Our research could be particularly relevant at a time when firms are hoarding cash, and CEO pay is attracting significant attention from the news media and regulatory agencies.
This post comes to us from Professor Hieu V. Phan at the University of Massachusetts Lowell, Professor Thuy Simpson at Grand Valley State University, and Professor Hang T. Nguyen at Michigan State University. It is based on their recent paper, “Tournament-Based Incentives, Corporate Cash Holdings and the Value of Cash,” available here.