How Executive Compensation Affects Firms’ Choice of Financing

The separation of corporate ownership from control leads to an agency problem caused by the divergent interests of shareholders (the principals) and management (the agent).  One area of contention is the level of risk-taking by the firm.  Managers’ investment in human capital makes them more risk-averse than shareholders are, and this difference creates losses that account in part for the agency cost of equity.  To mitigate this cost, prior research suggests that managers be paid in stock and stock options, in addition to cash compensation, so that their interests are aligned with those of shareholders.

Unfortunately, the convergence of managers’ and shareholders’ interests is also recognized by the firms’ debtholders and leads to a second source of conflict. The manager motivated by his equity-based compensation increases his risk-taking, to the detriment of bondholders, who, in turn, protect themselves by increasing debt costs or imposing more stringent bond covenants.  As the residual claimants of the firm’s assets, shareholders ultimately bear the agency cost of debt. Prior research again points to the use of the appropriate compensation for managers to mitigate this cost. By including debt-based compensation in the form of pensions and deferred compensation, commonly known as inside debt, managers are motivated toward more conservative policy decisions. As bondholders recognize the inside debt component of managers’ compensation, they reduce the cost of debt to the firm.  A firm-specific optimal mix of both equity and debt-based compensation for managers may provide maximum firm value because it considers both shareholders’ and bondholders’ interests.

In our latest research, we examine the relation between the level of chief executive officers’ debt-based compensation and their choice between external debt and equity financing for their firms.  Prior literature generally takes the view that increased inside debt causes managers’ interests to align more with debtholders and, consequently, results in less risk-taking, but the financing choice involves counterbalancing forces on managers’ welfare.  Inside debt could motivate managers to favor equity financing since greater debt, associated with greater financial risk, may put their debt-like compensation at risk.  However, debtholders also account for increased levels of inside debt and lower their cost of debt accordingly, which can nudge firms toward debt financing.  In addition, more debt can provide, up to a limit, more tax deductions, and can increase corporate performance through greater leverage, which can ultimately contribute to CEOs’ pension and deferred compensation. Because there are countervailing forces that affect the financing decision, we are motivated to empirically examine the issue.

Using a sample of 1,008 annual observations of 487 firms that accessed the public markets from 2007 to 2012, we find that firms with greater CEO inside debt are more likely to issue debt than equity.  A one standard deviation increase in our CEO inside debt measure increases the relative probability of a mixed debt-equity over equity-only financing by at least 17 percent, depending upon the inside debt measure, and it increases the probability of a debt-only financing over equity-only financing by at least 69 percent. CEO inside debt is also positively related to the proportion of debt used in a firm’s total external financing. Additional analysis indicates a negative relation between CEO inside debt and the cost of debt to the firm and a positive relation between inside debt and the stock-price reaction around the public debt announcement.  Our evidence supports the view that favorable debt terms induced by greater inside debt motivate CEOs to favor debt financing, which then increases shareholder value.

To the best of our knowledge, our study is the first to provide direct evidence of a significant relation between inside debt and a firm’s financing choices, a central decision in corporate finance.  Moreover, by using external financing events at points when firms change their capital structure, we are able to better identify the effect of inside debt on corporate financing policy.  Our research also identifies a channel, the corporate financing choice, through which an optimal compensation scheme that balances debt-based and equity-based incentives, can increase shareholder value.

This post comes to us from professors Steven Freund, Saira Latif, and Hieu V. Phan at the University of Massachusetts Lowell. It is based on their recent article, “Executive Compensation and Corporate Financing Policies: Evidence from CEO Inside Debt,” available here.