How Risk Aver­sion Moti­vates Executives

Senior exec­u­tives are often crit­i­cized for fail­ing to work hard enough to cre­ate val­ue for share­hold­ers. It takes far less effort to stay the course, after all, than to make painful-but-prof­itable choic­es like redis­trib­ut­ing resources, enforc­ing pay cuts, or clos­ing a plant and lay­ing off dozens of workers.

But a recent line of research sug­gests that exec­u­tives are also guid­ed by some­thing else: risk aversion. 

David Mat­sa of the Kel­logg School and Todd Gorm­ley of Whar­ton argue that man­agers shun mak­ing the risky — but poten­tial­ly reward­ing — deci­sions that could max­i­mize a firm’s val­ue because they wish to pro­tect their com­pen­sa­tion pack­ages or pre­serve the sheen of suc­cess that will land them their next job. 

Com­pa­nies would do well to keep these career con­cerns in mind when design­ing incen­tives to pro­tect share­hold­ers. In par­tic­u­lar, stock own­er­ship — com­mon­ly offered to exec­u­tives to encour­age strong per­for­mance — may in fact encour­age exec­u­tives to play it safe. 

“Pay­ing in equi­ty can cre­ate a per­verse incen­tive,” says Mat­sa, an asso­ciate pro­fes­sor of finance. 

Acquir­ing ​“Cash Cows” To under­stand the case for risk aver­sion, con­sid­er what hap­pens when firms sud­den­ly find them­selves exposed to poten­tial litigation.

In one study, Mat­sa and Gorm­ley inves­ti­gat­ed the behav­ior of over 2,200 com­pa­nies, each of which learned that one of the chem­i­cals used in their pro­duc­tion process had been declared a car­cino­gen. Because their employ­ees had already been exposed to the chem­i­cal, the dis­cov­ery dra­mat­i­cal­ly increased the like­li­hood that the firm would need to spend sig­nif­i­cant sums on legal fees, insur­ance pre­mi­ums, and oth­er pay­ments. It also height­ened the risk of bank­rupt­cy, should the chem­i­cal turn out to be the next asbestos.

In the face of uncer­tain­ty, and of poten­tial­ly crip­pling lia­bil­i­ties, what did the com­pa­nies do? 

“They start­ed buy­ing oth­er firms,” says Mat­sa. Dis­cov­er­ing that their work­ers had been exposed to a car­cino­gen was linked to a 6% increase in acqui­si­tions. But crit­i­cal­ly, acquir­ing these com­pa­nies didn’t actu­al­ly cre­ate any val­ue for share­hold­ers. That’s because, rather than mak­ing more strate­gic pur­chas­es, the trou­bled firms over­paid for large and unre­lat­ed ​“cash cows” — firms whose healthy prof­its might off­set any future pay­outs the com­pa­ny would have to make.

“We likened it to how tobac­co firms diver­si­fied into food when the health risks of smok­ing became more pro­nounced legal­ly,” says Mat­sa. (Con­sid­er, as the most famous exam­ple, Phillip Mor­ris’ acqui­si­tion of Kraft Foods in 1988.) ​“The man­agers were look­ing for a way to reduce risk.” 

Mat­sa and Gorm­ley argued that that the man­agers pur­sued this strat­e­gy to reduce their per­son­al expo­sure. Because their com­pen­sa­tion was close­ly tied to the firm’s per­for­mance, their own finances would have been dis­pro­por­tion­ate­ly hit by the firm’s col­lapse. And because a cat­a­stro­phe would like­ly cost them their jobs, their careers also hung in jeopardy. 

Avoid­ing a Takeover

Next, the researchers decid­ed to inves­ti­gate whether career con­cerns led exec­u­tives to be risk averse in oth­er sit­u­a­tions as well. In anoth­er study, Mat­sa and Gorm­ley took advan­tage of vari­a­tions in merg­er laws across the Unit­ed States to see whether man­agers behave dif­fer­ent­ly when they are ​“pro­tect­ed” from the threat of a takeover.

“Takeovers are seen as a dis­ci­plin­ing force that makes man­agers less like­ly to run firms in a sub­op­ti­mal way,” Mat­sa explains. 

How so? Con­sid­er a sce­nario in which a firm cre­ates 100 dol­lars of val­ue. If some­one else, run­ning the firm dif­fer­ent­ly, could cre­ate 110 dol­lars, than the firm is at risk of being pur­chased by that oth­er par­ty, per­haps for 105 dol­lars. Because the takeover would prob­a­bly involve replac­ing man­age­ment, the mere threat of a takeover keeps man­agers work­ing hard to make sure no one can run the firm more profitably. 

But some states make it much hard­er to com­plete hos­tile takeovers, giv­ing exec­u­tives in these states more lee­way to avoid tak­ing risks. ​“It’s a sit­u­a­tion where they can pur­sue their own inter­ests more eas­i­ly,” Mat­sa says. 

Indeed, cor­po­rate finan­cial data over a 30-year peri­od end­ing in 2006 showed that firms led by man­agers in ​“pro­tect­ed” sit­u­a­tions tend­ed to hold more cash and demon­strate less volatile stock prices. 

More­over, just as seen in the pre­vi­ous study, these man­agers active­ly reduced risk by pur­su­ing safe, diver­si­fi­ca­tion-focused acqui­si­tions. Their firms under­took 27% more acqui­si­tions com­pared with unpro­tect­ed busi­ness­es — with two-thirds of these trans­ac­tions diver­si­fy­ing the firms into new indus­tries rather than build­ing on exist­ing strengths. Dis­pro­por­tion­ate­ly, the firms tar­get­ed ​“cash cows.” 

And their cau­tion neg­a­tive­ly impact­ed their com­pa­nies’ val­ue, invest­ments, and growth. ​“These incre­men­tal acqui­si­tions destroy share­hold­er val­ue on aver­age,” Mat­sa says. 

Con­sis­tent with the idea that the pro­tect­ed man­agers are play­ing it safe — rather than sim­ply tak­ing it easy, or shirk­ing dis­taste­ful duties — the firms that did the bulk of the acquir­ing tend­ed to be at a high­er risk of fail­ing. These com­pa­nies had low­er cash flows, greater lever­age, and increased risk of finan­cial dis­tress. Their man­agers tend­ed to have larg­er own­er­ship stakes in their com­pa­nies — putting their per­son­al finances in more risk — and to be under the age of 55, with a longer career still ahead of them. 

An Inter­ven­tion Option

For firms that want to encour­age pru­dent risk-tak­ing by exec­u­tives, research sug­gests a way forward. 

For one, rethink the use of equi­ty for com­pen­sa­tion. Grant­i­ng exec­u­tives equi­ty is typ­i­cal­ly viewed as a means of moti­vat­ing behav­ior that increas­es share­hold­er val­ue, because it cre­ates a per­son­al stake for the man­ag­er. But it also cre­ates greater incen­tive to play it safe, as more of exec­u­tives’ finan­cial wealth is now tied to the firm’s prospects. Who wants to take a gam­ble with most of their eggs in the same basket? 

Mat­sa spec­u­lates that com­pen­sat­ing with own­er­ship may be espe­cial­ly like­ly to back­fire in firms that already face high risk, such as those close to bank­rupt­cy. Stock options, on the oth­er hand, should reduce exec­u­tives’ ten­den­cy to play it safe. Options moti­vate exec­u­tives to increase the stock’s val­ue above a cer­tain strike price, which often requires tak­ing smart risks. Indeed, in oth­er research by Mat­sa and his col­leagues, options helped to mit­i­gate the risk-averse behav­ior of firms that had recent­ly learned of their work­ers’ expo­sure to a carcinogen.