Why do executives leave money on the table when running their companies?

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.

Options motivate executives to increase the stock’s value above a certain strike price, which often requires taking smart risks.

“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.