How Risk Aversion Motivates Executives
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Finance & Accounting Mar 8, 2017

How Risk Aver­sion Moti­vates Executives

Incen­tiviz­ing lead­ers with too much stock pro­motes cau­tion — and encour­ages underperformance.

A CEO's risk aversion encourages underperformance.

Michael Meier

Based on the research of

Todd A. Gormley

David A. Matsa

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.

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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.

About the Writer

Kellogg Insight Editorial Team

About the Research

Gormley, Todd A., and David A. Matsa. 2011. “Growing Out of Trouble? Corporate Responses to Liability Risk.” The Review of Financial Studies. 24 (8): 2781–2821.

Gormley, Todd. A., and David A. Matsa. 2016. “Playing It Safe? Managerial Preferences, Risk, and Agency Conflicts.” Journal of Financial Economics, 122(3): 431-455.

Gormley, Todd A., David A. Matsa, and Todd T. Milbourn. “CEO Compensation and Corporate Risk: Evidence from a Natural Experiment.” 2013. Journal of Accounting and Economics, 56(2–3): 79–101.

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