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Article Excerpt
Suppose risk-averse managers can hedge the aggregate component of their exposure to firm's cash-flow risk by trading in financial markets but cannot hedge their firm-specific exposure. This gives them incentives to pass up firm-specific projects in favor of standard projects that contain greater aggregate risk. Such forms of moral hazard give rise to excessive aggregate risk in stock markets. In this context, optimal managerial contracts induce a relationship between managerial ownership and (i) aggregate risk in the firm's cash flows, as well as (ii) firm value. We show that this can help explain the shape of the empirically documented relationship between ownership and firm performance.
1. Introduction
The interests of managers and entrepreneurs are not necessarily aligned with those of the claimants of their firm. This is the case, for instance, when costly unobservable effort on their part is required to manage the firm or when they can divert part of the firm's cash flow to their private accounts. Incentive compensation schemes are hence devised to induce managers and entrepreneurs to act efficiently in the interests of their firm's claimants. Such schemes determine the share of their own firm that managers must retain in their portfolios. Accordingly, these schemes restrict managers from freely trading their firm. Similarly, a diverse set of regulations in financial markets also restricts the ability of managers and entrepreneurs to trade their own firm's stock. (1) Nonetheless, no regulation restricts or imposes disclosure on the portfolios of managers and entrepreneurs in dimensions other than the ownership of the managed firm. Also, rarely do boards impose direct contractual limitations on managerial hedging, a phenomenon that Schizer (2000) documents on the basis of off-the-record interviews with investment bankers, and that some authors, most notably Bebchuk, Fried, and Walker (2002), consider a manifestation of managerial rent extraction.
Given the lack of such contractual restrictions, risk-averse managers and entrepreneurs can (and do) to an extent enter financial markets in order to privately hedge their risk exposure to the firm. Evidence of managerial hedging is provided in the law literature by Easterbrook (2002) and in the finance literature by Bettis, Bizjak, and Lemmon (2001). Recent empirical evidence shows, however, that managers appear to be able to hedge aggregate-risk exposure more effectively than firm-specific risk. For instance, Jin (2002) and Garvey and Milbourn (2003) find that the pay-performance sensitivity of incentive contracts falls with the idiosyncratic risk of firm's cash flows but is invariant to the market risk. This finding is consistent with managers and entrepreneurs hedging their aggregate-risk exposure, for example, by trading in market indices or basket products, but being restricted from trading in their own firms.
If the restrictions imposed on managers' and entrepreneurs' trading in financial markets principally concern trading in their own firms (as we argued above), then risk-averse managers have an incentive to substitute the unhedgeable, firm-specific risk of their firm's cash flows for hedgeable, aggregate risks. For example, they may pass up innovative projects with firm-specific risk in favor of standard projects that have greater aggregate risk. (2) Such risk substitution enables managers to be better diversified, but has perverse implications for aggregate risk sharing in a general equilibrium context: if all managers in the economy engage in such risk substitution, then the correlation of cash flows of different firms is enhanced, as is, in turn, the aggregate risk in stock markets.
We study an economy in which managers and entrepreneurs face incentive compensation schemes and can only hedge the aggregate-risk exposure of their firm (but not firm-specific risk) by trading in capital markets. In this economy we study risk-substitution moral hazard, which arises when managers and entrepreneurs can affect the risk composition of their firms' cash flow for example, through investment activities which cannot be ex ante contracted upon. We cast risk-substitution moral hazard in a general-equilibrium setting in order to address the efficiency of endogenous risk composition. We show that in equilibrium, the level of aggregate risk in the stock market exceeds the first-best level. Nonetheless, it is constrained (second-best) efficient. We study the positive aspects of this moral hazard by characterizing the optimal incentive contract designed to address it. We show that such an optimal incentive compensation scheme might require a "dampening" of pay-performance sensitivity, whereby managerial ownership is smaller than in the absence of the risk-substitution moral hazard. We also characterize the resulting equilibrium relationship between managerial equity ownership and (i) the extent of aggregate risk in the firm's cash flows, as well as (ii) the firm's performance as measured by firm value. This analysis provides a structural model of the relationships between managerial ownership, risk composition, expected returns, and firm value, and has important empirical implications. In particular, we show that these endogenous relationships help explain various important cross-sectional relationships documented in corporate finance.
A detailed summary of our analysis follows. We study firms in an incomplete-markets, general-equilibrium capital asset pricing model (CAPM) economy. Our analysis can be applied equivalently to owner-managed firms and to corporations run by managers. Let us consider in this introduction the case of corporations, for concreteness. The fraction of their firm that managers retain in their portfolios, that is, their equity ownership of the firm, is determined contractually. Contractual agreements cannot, however, restrict their trades in aggregate indices. Once the ownership structure of firms is designed, agents trade in financial markets and prices are determined. Subsequently, managers choose the technology of the firm. Firms can produce a given expected cash flow with a given total risk through the use of different technologies: some technologies are standard and have greater betas with respect to the aggregate risk factor and thus have greater aggregate risk; others are innovative and have lower betas with respect to the aggregate risk factor and thus have greater firm-specific risk. Technological innovation (modifying the "intrinsic" or the initial aggregate-risk beta of each firm's project) is costly for managers. The resulting aggregate-risk beta is not observed by the firm's investors.
The choice of the firm's technology introduces risk-substitution moral hazard. In equilibrium, managers retain a positive share of their own firm in their portfolios. But, because they are risk averse and they can hedge only the aggregate-risk exposure by trading in market indices, managers have an incentive to increase the aggregate-risk beta of their firm's cash flows: by loading their firm's projects on aggregate risk, managers can reduce their own exposure to unhedgeable firm-specific risks. Such risk substitution by managers is aimed at diversification of their personal portfolios and it occurs at the cost of reducing the firm's market value: under CAPM pricing, the market price of the firm's shares decreases in its aggregate-risk beta, for given mean and variance of its cash flow.
We characterize the optimal ownership structure of firms in the face of risk-substitution moral hazard and the induced equilibrium risk composition of firms' cash flows. We show that if the firm's technology is intrinsically more loaded on aggregate risk factors (for example, in procyclical industries), then the optimal ownership scheme provides managers with a lower equity holding of their firms. Risk-substitution moral hazard is particularly severe for firms with high intrinsic aggregate-risk loadings. Thus, in equilibrium, a smaller managerial ownership share is optimal for these firms. Indeed, it may even be the case that it is optimal for these firms to choose equity holdings for managers that are smaller than the optimal contractual holdings in the absence of moral hazard, a situation we refer to as "dampening" of pay-performance sensitivity.
Our analysis has rich empirical implications. First, firms whose entrepreneurs or managers hold a larger share of equity in equilibrium are characterized by less aggregate risk in equilibrium, and hence by low expected returns. This implies, other things being equal, a negative relationship between managerial ownership and expected returns. To our knowledge, such a relationship has yet to be explored empirically.
Second, the risk-substitution moral hazard we study, when explicitly combined with an alternate moral hazard, for example, Jensen's (1986) free cash-flow agency problem, can help explain the hump-shaped cross-sectional relationship between managerial ownership and firm performance, measured by the ratio of the firm's market value to book value (documented by Morck, Shleifer, and Vishny, 1988, and McConnell and Servaes, 1990, among others). In particular, all else being equal, as the risk-substitution moral hazard becomes more severe, a positive equilibrium relationship is obtained between managerial ownership and performance. In contrast, an increase in the severity of the free cash-flow problem induces a negative relationship between ownership and performance (as also found empirically by Bizjak, Brickley, and Coles, 1993). Thus, a possible structural explanation of the hump-shaped relationship consists of recognizing that at low levels of ownership, the dominant moral hazard problem is the risk-substitution one, whereas at high levels of ownership, traditional moral hazard problems like the free cash-flow problem dominate (see Figure 1).
[FIGURE 1 OMITTED]
Importantly, this proposed distribution of the relative severity of different moral hazard problems--the dominance of risk substitution at low ownership levels and of the free cash-flow problem at high ownership levels--has independent implications regarding the shape of the relationship between managerial ownership and diversification. In particular, because risk substitution implies a negative relationship between ownership and diversification, and the free cash-flow problem a positive one, the proposed distribution implies a U-shaped relationship between diversification and ownership. Thus, our analysis of the risk-substitution moral hazard has the potential to simultaneously explain, as equilibrium relationships, the hump-shaped relationship between firm performance and inside ownership, and the U-shaped relationship between diversification ([R.sup.2]) and inside ownership.
Finally, our analysis also contributes to the understanding of the issue of relative performance evaluation (RPE). The literature (starting with Holmstrom, 1982) that assumes managers cannot affect the risk composition of their firms has argued that managers' compensation schemes should be independent of the aggregate component of their firms. In the context of our model, however, incentive schemes providing for explicit RPE clauses may in fact be inefficient. Because managers hedge their aggregate-risk position to hold the market share of such risk, but do so at a cost, in equilibrium managers reduce the aggregate-risk component of their firms (just not up to first-best levels). This is, in fact, in the interest of the firms' claimants and of efficient provision of incentives. Introducing RPE clauses would induce resistance in capital budgeting toward innovation because managers no longer bear the cost of having aggregate risk in their firm's cash flows.
The choice of risk composition of firms' cash flows by managers also endogenously affects the level of risk sharing in the economy. We show that, in equilibrium, managers choose aggregate risk in their firm's cash flows that exceeds the first-best level. However, market prices and the optimal ownership structure of the firm induce a level of aggregate risk in firms that is constrained (second-best) efficient. (3) That is, the ownership structure is efficient from the point of view of a planner who cannot internalize the externality of managerial activity aimed at substituting firm-specific risk of the firm's cash flows with aggregate risk. Prices in financial markets are not only market clearing but also efficiently align the objectives of management and stockholders with those of the constrained social planner: managers recognize that increasing the aggregate risk of the firm reduces the equilibrium price of the firm's shares; and, in equilibrium, the fraction of the firm's shares that managers retain induces them to choose the constrained-efficient firm loadings.
We extend our analysis by considering multiple sectors, whereby the aggregate risk factor can be interpreted as a stock market index. In this setting, we argue that the risk-substitution moral hazard also gives rise to an excessive loading of the firm's stock returns on the index returns and, in turn, that it generates an excessive correlation of returns across sectors. Next, we show that the risk-substitution moral hazard is more severe the greater the extent of purely idiosyncratic risk in the firm's cash flows.
The remainder of the article is structured as follows. After a discussion of some related literature, Sections 2 and 3 contain the model and analysis of the risk-substitution moral hazard. Section 4 discusses empirical implications and Section 5 addresses the efficiency of equilibrium choices. Section 6 establishes the isomorphism between owner-managed firms and corporations. Section 7 considers various extensions. Section 8 concludes. Appendices A and B contain the closed-form expressions for the competitive equilibrium and the proofs of Propositions 1 and 2, respectively. More detailed appendices, containing a formal analysis of a more general CAPM economy, the expression for the welfare criterion, and complete proofs of all the propositions in the article are available upon request.
Related literature. The design of entrepreneurial ownership and managerial compensation under asymmetric information and moral hazard has been examined extensively in the corporate finance literature. Diamond and Verrechia (1982) and Ramakrishnan and Thakor (1984) were the first to analyze moral hazard when the firm's returns have systematic and idiosyncratic risks. These papers are cast in partial-equilibrium settings. Our principal theoretical contribution is rather to embed the agency-theoretic approach of Fama and Miller (1972) and Jensen and Meckling (1976) into a general equilibrium model of the price of risk, such as the CAPM. (4)
Few general equilibrium analyses of the ownership structure of firms have been developed. Allen and Gale (1988, 1991) study the capital structure of firms in general equilibrium. However, they do not study economies with moral hazard. Magill and Quinzii (2002) and Ou-Yang (2002) do in fact consider the issue of moral hazard between entrepreneurs and investors in a general equilibrium setting. In the setup of these papers, entrepreneurs can affect the variance of their firm's cash flows and/or their levels, rather than their correlation with aggregate risk, as in our case.
The moral hazard we concentrate on, risk substitution, is induced by incentive compensation. Specifically, it arises because incentive compensation might give managers incentives to substitute from unhedgeable, firm-specific risk in the firm's cash flows toward hedgeable aggregate risks. To our knowledge, this form of moral hazard has not been directly studied in previous work. Theoretical and empirical literature in corporate finance has concentrated instead on the incentives of managers to inefficiently alter only the firm-specific variance by means of diversification activities (Amihud and Lev, 1981; Lambert, 1986), to reduce the firm's expected cash flow by expropriation of the firm's assets and diversion of cash flow (Jensen, 1986), or to reduce the effort provided in the management of the company.
The interaction between incentive compensation and hedging opportunities of managers has also been studied mostly in the context of economies in which managers affect the expected returns of their companies by their choice of effort (Jin, 2002; Garvey and Milbourn, 2003; Ozerturk, 2006; Bisin, Gottardi, and Rampini, 2008). In this context, the managers' ability to hedge the risk exposure in their compensation need be restricted because, by hedging unrestrictedly in capital markets, managers could completely undo the incentives in their compensation. In this article, we instead model risk-substitution moral hazard. For simplicity, we do not directly model other forms of moral hazard, for example effort choice, but rather we take incentive compensation and hedging restrictions as primitives of the analysis, in fact justified by such other forms of moral hazard. (5)
Our structural modelling approach is in the spirit of important antecedents such as Demsetz and Lehn (1985) and, more recently, Himmelberg, Hubbard, and Love (2002). Specifically, from the standpoint of providing a structural model linking managerial ownership and firm value, our article is closest to the recent work of Coles, Lemmon, and Menschke (2006). These authors provide a different structural explanation of the hump-shaped empirical relationship between...
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