CEOs who have been granted stock options as part of their remuneration are more likely to carry out a successful acquisition of another company. Apparently, risk-taking incentives embedded in executive compensation plans are actually effective in motivating managers to make risky investments.
What’s Inside?
The authors investigate the relationship between the sensitivity of CEO wealth to the volatility of the firm’s stock returns, the so-called vega that is tied to the inclination to engage in merger and acquisition (M&A) activity with the goal of maximizing value for shareholders. This relationship is found to be positive and statistically significant at the 1% level, even after the authors control for factors recognized to affect the propensity to bid for and acquire another firm, such as compensation delta, firm size, book to market, leverage, M&A liquidity, CEO level of entrenchment, and other corporate governance characteristics. Moreover, this result seems to be confined to CEOs who are not overconfident.
How Is This Research Useful to Practitioners?
Previous researchers argued that the tendency to make riskier investments is essentially driven by the overconfidence managers feel by nature. Therefore, making risky investments is insensitive to increasing the convexity of managers’ remuneration by granting them call options on the firm’s stock. Yet, the authors find empirical evidence suggesting that risk-taking incentives in compensation could make up for a lack of managerial overconfidence, thereby leading to successful takeover bids.
First, they define vega as the change in dollar value of CEO wealth accumulated in stock options, as opposed to cash or other financial assets, for a 1% change in the annual standard deviation of the stock’s returns. Then, they empirically show that vega is one of the main determinants of intense M&A activity from 1997 to 2011, during which period managerial compensation became more dependent on stock price performance.
Moreover, the authors find that CEO vega is positively associated with positive abnormal returns for the bidder apparent a few days around the acquisition announcement, thereby suggesting that risk-taking incentives embedded in compensation schemes play a nontrivial role in selecting better-quality acquisition targets.
Finally, on the basis of the coefficients estimated from regressing the intensity of acquisitions on CEO vega, the authors calculate that an increase in the sensitivity of managerial wealth to stock return volatility from 25% to 75% is capable of increasing the aggregate value of acquisitions taking place in a single year by 4.2%.
How Did the Authors Conduct This Research?
The authors use an extensive dataset of takeovers, which serves as the ideal framework to test whether the practice of granting stock options in the context of executive compensation plans actually increases the record of acquisitions executed in the corporate world. They use data from all acquisitions made by US publicly listed bidding firms during 1997–2011 that had a deal value of more than $1 million, and they use pooled Tobit and probit models. They test the significance of the relationship between CEO vega and the magnitude/probability of acquisition activity.
According to empirical results, the relationship remains positive and statistically significant across a wide set of alternative specifications. The authors control for the degree of entrenchment of the CEO and other corporate governance characteristics as well as account for M&A liquidity. They also use three-stage least-squares regressions to control for potential reverse causality between vega and engagement in acquisition activity. In addition, they test for bias resulting from the omission of an unobserved confounding variable and replace vega point values with vega increases to eliminate the possibility that results are dominated by firms with persistently high vega. Finally, they test for robustness with subsamples of riskier (by construction) acquisition investments, such as those that are large or private or that entail great diversification risk. In all cases, the regression coefficient of the vega explanatory variable remains positive and highly significant.
Abstractor’s Viewpoint
Finance literature has showcased the difficulty in aligning interests between principals and agents in the corporate finance setting. Often, managerial risk aversion creates a strong impediment to making decisions that aim to maximize shareholder value. In this respect, executive remuneration experts have come up with relevant innovations in pay schemes, such as granting stock options, with the goal of boosting risk-taking initiatives by managers. Nevertheless, excessive convexity borne by managers whose compensation overly relies on the moneyness of stock options could potentially lead to excessive risk taking, which may trigger unwarranted takeover bidding that ultimately results in acquisitions that destroy rather than enhance shareholder value.