Negative Hedging: Performance-Sensitive Debt and CEOs’ Equity Incentives

Abstract

We examine the relation between CEOs' equity incentives and their use of performance-sensitive debt contracts. These contracts require higher or lower interest payments when the borrower's performance deteriorates or improves, thereby increasing expected costs of financial distress while also making a firm riskier to the benefit of option holders. We find that managers whose compensation is more sensitive to stock price volatility choose steeper and more convex performance pricing schedules, while those with high delta incentives choose flatter, less convex pricing schedules. Performance pricing contracts therefore seem to provide a channel for managers to increase firms' financial risk to gain private benefits. JEL classifications: G30; G34

R&D Investment, Executive Incentive, and Financial Performance in GEM: Based on Three-Stage Least Squares Method

“…Based on previous literature (Q. Cheng & Warfield, 2005; Tchistyi et al, 2011), equity incentive is also an important influence variable. Equity incentive plan (EQ_INC) can motivate CEO to promote R&D process (Miller et al,2002; Zahra et al, 2000).…”

“…Cheng & Warfield, 2005). The shareholding makes them more loyal to the company and exert more effort on the work (Tchistyi et al, 2011). The literature showed that compensation and equity incentive both had a significant positive impact on corporate financial performance.…”

CEO contractual protection and debt contracting

“…Tchistyi et al. (2011) find that CEOs’ equity incentives are related to the steepness and convexity of performance‐pricing provisions. Therefore, we include three variables that capture CEO equity incentives: (1) CEO Equity Compensation , measured as the ratio of the CEO's stock and option grants to her total compensation; (2) CEO Equity Ownership , defined as the CEO's stock and option holdings in shares divided by the firm's outstanding shares and (3) CEO Portfolio Sensitivity , defined as the change in the value of the CEO's option portfolio resulting from a 1% increase in the firm's annualized standard deviation of stock returns.…”

“…Our paper complements the literature on the relationship between CEO equity incentives and debt contracting. Prior studies have examined how equity‐based compensation and managerial ownership affect debt pricing (Bagnani et al., 1994; Brockman et al., 2015; Ortiz‐Molina, 2006; Tchistyi et al., 2011), debt maturity (Brockman et al., 2010; Datta et al., 2005), and loan syndicate structure (L. Chen, 2014). CEO equity incentives enhance the upside potential of risky investments for CEOs and encourage risk‐taking.…”

Options Compensation as a Commitment Mechanism in Oligopoly Competition

“…Awarding managers stock options, which go up in value as the volatility of the underlying asset goes up, has the potential to make managers more willing to take risks and make decisions that are more aligned with shareholder interests. Empirical studies including Rajgopal and Shevlin (2002), Knopf et al (2002), Coles et al (2006), Sanders and Hambrick (2007), Low (2009), Billett et al (2010, Tchistyi et al (2011), andGormley et al (2013) show that stock options compensation is linked to managerial risk taking. Our paper goes one step further by finding that in oligopoly competition, shareholders have an incentive to make managers more risk taking than themselvesmaking the managers risk seeking, rather than just risk neutral, to gain an advantage in oligopolistic competition.…”