CEO's Inside Debt and Dynamics of Capital Structure

DOIhttp://doi.org/10.1111/fima.12169
Date01 September 2017
Published date01 September 2017
CEO’s Inside Debt and Dynamics
of Capital Structure
Eric R. Brisker and Wei Wang
Debt-type compensation (inside debt) exacerbates the divergence in risk preferencesbetween the
chief executive officer (CEO) and shareholders and, in turn, affects capital structure decisions.
An excessively risk-averse CEO tends to use less debt than the shareholders desire, reduce debt
quickly whenthe f irm is overlevered, but is reluctantto increase debt when the firm is underlevered.
We find that higher CEO’s inside debt ratio (i.e., inside debt as a percentage of total incentive
compensation) is associated with lower firm leverage and faster (slower) leverage adjustments
toward the shareholders’ desired level for overlevered (underlevered) firms. The CEO’s inside
debt ratio most conducive to capital structurerebalancing is around 10% of the firm’s marketdebt
ratio.
Two well-knowntypes of agency conflicts exist within corporations: that between managers and
shareholders (separation of ownership and control) and that betweenshareholders and debtholders
(asset substitution or risk shifting). One remedy proposed by Jensen and Meckling (1976) for
these agency problems lies in the managerial compensation structure. On the one hand, firms
could use equity-type compensation such as stock and stock options to align managers’ interest
with shareholders. On the other hand, debt-type compensation (sometimes called inside debt),
including defined benefit pensions and defer red compensation, could incentivize managers to
take debtholders’ interests into account.1They postulate that a manager whose compensation
consists of both equity and debt, similar to the firm’s debt and equity mix, would consider the
interests of both shareholders and debtholders appropriately.
In this article, we empirically investigate the impact of inside debt on the capital structure
dynamics of the firm. We consider how inside debt influences excessively risk-averse chief
executive officers (CEOs) in setting firm leverage ratios and the speed of adjustment (SOA) of
capital structure toward shareholders’ desired level. Edmans and Liu (2011) provide an analytical
model for deriving optimal compensation contracts, which include both inside equity and debt,
for managers facing effort and investment (i.e., risk preference) choices. They find that while
equity induces managerial effort, debt is part of the solution to the risk-shifting problem. In
particular, because the value of debt hinges not only on the probability of bankruptcy, but also
on the liquidation value if the firm fails, debt-type compensation serves as an efficient tool
to address the risk-shifting problem and finds its place in the optimal compensation structure.
They further determine that, in most cases, an equity bias (equity stake exceeding debt stake) in
Wethank an anonymous reviewer and Raghavendra Rau (Editor) for their constructive comments.
Eric R. Brisker is an Assistant Professor at The University of Akron in Akron, OH. Wei Wang is an Assistant Professor
in the Monte Ahuja College of Business at Cleveland State University in Cleveland, OH.
1The term “inside debt” as used in the analytical models of Jensen and Meckling (1976) and Edmans and Liu (2011) refers
to granting the executive a straight fraction of the firm’sdebt. Sundaram and Yermack (2007) confirm that certain forms
of compensation widely observed in practice (e.g., pensions and other deferred compensation contracts) have debt-type
payoffsand could potentially be viewed as inside debt. In this article, we use “debt-type compensation” and “inside debt”
interchangeably.Likewise, in some places we use “inside equity” to refer to equity-type compensation.
Financial Management Fall 2017 pages 655 – 685
656 Financial Management rFall 2017
managerial compensation is optimal as the effort effect of equity-type compensation outweighs
its “occasional risk-shifting” effect.
The effect of inside debt on managerial risk preference is in need of more in-depth exploration,
especially when considering yetanother type of agency problem: the divergence in risk preference
between managers and shareholders. In the Edmans and Liu (2011) model, managers are assumed
to be similar to well-diversified shareholders in that they are risk neutral. However, a substantial
literature has argued that managers behave in a more risk-aversefashion than shareholders would
prefer (Jensen and Meckling, 1976; Amihud and Lev, 1981; Smith and Stulz, 1985; Hirshleifer
and Thakor, 1992; Klein and Coffee, 1996; Holmstr¨
om, 1999; Gormley and Masta, 2016). Thus,
managers are more aligned with debtholders than shareholders to begin with in terms of risk
preference. Theoretically, offering managers equity-type compensation would encourage risk
taking and mitigate managerial conservatism, but offering them debt-type compensation would
have the unintended effect of exacerbating this agency problem. To the extent managers face
the same asymmetric payoff structure for their inside debt holdings as outside debtholders (i.e.,
they receive fixed payoffs if the firm is successful, but bear the loss proportionally if the firm
fails,) managers tend to act like debtholders (Bebchuk and Jackson, 2005). As a result, managers
compensated with high stakes of inside debt could have the tendency to adopt excessively
conservative business policies that would compromise shareholders’ wealth.
Among the financial policies that are subject to managers’ excessive conservatism, capital
structure is of particular interest as inside debt is hypothesized to help balance the interests of
outside shareholders and debtholders. Cassell et al. (2012) investigation provides some prelimi-
nary evidence in this regard, but it is not the focus of their paper nor is it adequate to fully reveal
the relationship between managerial inside debt and firm leverage. In this article, we attempt to
conduct a focused and full-fledged investigation of this issue.
The use of debt incurs the risk of bankruptcy that is often described as increasing convexlywith
the debt ratio. Excessively risk-aversemanagers would avoid lifting the debt ratio to the level that
shareholders desire. Consistent with this conjecture, Liao, Mukherjee, and Wang (2015) find that
firms, on average, are underlevered, falling short of using debt at the shareholders’ desired level.
Inside debt would aggravate managerial conservatism, so we hypothesize that managerial inside
debt holdings negatively influence the firm’s financial leverage. Moreover, the more risk-averse
the manager is, the less likely he would adjust leverage upwardly if the firm is underlevered, but
more likely he would adjust leverage downwardly if the firm is overlevered. Thus, our second
hypothesis is that managerial inside debt holdings negatively affect the capital structure SOA of
underlevered firms, but positively affect that of overlevered firms.
We use the CEO’s Inside Debt Ratio as our measure of managerial inside debt holdings,
defined as accumulated holdings of pensions and deferred compensation divided by total incentive
compensation, where total incentivecompensation includes pensions, defer red compensation, and
the value of both stock and options. Using a sample of US firms from 2007 to 2013, we find
that a CEO’s inside debt ratio is quite persistent and it moves in tandem with the firm’s debt ratio
over calendar time. Over the length of the CEO’s tenure, however, the two variables exhibit a
mirror-image relationship. These patterns indicate the presence of common fir m and time factors
that shape both the CEO’s inside debt and firm leverage, yet CEO’s inside debt may have a
negative within-firm effect on firm leverage. The estimation of an augmented capital structure
dynamics model using the Elsas and Florysiak (2015) doubly censored fractional dependent
variable estimator (DPF estimator) and the Blundell and Bond (1998) system generalized method
of moments (GMM) estimator confirms our conjecture. We find that the CEO’s inside debt ratio
is negativelyassociated with f irm leverage, and a one-standard deviation increase in CEO’s inside
debt leads to a nontrivial decrease of 1.7 percentage points in the firm’s debt ratio.

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