Tournament incentives and firm credit risk: Evidence from credit default swap referenced firms

• Date: 01 July 2019
• Author: Jian Huang,Bharat A. Jain,Lijing Du
• DOI: http://doi.org/10.1111/jbfa.12395
• Published date: 01 July 2019

DOI: 10.1111/jbfa.12395

Tournament incentives and firm credit risk:

Evidence from credit default swap referenced

firms

Lijing Du Jian Huang Bharat A. Jain

TowsonUniversity, Towson,MD 21252, USA

Correspondence

LijingDu, Towson University,Towson,MD 21252,

USA.

Email:ldu@towson.edu

Abstract

In this paper, we evaluate the impact of managerial tournament

incentives on firm credit risk in credit default swap (CDS) referenced

firms. We find that intra-firm tournament incentives are negatively

related to credit risk. Our results suggest that tournament incentives

reduce credit risk by alleviating the potential for underinvestment

when managers are concerned about exacting empty creditors.

Further, we find that tournament incentives decrease credit risk

when internal governanceis strong or product market competition is

intense. Takentogether, our results suggest that creditors perceive

senior manager tournament incentives (SMTI) as a critical determi-

nant of a firm’s credit risk, particularly in settings where managerial

risk aversion is high.

KEYWORDS

credit default swaps, credit risk, internal governancequality, product

market competition, tournament incentives

JEL CLASSIFICATION

G32, G34, J31

1INTRODUCTION

Recently, a growing stream of literature has focused on evaluating whether intra-firm rank order tournaments are

effective in alleviating agency conflicts arising largely because of moral hazard and differences in risk preferences

between diversified shareholders and underdiversified risk-aversemanagers (Kale, Reis, & Venkateswaran, 2009; Kini

& Williams, 2012). The basic premise underlying this stream of literature is twofold, i.e., that the compensation of one

executiveaffects the incentives of others and that senior managerial incentives shape firm risk-taking behavior (Géczy,

Minton, & Schrand, 2007; Kale et al., 2009; Kini & Williams, 2012). In a typical intra-firm rank order tournament, the

best performer among senior executives wins the tournament and is promoted to the CEO position. The higher pay

and prestige that comes with the promotion is expected to motivate senior managers to expend additional effort to

increase their likelihood of winning the tournament (Kale et al., 2009). Further,managerial effort level is expected to

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914 DU ET AL.

rise with the size of the prize and the probability of winning the tournament (Kale et al., 2009; Lazear & Rosen, 1981;

Prendergast, 1999). In addition to managerial effort, tournament incentives are expected to promote risk-taking

behavior since, in equilibrium, each executivehas an incentive to undertake projects riskier than the current portfolio

to increase her chances of winning the tournament (Goel & Thakor,2008). While research suggests that the economic

effects of tournament incentives are stronger in the United States, evidence points to their effectiveness in shaping

managerial behavior internationally as well (Burns, Minnick, & Starks, 2017; Oxelheim & Randøy, 2005; Wahlgren,

2001). Overall, empirical evidence supports the above-described predictions of tournament theory, i.e., that the

inherent optionality present in CEO and intra-firm tournaments provides managers with distinct and incremental

benefits over option-based compensation incentives to work harder and pursue riskier but value-enhancing firm

policies (Coles, Li, & Wang,2018; Kale et al., 2009; Kini & Williams, 2012).

Despite the growing literature on the economic impact of managerial tournaments in alleviating agency conflicts

between shareholders and managers, their corresponding impact on the agency cost of debt remains an unexplored

area of research. Research suggests that the agency cost of debt can increase either when weak managerial incentives

encourage underinvestment or alternativelywhen they are structured to encourage risk-shifting behavior, i.e., under-

taking projects that are riskier than the current portfolio (Jensen & Meckling, 1976; Myers, 1977). As suggested in

the literature, rank order tournaments havetwo distinct effects on managerial behavior, i.e., motivate them to expend

additional effort and promote risk-taking behavior.While the former can be beneficial to both stockholders and bond-

holders since it reduces the potential for underinvestment and inefficiency,the latter potentially benefits sharehold-

ers at the expense of bondholders. Therefore, the net impact of intra-firm tournaments on bondholder value likely

depends on whether the benefits to bondholders from the reduced potential for underinvestmentoutweighs the c osts

to them from risk-shifting behavior or vice versa. However,the question as to whether managerial tournament incen-

tives enhance both stockholder and bondholder value or alternatively,facilitate a wealth transfer from bondholders to

stockholders remains an unaddressed area of research. Further,addressing this question is vital to gaining an under-

standing of the overalleconomic impact of managerial tournaments on the providers of capital.

Centralto addressing whether and how managerial tournaments influence bondholder value is an evaluation of how

managers are likely to respond to risk-taking incentives when they are forced to balance the interests of both share-

holders and bondholders. Specifically,alternative bondholder governance regimes that differ in terms of the extent of

bondholder power are likely to differentially influence how managers react to risk-taking incentives arising from rank

order tournaments. For instance, research suggests that CEOs are less likely to engage in risk shifting and may even

reduce firm risk despite the presence of compensation based risk-taking incentives when they are concerned about

default risk or stringent bondholder covenants (Milidonis & Stathopoulos, 2014). Further,managerial risk aversion in

levered firms tends to be higher since the higher default risk can impose career related costs on managers in the form

of loss of job security and/or reputational capital (Amihud & Lev,1981; Grossman & Hart, 1982; Hirshleifer & Thakor,

1992). Overall, research suggests that managerial risk preferences are derived from a tradeoffbetween the potential

positive wealth effects of increased risk-taking versusthe negative career and reputational effects when the pursuit of

risky policies results in firm underperformance (Guay,1999; Milidonis & Stathopoulos, 2014; Smith & Stulz, 1985). As

such, it is important to gain insights as to whether the effectiveness of risk-taking incentives arising from rank-order

tournaments maybe diluted in settings where bondholder power is strong and/or managerial risk aversion is especially

high due to career and reputational concerns.

Therefore, to gain a more complete picture of the overall economic impact of rank-order tournament incentives,

we address two related research questions of interest, i.e., whether rank-order tournament incentives positively or

negatively affect the value of bondholder claims as well as whether managerial embrace of risk-taking incentives is

contingent on the extent of balance of power between shareholders and bondholders. Our study attempts to address

these two research questions by examining the impact of senior manager tournament incentives(SMTI) on firm credit

risk in the contextof credit default swap (CDS) referenced firms. As discussed below, we focus on CDS referenced firms

since the CDS market provides us with an ideal platform to evaluate the effectiveness of risk-taking incentiveswhen

managers are faced with the dilemma of having to balance the competing interests of stockholders and bondholders.