10 - Executive compensation and managerial overconfidence:: Impact on risk taking and shareholder value in corporate acquisitions

Abstract

This chapter presents an integrated framework to explore the relationships among executive compensation, CEO behavioral bias, corporate governance, risk-taking, and firm performance. This framework is applied to corporate acquisitions, which are very often relatively large and externally observable; they are also discretionary long-term investments that can substantially alter the risk profile of acquirers and thereby exacerbate the potential risk-related conflict of interests between managers and shareholders. The chapter considers the behavioral agency model that posits managers' behavioral biases as influencing their risk preferences irrespective of the risk incentives offered by compensation contracts. This work is extended by examining the joint impact of risk incentives from compensation contracts and overconfidence. The review of the anecdotal as well as empirical evidence suggests that both monetary risk incentives and overconfidence can be complementary and lead to excessive risk taking. Avoiding such excessive risk taking or, conversely, inadequate risk taking by risk averse managers calls for appropriate monitoring of managers' risk incentives and their behavioral biases. The chapter presents the results from two recent studies in which the joint impact of executive compensation structure, behavioral bias, and corporate governance is empirically tested. The first, based on a U.K. sample of high and low risk acquisitions, finds that certain compensation components like salary and bonus and, at lower levels, stock grants induce risk aversion whereas corporate governance does not have any moderating effect on risk taking. In the second study of U.S. acquisitions from 1993 to 2004, the results presents evidence that stock options lead to increased risk taking and overconfidence also leads to more risky acquisitions.