Idiosyncratic Risk, Risk-Taking Incentives and the Link between Managerial Ownership and Firm Value

Abstract

We study the moral hazard problem that arises from risk-averse managers having a substantial personal investment in their companies (i.e. large equity holdings) and strong risk-substitution incentives; that is, they pass up innovative projects with high idiosyncratic (firm-specific) risk in favor of standard projects that have greater aggregate (systematic) risk. Risk-substitution incentives originate from the fact that, from a manager’s point of view, idiosyncratic risk is typically more difficult to hedge than aggregate risk. We hypothesize that while risk-substitution may help managers to diversify away their (excessive) risk exposure to their own firm, it may lead to suboptimal investment policies at a company level, offsetting the well-documented alignment effect of managerial ownership. This results into to a weak (or non-existent) association between managerial ownership and performance for firms that are exposed to severe risk-substitution problems. We test this hypothesis using parametric and semi-parametric estimation methods and report supporting evidence for it. Our results suggest that managerial ownership affects firm value in a strong positive way only for low idiosyncratic risk companies, whose managers are less likely to engage in risk-substitution. For high idiosyncratic risk companies no such link exists. Our results also reveal that the risk-substitution problem is (at least) partially mitigated by the inclusion of stock options in managerial compensation packages.