Managerial Risk Aversion and Vertical Integration

Abstract

In this paper, we provide a new explanation for vertical integration decisions and the wealth effects of those decisions. Our hypothesis is based on managerial risk aversion. Agency theory posits that differences in risk preferences between managers and shareholders can impose costs on shareholders. Using CEO relative inside leverage (the ratio of the CEO’s inside leverage to firm leverage) to proxy for managerial risk aversion, we find that CEOs with higher relative inside leverage are more likely to engage in vertical mergers. Furthermore, vertical acquisitions made by CEOs with higher relative inside leverage generate lower announcement returns, and this negative effect of CEO relative inside leverage on acquisition returns for shareholders is more pronounced when the acquirer has a higher degree of informational opacity, weak corporate governance, excess cash holdings, and higher cash-flow volatility. Further analyses show that CEOs with large inside debt holdings tend to overpay in vertical acquisitions, which might be one channel through which such acquisitions damage shareholder wealth. Our study provides new evidence on how managerial objectives affect shareholder wealth in merger and acquisitions.