Abstract
Executive pensions and deferred compensation, collectively referred to as inside debt, tend to align CEO incentives with those of debt holders. Although CEO equity compensation is well known to induce risk-shifting incentives and thereby add to the agency cost of debt, too much inside debt may drive incentives to reduce risk and thereby increase the agency cost of equity. We study this effect of inside debt by examining firms’ incentives to pursue diversifying acquisitions. We find that when the CEO-firm relative debt-to-equity ratio is greater than one, firms undertake value-destroying diversifying acquisitions that are anticipated to decrease overall firm volatility. Our findings are stronger for smaller firms. We further find that when the CEO-firm relative debt-to-equity ratio is greater than one, the merger pushes the ratio toward one which is consistent with the direction suggested by optimal contracting theory.
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