The Effect of CEO’s Risk-Taking Incentives on Relationship-Specific Investments by Customers and Suppliers

Abstract

Customers and suppliers often make relationship-specific investments (RSI) whose value is undermined if the firm undertakes risky investments. We hypothesize that the risk-taking incentives in the compensation of a firm’s CEO will be associated with lower RSI by firms up and down in the vertical channel. Our empirical analysis offers significant evidence that customer and supplier RSI declines with the risk-taking incentives of the firm’s CEO. Moreover, we find that customer firms are more sensitive to the CEO’s risk-taking incentives when these incentives are more likely to increase the firm’s cash flow volatility. Our findings are robust to correction for endogeneity, inclusion of a wide array of controls, and different proxies for RSI. By showing significant externalities of CEO compensation, on investments decisions of supplier and customer firms, our results impart a different and important perspective to the debate on executive compensation.