The Effect of Customer Concentration on CEO Risk-Taking Incentives

Abstract

This paper examines the effect of customer base concentration (“CC”), which captures the extent to which sales to major customers account for a supplier’s total annual revenue, on the supplying firm’s CEO risk-taking equity incentives. Existing literature predominantly uses total annual revenue as a proxy for firm size or managerial decision difficulty without examining from whom the revenue is earned. My paper improves this design by decomposing total annual revenue into revenue from major customers and revenue from the rest based on the CC concept posited by Patatoukas (2012). As prior literature shows CC risk to be idiosyncratic (Dhaliwal et al., 2013) and modern risk-based asset pricing theories posit that idiosyncratic return volatility is not priced amongst the risk-neutral investors, CC risk is diversifiable at the shareholder level – hence, only the performance-related net-benefits (Patatoukas, 2012) of engaging in contractual relationships with a few major customers should determine the desirability of high CC for the risk-neutral investors. However, in the midst of deficient accommodation, a risk-averse, undiversified manager may exhibit risk-aversion towards the state of high CC. Thus, I expect the BOD to recognize this potential agency problem and provide more risk-taking incentives for a CEO who manages a highly concentrated customer base. Upon empirical investigation, I document that CC exerts a positive influence over the supplier’s CEO vega incentives, whereby the CEO is compensated for assuming additional CC risk as her equity wealth becomes an increasing function of the firm’s stock return volatility. Furthermore, I show that less risk-taking incentives are expected when the degree of product substitution difficulty is high or the supplier’s trade credit levels are low, illustrating that the predictability of CC over CEO equity incentives varies with the settings in which the suppliers and customers interact.