ABSTRACT
This article finds evidence consistent with the hypothesis that managers consider
personal risk when making decisions that affect firm risk. I find that Chief Executive
Officers (CEOs) with more personal wealth vested in firm equity tend to diversify.
CEOs who are specialists at the existing technology tend to buy similar technologies.
When specialists have many years vested, they tend to diversify, however. Poor
performance in the existing lines of business is associated with movements into new
lines of business.
AGENCY THEORY IS RICH in models that explain how differences in risk aversion
between managers and shareholders can impose costs on shareholders. However,
to date there is little evidence that managers' personal risk preferences
are associated with firm decisions. This study presents such evidence. I do this
by examining how CEO and firm characteristics are associated with firm risk
attributes. First, I examine how the diversification level sought in a given
acquisition is related to the CEO's human capital vested in the firm, equity
wealth vested in the firm, asset specialization, and past performance. I then
examine whether these same CEO characteristics are associated with other
firm risk attributes such as debt ratios and equity variances.
Such an examination is important in light of recent evidence that diversification
strategies do not necessarily add value for shareholders. For example.
Comment and Jarrell (1995) find that firm performance is Increasing in firm focus
level. Lang and Stulz (1994) conclude that firms diversify when they have exhausted
growth opportunities in their primary industry, but that such diversification
strategies do not necessarily benefit shareholders. Berger and Ofek (1995)
compare the stand-alone value of diversified firm segments to specialized firms
and find a 13 percent to 15 percent value loss from diversification.
One explanation for why firms pursue risk reducing strategies such as
diversification is presented in Amihud and Lev (1981). They argue that imperfect monitoring and contracting allow managers to take actions that are in
their own best interests and not necessarily those of shareholders. One such
action is firm-level diversification. The problem arises because shareholders
can easily control the risk of their individual portfolios in the capital market.
However, managers can only reduce their human capital risk at the firm level.
Thus, for managers, diversification may have a positive net present value
(NPV), while for shareholders it may have negative value. Consistent with
their theory, Amihud and Lev find that conglomerate mergers are more numerous
when shareholdings are widely dispersed, because in such cases managers
are better able to pursue policies that serve their own interests.
This article extends the work of Amihud and Lev, who examine differences
in management's opportunity to pursue risk reduction. Here I examine crosssectional
differences in CEO motive to pursue risk reduction. My proxies for
CEO motive are years with the firm, proportion of personal wealth vested in
firm equity, asset specific expertise, and the firm's recent performance. I find
that CEOs tend to pursue equity variance, reducing acquisitions when they
have higher levels of personal wealth vested in firm equity. CEOs with backgrounds
specific to their firm's existing technology tend to acquire similar
technologies. However, when specialists have many years vested with the firm,
they tend to diversify. This is consistent with the view that, as human capital
becomes more firm specific, the personal gains to diversification outweigh the
gains to specialization. (Shleifer and Vishny (1989)). I also find, similarly to
Lang and Stulz (1994), that firms tend to move into new lines of business when
they are performing poorly in their existing business. Also consistent with the
human capital diversification hypothesis, I find a negative relation between
CEO years vested and firm debt ratios as well as equity return variances.
The evidence presented in this paper offers empirical support for the view
that firm-level risk reduction decisions are affected by managerial objectives.
This could explain why strategies such as diversification occur even when they
do not increase shareholder value. By pointing out the characteristics that influence
management's desire to reduce risk, these findings may also be helpful in
designing contracts and control mechanisms that reduce such agency conflicts.
That is, they may indicate when such mechanisms may be most appropriate.
The remainder of this article is organized as follows. In Section I, I describe
and motivate the dependent and independent variable proxies. I describe the
sample and present the findings in Section IL I conclude with a summary and
implications in Section III.
I. Independent and Dependent Variable Proxies
A. The Independent Variable Proxies-CEO and Firm Characteristics
. . .Continue to read rest of article (PDF).
Donald M. May PhD, CPA, Managing Partner at DMA Economics, LLC, possesses over 30 years of Valuation and Economic Damages experience. He implements a broad range of damage analyses and valuations for clients, including billion-dollar investment funds under SEC investigation as well multi-national firms involved in intellectual property disputes, consumers in product mislabeling cases, and small to mid-sized businesses involved in complex commercial litigation.
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