Managerial hedging, equity ownership, and firm value.

Suppose risk-averse managers can hedge the aggregate component of their exposure to firm's cash-flow risk by trading in financial markets but cannot hedge their firm-specific exposure. This gives them incentives to pass up firm-specific projects in favor of standard projects that contain greater aggregate risk. Such forms of moral hazard give rise to excessive aggregate risk in stock markets. In this context, optimal managerial contracts induce a relationship between managerial ownership and (i) aggregate risk in the firm's cash flows, as well as (ii) firm value. We show that this can help explain the shape of the empirically documented relationship between ownership and firm performance.

1. Introduction

The interests of managers and entrepreneurs are not necessarily aligned with those of the claimants of their firm. This is the case, for instance, when costly unobservable effort on their part is required to manage the firm or when they can divert part of the firm's cash flow to their private accounts. Incentive compensation schemes are hence devised to induce managers and entrepreneurs to act efficiently in the interests of their firm's claimants. Such schemes determine the share of their own firm that managers must retain in their portfolios. Accordingly, these schemes restrict managers from freely trading their firm. Similarly, a diverse set of regulations in financial markets also restricts the ability of managers and entrepreneurs to trade their own firm's stock. (1) Nonetheless, no regulation restricts or imposes disclosure on the portfolios of managers and entrepreneurs in dimensions other than the ownership of the managed firm. Also, rarely do boards impose direct contractual limitations on managerial hedging, a phenomenon that Schizer (2000) documents on the basis of off-the-record interviews with investment bankers, and that some authors, most notably Bebchuk, Fried, and Walker (2002), consider a manifestation of managerial rent extraction.

Given the lack of such contractual restrictions, risk-averse managers and entrepreneurs can (and do) to an extent enter financial markets in order to privately hedge their risk exposure to the firm. Evidence of managerial hedging is provided in the law literature by Easterbrook (2002) and in the finance literature by Bettis, Bizjak, and Lemmon (2001). Recent empirical evidence shows, however, that managers appear to be able to hedge aggregate-risk exposure more effectively than firm-specific risk. For instance, Jin (2002) and Garvey and Milbourn (2003) find that the pay-performance sensitivity of incentive contracts falls with the idiosyncratic risk of firm's cash flows but is invariant to the market risk. This finding is consistent with managers and entrepreneurs hedging their aggregate-risk exposure, for example, by trading in market indices or basket products, but being restricted from trading in their own firms.

If the restrictions imposed on managers' and entrepreneurs' trading in financial markets principally concern trading in their own firms (as we argued above), then risk-averse managers have an incentive to substitute the unhedgeable, firm-specific risk of their firm's cash flows for hedgeable, aggregate risks. For example, they may pass up innovative projects with firm-specific risk in favor of standard projects that have greater aggregate risk. (2) Such risk substitution enables managers to be better diversified, but has perverse implications for aggregate risk sharing in a general equilibrium context: if all managers in the economy engage in such risk substitution, then the correlation of cash flows of different firms is enhanced, as is, in turn, the aggregate risk in stock markets.

We study an economy in which managers and entrepreneurs face incentive compensation schemes and can only hedge the aggregate-risk exposure of their firm (but not firm-specific risk) by trading in capital markets. In this economy we study risk-substitution moral hazard, which arises when managers and entrepreneurs can affect the risk composition of their firms' cash flow for example, through investment activities which cannot be ex ante contracted upon. We cast risk-substitution moral hazard in a general-equilibrium setting in order to address the efficiency of endogenous risk composition. We show that in equilibrium, the level of aggregate risk in the stock market exceeds the first-best level. Nonetheless, it is constrained (second-best) efficient. We study the positive aspects of this moral hazard by characterizing the optimal incentive contract designed to address it. We show that such an optimal incentive compensation scheme might require a "dampening" of pay-performance sensitivity, whereby managerial ownership is smaller than in the absence of the risk-substitution moral hazard. We also characterize the resulting equilibrium relationship between managerial equity ownership and (i) the extent of aggregate risk in the firm's cash flows, as well as (ii) the firm's performance as measured by firm value. This analysis provides a structural model of the relationships between managerial ownership, risk composition, expected returns, and firm value, and has important empirical implications. In particular, we show that these endogenous relationships help explain various important cross-sectional relationships documented in corporate finance.

A detailed summary of our analysis follows. We study firms in an incomplete-markets, general-equilibrium capital asset pricing model (CAPM) economy. Our analysis can be applied equivalently to owner-managed firms and to corporations run by managers. Let us consider in this introduction the case of corporations, for concreteness. The fraction of their firm that managers retain in their portfolios, that is, their equity ownership of the firm, is determined contractually. Contractual agreements cannot, however, restrict their trades in aggregate indices. Once the ownership structure of firms is designed, agents trade in financial markets and prices are determined. Subsequently, managers choose the technology of the firm. Firms can produce a given expected cash flow with a given total risk through the use of different technologies: some technologies are standard and have greater betas with respect to the aggregate risk factor and thus have greater aggregate risk; others are innovative and have lower betas with respect to the aggregate risk factor and thus have greater firm-specific risk. Technological innovation (modifying the "intrinsic" or the initial aggregate-risk beta of each firm's project) is costly for managers. The resulting aggregate-risk beta is not observed by the firm's investors.