Holding increased inside debt makes CEOs more risk averse

October 28, 2021

Shahbaz Sheikh, Professor of Finance in the DAN Department of Management & Organizational Studies

Story and photo by Rob Rombouts

How an organization decides to provide compensation for its CEO will impact its risk and dividend policy.

Shahbaz Sheikh, Professor of Finance in the DAN Department of Management & Organizational Studies, has examined the influence of CEO compensation in , ‘CEO inside debt, market structure and payout policy,’ published in International Review of Financial Analysis.

CEOs get salary and bonus, but most compensation comes from stocks and options. Providing compensation through these means is considered good corporate governance, connecting the compensation of the CEO to the performance of the company.

“The CEO does not own the company. If the CEO does not own company, he/she does not have incentives to work hard to make the company work hard,” said Sheikh. “Boards try to link CEO compensation with performance, so the CEO has a reason to work hard.”

Sheikh also said boards can use compensation to encourage CEOs to take more or less risk. Compensation packages are made up of a mix of equity – stocks and options – and inside debt – such as pension and other deferred benefits. Sheikh used data from a large sample of US firms, from 2006 to 2016, and calculated the ratio of CEO compensation in inside debt over equity. He then compared that ratio to the debt level of the firms, to estimate CEOs personal leverage compared to their firm leverage.

“How you pay your CEO affects their risk-taking behaviour,” said Sheikh. “If a CEO is paid more in inside debt, it makes the CEO more risk averse.”

Beyond impacting the level of risk, a firm may take on, the compensation ratio may also impact how dividends are paid out. CEOs have the capability to reduce their exposure to risk, and one way to do this is by increasing dividend payouts

“CEOs may avoid investing in risky projects and prefer to pay out to dividends. They may view dividend payments as lower risk alternative to risky investments,” said Sheikh. “Shareholders generally want CEOs to take more risk, as they are more diversified, but the CEOs are the least diversified. Their income, pension and jobs are all tied to the company.”

Sheikh said other factors will impact the likelihood of paying out dividends, specifically the level of competition. CEOs will pay out dividends when they have predictive cashflows, when there is not much competition and when there is more predictability.