CEO inside debt and firm debt

Author:Randy Beavers
DOI:https://doi.org/10.1108/CG-06-2017-0125
Pages:686-713
Publication Date:06 Aug 2018
CEO inside debt and rm debt
Randy Beavers
Abstract
Purpose This paper aimsto examine jointly the CEO inside debt and firmdebt to further investigate the
compensation incentives on risky decision-making and the resulting financial policy decisions
concerningthe debt structure of the firm.
Design/methodology/approach Using S&P 1500 data from CRSP, Compustat, Execucomp and Capital
IQ between 2006 and 2011, statistical analysis and regression models are used to determine potential
correlations between the variable of interest, inside debt and debt control variables, including specia lization.
Findings Firms with high inside debt specialize in commercial loans and drawn credit lines. Larger
firms diversify their debt holdings among commercial instruments and senior bonds. As firm size
increases with inside debt, the effects are counteracted. Larger firms with high CEO inside debt have
lower interest rates on these debt instruments and shorter maturities, suggesting a more conservative
financingpolicy with regards to debt.
Research limitations/implications Debt diversification is partially affected by compensation in the
form of insidedebt. Future studies of debt diversificationshould include CEO compensationcontrols.
Practical implications For struggling companies or for those that want to return to a conservative
financial policy, they can influence the CEO to make this decision by deferring his compensation to
retirement.
Originality/value This paper considersdebt policy through the lens of a key decision maker, the CEO,
and uses compensationas an incentive to determinewhat choices are made concerning debt.
Keywords Corporate governance, Executive compensation, Debts, Debt specialization, Inside debt
Paper type Research paper
1. Introduction
This paper extends the literature by analyzing the various components of a firm’s total debt
and the new data on CEO’s compensation structure in the USA from 2006 to 2011.
Specifically, using Capital IQ, this paper breaks down the specific components of short-
term and long-term debt to determine what types of debt instruments are preferred among
CEOs with greater incentives to cater to debt holders.Doing so provides greater insight into
how CEO incentives affect important financial policy decisions, such as specialization,
maturity and yields. New empirical research demonstrates imprinting theory (the founder-
CEO sets initial policies) is especially true for debt policies but changes with new CEOs
(Hanssens et al., 2016); thus, we should look to the CEO and his or her incentives and the
implications of this on financial policies. These new data provide opportunities to address
several different empirical questions related to compensation incentives. Does inside debt
lead to firm debt diversification or firm debt specialization? In the presence of inside debt, is
short-term debt or long-term debt used more? How does inside debt relate to debt holder
concerns over yield and maturity?Answering these questions is essential to understand the
financial policy implicationsof incentivizing a CEO with more inside debt.
First, inside debt is analyzed as another supply-side factor of debt specialization, as firms
have to compensate staff, especially the CEO, for their use of human capital. Using the
HerfindahlHirschman index of type usage, firms who pay the CEO with more inside debt
tend to specialize the firm’s capital structure more often than other firms do. This is
Randy Beavers is an
Assistant Professor of
Finance at the School of
Business, Government and
Economics, Seattle Pacific
University, Seattle,
Washington, USA.
Received 22 June 2017
Revised 20 October 2017
18 February 2018
Accepted 28 February 2018
This research occurred as part
of dissertation work at the
University of Alabama. The
author thanks Shawn Mobbs,
Doug Cook, David Cicero,
Junsoo Lee, Tom Lopez,
Clemens Otto, Xiaojing (Aggie)
Yuan, Emilia Garcia-Appendini,
Tao-Hsien King, anonymous
referees, and participants at
the 2014 meetings of MFA,
EFA, IBEFA, and FMA.
PAGE 686 jCORPORATE GOVERNANCE jVOL. 18 NO. 4 2018, pp. 686-713, ©EmeraldPublishing Limited, ISSN 1472-0701 DOI 10.1108/CG-06-2017-0125
especially true for firms with 90 per cent or more of their debt structure based on a specific
class of debt. However, when the interaction between inside debt and firm size (a proxy for
information asymmetry) is considered, larger firms with larger amounts of CEO inside debt
diversify their debt holdings.
Second, we examine the relationships between inside debt and the various components of total
debt. Firms with high CEO inside debt are more likely to use commercial paper, senior bonds
and commercial loans; have a higher percentage of debt from drawn credit lines; and have a
lower percentage of term loans; however, larger firms with high CEO inside debt are less likely to
use commercial paper and senior bonds; have a lower percentage of debt from drawn credit
lines and commercial loans; and have a higher percentage of debt from term loans.
Finally, specific components of debt important to debt holders, namely, interest rates and
maturity, are considered. As higher inside debt compensation is associated with lower
levels of CEO risk-seeking behavior (Cassell et al., 2012), CEO’s with higher debt
compensation might be expected to make bonds less risky and thus warranting a lower
rate. However, after controlling for factors related to bankruptcy, such as profitability and
cash flow volatility, we find firms with higher inside debt tend to reward debt holders, on
average, with higher interest rates and longer issue maturities. Higher inside debt,
especially above the firm’s debt-to-equity ratio, incentivizes the CEO to cater more to the
needs and desires of debt holders through higher interest payments, just as shareholders
prefer higher dividends. In addition, longer maturities are preferred for investors concerned
about retirement. Similarly, Sundaram and Yermack (2007) find CEOs with higher inside
debt are also concerned with longer time horizons. However, the effect is the opposite for
larger firms with large CEO inside debt holdings. One explanation for this can be
asymmetry. In smaller firms, the issuance of long-term securities is more of a signal of
sustainability, and thissignal is more believable the more inside debt the CEO has, whereas
in larger firms, the long-term sustainability of the firm is less of a concern; thus, there is no
need to signal and thus the CEO makes conservativesafe decisions.
This paper contributes to the literature in several ways. First, we provide another variable to
consider with supply-side effect analysis of debt specialization with insid e debt. Second, we
provide a benchmark for future analysis of specific debt instruments left unexplored, incl uding
total trust-preferred stock, a component of “other” debt. Third, we demonstrate structures of
inside debt and firm debt are interrelated. Finally, the evidence here provides regulatory
authorities with further evidence on how CEO inside debt affects financial deci sion-making.
The remainder of the paper is organized as follows. Section 2 describes the characteristics
of debt, both for the firm and CEO, in the context of the USA. Section 3 provides a
theoretical framework, leading to an empirical literature review and hypotheses
development in Section 4. Section 5 describes the research design implemented to provide
findings, which are discussedin detailin Section 6. Section 7 summarizes and concludes.
2. CEO inside debt, firm debt and executive compensation
Firm capital structure and Chief Executive Officer (CEO) compensation structure have been
of interest to academicians and regulators for years. Until recently, capital structure has
been analyzed in the context of total debt and total equity. However, the Capital IQ
database, starting in 2001, provides details of debt capital structure, such as types and
term structures of debt instruments. New studies by Rauh (2006) and Colla et al. (2013)
introduce the use of the new and comprehensive Capital IQ database to break down the
components of total debt, into commercial paper, drawn credit lines, senior and
subordinated bonds and notes, term loans and capital leases. Firms who debt specialize
have higher bankruptcy costs, are less transparent and lack access to debt markets.
However, their work did not include consideration of CEO compensation incentives, which
could influence decision-makingon financial policies.
VOL. 18 NO. 4 2018 jCORPORATE GOVERNANCE jPAGE 687

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