Does the market for corporate control influence executive risk-taking incentives? Evidence from takeover vulnerability

• Published date: 13 November 2020
• DOI: https://doi.org/10.1108/CG-03-2020-0106
• Pages: 62-77
• Date: 13 November 2020
• Subject Matter: Strategy,Corporate governance
• Author: Viput Ongsakul,Pattanaporn Chatjuthamard,Napatsorn Jiraporn,Pornsit Jiraporn

Does the market for corporate control

inf‌luence executive risk-taking incentives?

Evidence from takeover vulnerability

Viput Ongsakul, Pattanaporn Chatjuthamard, Napatsorn Jiraporn and Pornsit Jiraporn

Abstract

Purpose –This study aims to investigate the role of the market for corporate control as an external

governance mechanism and its effect on executive risk-taking incentives. Managers tend to be risk-

averse as they are more exposed to idiosyncratic risk, resulting in sub-optimal risk-taking that does not

maximize shareholders’wealth. The takeover market alleviates this problem, inducingmanagers to take

more risk. Therefore, risk-taking incentives inside the firm are less powerful when the outside takeover

marketis more active.

Design/methodology/approach –Exploiting a novel measure of takeover vulnerability recently

constructed by Cain et al. (2017), the authors explore how takeover vulnerability influences executive

risk-taking incentives. Using a large sample of US firms, the authors use fixed-effects regressions,

propensityscore matching and instrumental variableanalysis.

Findings –Consistentwith this study’s hypothesis, a more activetakeover market results in less powerful

risk-taking incentives.Specifically, a rise in takeover vulnerability by one standard deviation diminishes

executiverisk-taking incentives by 22.39%,which is an economically meaningfulmagnitude.

Originality/value –To the best of the authors’knowledge, this study is the first to explore the effect of the

takeover market on managerial risk-taking incentives,using a novel measure of takeover susceptibility.

The authors’ measureof takeover vulnerability is considerably less susceptibleto endogeneity, enabling

the authorsto draw causal inferences with more confidence.

Keywords Corporate governance, Risk-taking incentives, Vega,Takeover market,

Market for corporate control

Paper type Research paper

1. Introduction

Grounded in agency theory, our study explores the effect of the takeover market on

managerial risk-taking incentives. Economic theory suggests that, because managers are

more exposed to idiosyncratic risk, they develop strong risk aversion (Fama, 1980;Amihud

and Lev, 1981). This strong risk aversionmay motivate them to adopt less risky projects that

do not maximize shareholders’ wealth, resulting in sub-optimal risk-taking. This can be

considered an agency cost as managers make investment decisions that reflect their own

risk preferences at the expense of shareholders. Stock options provide incentives for

managers to overcome their risk aversion and invest in more risky projects (Harris and

Raviv, 1978;Amihud and Lev, 1981). Consistent with this notion, prior research shows that

managers adopt more risky projects when granted stock options, thus moving the degree

of corporate risk-taking closerto the optimal level (Guay, 1999;Coles et al.,2006).

The market for corporate control is recognized as a crucially important externalgovernance

mechanism, bringing into closer alignment the interests of managers and shareholders

(Manne, 1965;Fama, 1980;Fama and Jensen, 1983;Lel and Miller, 2015). To the extent

Viput Ongsakul is basedat the

National Institute of Development

Administration,Bangkok,

Thailand.

Pattanaporn Chatjuthamard is

based at the Sasin School of

Management, Chulalongkorn

University, Bangkok, Thailand

and Center of Excellence in

Management Research for

Corporate Governance and

Behavioral Finance,

Chulalongkorn University,

Bangkok, Thailand.

Napatsorn Jiraporn is based at

the State University of New York

at Oswego, Oswego,

New York, USA.

Pornsit Jiraporn is based at the

Pennsylvania State University,

University Park, Pennsylvania,

USA.

JEL classif‌ication –G32, G34

Received 21 March 2020

Revised 28 July 2020

1 October 2020

Accepted 1 October 2020

This research was funded by

the Chulalongkorn University

under the Ratchadapisek

Sompoch Endowment Fund

(2020) through the

Collaborating Center for Labor

Research at Chulalongkorn

University (CU-Collar) (763008)

and the Center of Excellence in

Management Research for

Corporate Governance and

Behavioral Finance. Part of this

research was carried out while

Pornsit Jiraporn served as

Visiting Professor of Finance at

SASIN School of Management,

Chulalongkorn University, in

Bangkok, Thailand.

PAGE 62 jCORPORATE GOVERNANCE jVOL. 21 NO. 1 2021, pp. 62-77, ©EmeraldPublishing Limited, ISSN 1472-0701 DOI 10.1108/CG-03-2020-0106

that managerial risk aversion is an agency cost, where suboptimal risk-taking reduces

shareholders’ wealth, the takeover market is expected to mitigate this agency problem,

preventing managers from taking too little risk. What should be the effect of the takeover

market on managerial risk-takingincentives?

Because both the market for corporate control and managerial risk-taking incentives

motivate managers to take more risk, when one mechanism is strong, the other mechanism

does not need to be as strong, resulting in a substitution effect. Therefore, we hypothesize

that a more active takeover market results in weaker executive risk-taking incentives. Firms

more subject to a takeover threat offer weaker risk-taking incentives to their managers than

those more vulnerable to a takeover threat. This prediction is intuitive and straightforward,

but it is quite challenging to test this hypothesis empirically because of endogeneity, which

complicates any causal inferences. Fortunately, recently, Cain et al. (2017) construct a

takeover index that captures the extent of takeover vulnerability, using plausibly exogenous

factors. This index makes endogeneity substantially less likely, enabling us to draw causal

inferences with more confidence.

Based on a large sample of almost 10,000 observations across 18years, our results reveal

that a more active takeover market brings about significantly weaker managerial risk-taking

incentives, corroborating the prediction of the substitution hypothesis. Specifically, as

takeover vulnerability increases by one standard deviation, executive risk-taking incentives

become 22.39% less powerful.Therefore, the effect is not only statistically significant, but is

also economically meaningful. Although our measure of takeover vulnerability is already

less vulnerable to endogeneity, we execute additional analysis to minimize endogeneity

even further. Specifically, we run generalized method of moments dynamic panel data

analysis, propensity score matching (PSM) and instrumental-variable analysis. All the

robustness checks confirm that stronger takeover vulnerability results in weaker risk-taking

incentives. Our results are thereforehighly unlikely driven by endogeneity.

The results of our study make important contributions to the literature. First, we contributeto

the literature on executive risk-taking (Guay, 1999;Coles et al., 2006;Chava and

Purnanandam, 2010;Croci et al.,2017;Chakrabarty et al.,2017;Ongsakul and Jiraporn,

2019;Chatjuthamard et al., 2020b). To the best of our knowledge, our study is the first to

show that takeover susceptibility is one of the crucial determinants of managerial risk-taking

incentives. Future research should incorporate takeover susceptibility into its empirical

model on risk-taking. Second, we contribute to the strand of the literature that investigates

the effect of the takeover market on corporate policies and outcomes (Bertrand and

Mullainathan, 1999,2003;Giroud and Mueller, 2010;Garvey and Hanka, 1999;Cheng

et al., 2005;Lel and Miller, 2015). We demonstrate that risk-taking incentives are

considerably weakened by the takeover market. Third, we contribute to a fledging, albeit

rapidly rising, area of the literature that exploitsthe takeover index as a measure of takeover

vulnerability (Cain et al., 2017;Chatjuthamard et al., 2020a). This area of the literature is

crucial as the takeover index is likely exogenous and is more likely to reveal a causal effect.

Moreover, the takeover index takes into account all the state laws, whereas most prior

studies focus on one or only a few state laws. Studies using the takeover index are thus

more likely to produce accuratecausal inferences than prior studies.

2. Theoretical framework and literature review

2.1 Theoretical framework

According to the economic theory, managers are more exposed to idiosyncratic risk. As a

result, they exhibit strong risk aversion (Fama, 1980;Amihud and Lev, 1981;Smith and

Stulz, 1985;Williams, 1987;Holmstorm, 1999;Gormley and Matsa, 2016). Managers

exercise their discretion to change firm risk via the selection of investment projects.

Managers can reduce firm risk by accepting projects with lower cash flow volatility or

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