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

Author:Viput Ongsakul, Pattanaporn Chatjuthamard, Napatsorn Jiraporn, Pornsit Jiraporn
Publication Date:13 Nov 2020
Does the market for corporate control
inuence executive risk-taking incentives?
Evidence from takeover vulnerability
Viput Ongsakul, Pattanaporn Chatjuthamard, Napatsorn Jiraporn and Pornsit Jiraporn
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
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,
JEL classication 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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