During periods of financial distress, managers and shareholders often view risk differently. While managers may favor caution to protect their careers, shareholders might prefer risk-taking to maximize equity value. A study published in the Journal of Accounting and Economics by Xiao Cen, assistant professor in the Adam C. Sinn ’00 Department of Finance at Texas A&M University’s Mays Business School, along with co-authors Nan Li (University of Minnesota), Chao Tang (Hong Kong University of Science and Technology), and Juanting Wang (Shanghai University of Finance and Economics), reveals how firms adjust executive compensation to balance these competing interests when asset values decline.

The Asset-Incentive Connection

The study uncovers a crucial relationship between a firm’s asset value and executive risk-taking incentives. When asset values decrease, firms respond by increasing risk-taking incentives in executive compensation, particularly through option-based compensation. This adjustment helps align managerial actions with shareholder interests, especially when firms face higher distress risks.

The researchers used comprehensive data from multiple sources, including Compustat, Execucomp, the Federal Housing Finance Agency, and the U.S. Census Bureau’s Longitudinal Business Database. This rich dataset allowed them to track how changes in asset values influenced compensation structures across different market conditions and time periods.

Evidence from Two Fronts

To establish this relationship, the researchers examined two distinct scenarios. First, they analyzed how local real estate price changes affect firms’ compensation policies. This approach took advantage of variations in property markets to identify how changes in asset values influence executive incentives. The real estate focus provided a clear window into how firms adjust compensation when faced with measurable changes in asset values.

Second, they studied how natural disasters impact executive incentives. This natural experiment setting helped isolate the effect of unexpected shocks to business fundamentals on compensation decisions. Both approaches revealed the same pattern: when external shocks erode asset values, firms increase risk-taking incentives in executive compensation.

Understanding the Trade-Offs

The research demonstrates that compensation contracts must balance competing forces. When asset values decline, managers’ natural inclination toward caution increases, potentially conflicting with shareholders’ preference for risk-taking to recover value. This tension becomes particularly acute when managers face significant personal costs from financial distress, such as reputational damage or career concerns.

The study found that firms respond to these challenges by adjusting their compensation structures. Option-based compensation becomes more prominent during downturns, providing managers with greater upside potential to encourage appropriate risk-taking while maintaining their motivation to perform.

Implications for Corporate Boards

For corporate boards, the findings highlight the importance of dynamic compensation policies. Static approaches to executive compensation may fail to align interests effectively as conditions change. Boards must consider how external economic conditions and firm-specific challenges affect the balance between managerial caution and necessary risk-taking.

The research suggests boards should carefully monitor changes in firm asset values and their impact on risk preferences. This includes regularly assessing compensation structures to maintain appropriate risk-taking incentives and considering the personal costs managers face during periods of distress. Boards also need to ensure their compensation committees understand these dynamics when designing and adjusting executive pay packages.

Regulatory Considerations

The study carries significant implications for policymakers and regulators overseeing executive compensation. Understanding how firms naturally adjust risk-taking incentives in response to changing conditions can inform more effective oversight frameworks. This might include ensuring compensation policies remain flexible enough to adapt while maintaining appropriate risk management controls.

Regulators might also consider how disclosure requirements and oversight mechanisms can better reflect the dynamic nature of compensation adjustments. This could help shareholders better understand how and why compensation structures change in response to shifting economic conditions.

Looking Ahead

This research underscores the importance of aligning executive incentives with dynamic risk preferences, particularly during periods of financial distress or external shocks. By tailoring compensation policies to reflect changing conditions, firms can foster better alignment between managerial actions and shareholder goals.

For boards, this means moving beyond one-size-fits-all compensation models. For policymakers, it highlights the need for nuanced regulations that account for economic variability. Ultimately, understanding the interplay between asset values, risk preferences, and compensation design is key to promoting sustainable corporate governance in an ever-changing business landscape.

Research Takeaways

• Asset Value Impact: Decreases in firm asset values lead to increased risk-taking incentives in executive compensation, particularly through option-based compensation.
• Context Matters: The effect strengthens when managers face higher personal costs from distress and when firms have elevated distress risk.
• Dynamic Adjustment: Compensation contracts adapt to align the changing risk preferences of managers and shareholders during periods of financial pressure.