Finance - Theses
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ItemThree Essays on CEO Compensation and the Agency Problem of Debt( 2020)Jensen and Meckling [1976] propose that compensating a manager with debt-like payment, a.k.a. “inside debt”, can be a mechanism to mitigate the agency problem of debt. Recent empirical papers document that higher inside debt held by a chief executive officer (“CEO”), which is measured by the present value of their supplemental retirement benefits, is associated with more conservative management and lower cost of debt. However, the grant of inside debt might originate from rent extraction purposes, and happens to encourage risk aversion among CEOs. Therefore, it remains unclear whether companies use CEO inside debt as a mechanism to mitigate the agency problem of debt. To address this question, my thesis examines how U.S. public companies adjust their use of CEO inside debt in three corporate events that involve changes to the agency problem of debt. In the first essay (Chapter 4), I show that new active blockholders adjust CEO inside debt-equity ratios to increase total firm value, not just equity value. These investors are more like to arise when CEO inside debt-equity ratios are not properly set up to maximize total firm value. The speed of adjustments towards the appropriate ratios triples in the presence of active blockholders, but returns to the normal level once these investors “exit”. Such compensation adjustments are associated with positive stock and bond abnormal returns over the active block holding period. I also find that new active blockholders arise and restructure compensation when the old structures over-align CEOs’ incentives to either shareholders’ or debtholders’ interests. I argue that superb stock-picking skill, a mean-reverting process of compensation changes, or co-founding firm characteristics cannot explain the large compensation adjustments during active blockholders’ presence. Instead, these blockholders actively affect CEO compensation structures by appointing their favored directors into the targeted firms’ boards, especially into the compensation or governance committees. In the second essay (Chapter 5), I show that companies raise their CEO inside debt to address the heightened agency problem of debt due to increased leverage, after they remove anti-takeover provisions (“ATPs”). By using a difference-in-difference-in-difference analysis, I document significant increases in CEO inside debt-equity ratios after companies remove ATPs. Inside debt also rises significantly after ATP removals, which accounts for 70% of increases in the overall ratios. In contrast, inside equity significantly decreases after companies remove ATPs, as these companies reduce the stocks and options awarded to their CEOs. These findings are robust to different explanatory variables, matching samples, and removals of certain ATPs. Further analysis displays that inside debt-equity ratios increase continually for the first three years after ATP removals. This trend coincides with the after-ATP-removal spike in leverage, which is caused by increased debt issuance. I also show that increasing inside debt-equity ratios, especially increasing inside debt, helps companies reduce the cost of borrowing after ATP removals. However, increasing inside debt can only address part of the heightened agency problem of debt, as companies still face more costly debt financing after ATP removals. Despite the increase in inside debt and decrease in inside equity, CEOs take more risks after their companies remove ATPs. This result suggests that removing ATPs can substitute for the role of inside equity in providing CEOs with more risk-taking incentives. In the third essay (Chapter 6), I explore the timing strategies for bond issuances based on disclosures of CEO inside debt. During the months before proxy statement releases, new changes in CEO inside debt are private information to companies’ insiders. Companies can exploit this information asymmetry to issue bonds when the market, based on publicly available information of inside debt, perceives these companies’ debt agency problems as relatively insignificant. I find that companies cluster their bond offerings in the immediate quarters after (before) disclosures of positive (negative) inside debt changes. The tendencies to time bond issuances based on inside debt disclosures also increase with the magnitudes of the disclosed changes. In addition, the adoption of these timing strategies is more observable when the issuing firms are regular issuers or when the new issues do not include covenants, especially the debt-restriction covenants. Finally, I verify that these timing strategies help reduce the cost of borrowing. The bonds issued at favorable times, i.e. right after positive change disclosures or before negative change disclosures, have lower offering yield spreads than those issued at non-favorable times.