You hear about them often in the news — those longtime managers who survive corporate mergers with a golden parachute and a backpack full of fabulous perks. They must have done a great job in helping the company grow, right? Not necessarily, according to research done by Lubomir Litov, Ph.D., assistant professor of finance at Washington University’s Olin School of Business.
In a series of studies Litov conducted, he found that, longtime, or entrenched, managers tend to avoid risky investments and projects, and they end up saddling their firms with higher debt levels and slowing the firm’s growth.
Litov loosely defines an entrenched manager as someone who cares more about his interests than those of shareholders, or as a management team that doesn’t maximize the value of shareholders.
“Entrenched managers tend to invest very conservatively in safe projects, as opposed to taking risky, but value-enhancing projects,” Litov says. “As a result, we empirically see that entrenched managers create more debt for their firms.”
As a result of the conservative investment, these firms are safer, so they benefit from higher debt levels and the resulting tax-deductible higher interest payments. For the shareholders of these firms higher debt levels can be beneficial, Litov says.
That doesn’t necessarily mean entrenched managers don’t avoid debt.
“Perhaps they do, if everything else is the same,” Litov says. “However, not everything else is the same when a manager becomes entrenched. He would prefer conservative investments, so at least the investment policy is not the same.” For research purposes, Litov used an index found in corporate charters to identify entrenched managers. The terms “weak corporate governance” and “entrenched management” are used interchangeably in Litov’s studies.
Entrenched managers’ concern for their own welfare doesn’t just increase a company’s debt level, it can also put a wrench in a company’s plan for new projects. In short, managers don’t want to take risks because they don’t want to lose their jobs and the attending benefits, Litov says.
“They try to preserve their consumption of those corporate perks,” Litov says. “An entrenched manager may wish to stay on the job longer because there are a lot of benefits that come with it, tangible perquisites, like corporate cars or year-end bonuses, as well as intangible perks like prestige, or power.”
Litov points out that such behavior isn’t necessarily bad for the company. The shareholders may want to give the manager such perks in order to compete with other corporations. It may even be cheaper to provide perks such as a corporate jet rather than to give the manager the money to buy one.
“Sometimes the management places more value on the perquisites as opposed to the cash,” he says.
Companies that fall victim to play-it-safe managers tend to be older firms that want to maintain the status quo and not engage in risky innovations. European companies are generally more conservative than those in the United States, which is the benchmark for high investor protection. The risk-taking American entrepreneurial spirit, in combination with the highly competitive U.S. banking structure, has contributed to the outstanding growth of the American economy, Litov says.
Litov’s conclusions come from two separate papers: “Corporate Governance and Financing policy: New Evidence,” and “Corporate Governance and Managerial Risk Taking: Theory and Evidence,” co-authored with Kose John and Bernard Yeung, both at New York University. Both studies have been submitted to financial journals for possible publication.