We examine the role of CEO behavioral characteristics in the design of debt covenants. The behavioral finance literature that examines the consequences of behavioral biases of managers has primarily focused on managerial optimism and overconfidence; traits that have been shown to be prevalent in managers (see Malmendier and Tate (2005, 2008) and Ben-David, Graham, and Harvey, 2007). DellaVigna (2009) points out that the standard model of behavior in economics assumes, among other things, that individuals on average hold correct beliefs about the distribution of states of the world. Experimental evidence however suggests that such an assumption is not valid and individuals tend to maintain overconfident beliefs. Overconfident managers “systematically overestimate the probability of good firm performance and underestimate the probability of bad firm performance” (Heaton, 2002). As a result they have been found to display hubris (Roll, 1986) that manifests in inefficient investment decision and value destroying acquisitions (Malmendier and Tate, 2008).
Despite the growing evidence on the effects of managerial overconfidence on corporate decisions, it is unclear whether investors incorporate such overconfidence in contracting with firms with overconfident CEOs. This study sheds light on this issue by examining how debt investors contract with firms in the presence of overconfident CEOs. We particularly focus on debt contracts because Malmendier and Tate (2005) show that overconfident managers avoid equity financing and rely on internal cash and debt to fund projects. Thus, our primary research question is: how do debt investors structure debt covenants when faced with overconfident managers accessing public debt markets for financing?
We conjecture that bondholders demand greater covenant protection to reflect the implications of CEO overconfidence, incremental to the relevant firm risk characteristics. Models by Heaton (2002) and Malmendier and Tate (2005)demonstrate the tendency of over confident CEOs to over invest. Therefore, we examine whether bondholders design covenants to restrict merger and investment activities. In additional analyses, we examine whether the overconfident managers face higher borrowing costs. Finally, we examine if bondholders place covenant restrictions on their ability to raise subsequent financing which indirectly limits investment and acquisition activities.
While many of the predictions of managerial overconfidence are similar to moral hazard problems in agency settings, such as managerial entrenchment and perquisite consumption, CEO overconfidence and moral hazard problems are fundamentally very different. According to Baker, Ruback, and Wurgler (2007), “unlike in a traditional agency problem, which arises when there is a conflict between managers and outside investors, standard incentive contracts have little effect: An irrational manager may well think that he is maximizing value”. Therefore, they highlight the importance of distinguishing implications of overconfidence from the traditional agency problems in empirical studies. We address this challenge by using overconfidence measures that are unrelated to moral hazard problems and we also control for managerial entrenchment in all empirical tests. We discuss this in detail in the following paragraphs.
We follow the “revealed beliefs” approach used by Malmendier and Tate (2005) to capture CEOs’ expectations with respect to future returns of their firms. CEO overconfidence is inferred from the CEO’s propensity to hold in-the-money vested options in their own firm beyond optimal thresholds of risk diversification. The willingness to hold a large undiversified stake in their companies suggests that overconfident CEOs systematically overestimate the future returns of their projects. Assuming reasonable levels of risk aversion and CEO wealth concentration in the firm, Hall and Murphy (2002) calibrate a utility model to generate the exercise thresholds in terms of in-the-moneyness of the option over the life of the option. Our measures of overconfidence classify CEOs as overconfident if they continue to hold their fully vested options well beyond the threshold (see Appendix 1A for a detailed discussion of the variable construction). The idea is that since the CEO’s wealth and human capital is already exposed to firm specific risk they should exercise their in-the-money options earlier than a diversified holder (Lambert, Larcker, and Verrecchia, 1991; Hall and Murphy, 2002). The advantage of this measure is that traditional agency conflicts do not predict irrational concentration of wealth in the firm whereas it is consistent with managers’ revealed overconfident beliefs.
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