Risk-substitution Incentives, Managerial Ownership, and Firm Value

Recent theoretical insights suggest that risk-averse managers, especially those with relatively high equity holdings, have a greater propensity to engage in risk-substitution; that is, they pass up innovative projects with high firm-specific (idiosyncratic) risk in favor of standard projects that have greater aggregate (systematic) risk (Acharya and Bisin, 2009; Rand Journal of Economics 40: 47-77). Such risk-substitution incentives could potentially offset the well-documented alignment effect of managerial ownership, leading to a weak association between managerial ownership and firm value. However, no empirical evidence yet exists to confirm the existence of such effect convincingly. This study attempts to fill in the gap in the literature by investigating the relation between managerial ownership and firm value, contingent upon idiosyncratic risk. Using a carefully assembled dataset of 2,006 companies listed on NYSE, AMEX and NASDAQ, this study makes three contributions. First, managerial ownership affects firm value in a strong positive way, but this effect applies only for low idiosyncratic risk companies that are not exposed to severe risk-substitution problems. Second, for high idiosyncratic risk companies, which are normally characterized by stronger risk-substitution incentives, the link between managerial ownership and firm value is weak, if any. Thirdly, the ownership-firm value relationship is not necessarily linear, dictating the use of semi-parametric estimation methods.