According to Wharton finance professor Todd Gormley, shareholders view managers as performing poorly in three ways. One way is fairly clear-cut — when managers are perceived as not exerting enough effort in their role. Another is when they take actions that benefit themselves but not investors. The third — and perhaps less obvious — instance is when managers “play it safe” by not taking the risks necessary to create shareholder value. 

In a new research paper, “Playing It Safe? Managerial Preferences, Risk and Agency Conflicts,” Gormley and co-author David Matsa of Northwestern University’s Kellogg School of Management look at the problems that can arise when managers avoid taking risks that could potentially harm a firm, but could also lead to the creation of shareholder value. In an interview with Knowledge at Wharton, Gormley talks about why “playing it safe” is a problem that is hard to detect, and how giving managers a bigger ownership stake in a company can lead to the kind of risk avoidance that affects shareholder value. 

An edited transcript of the conversation appears below. 

Why and how managers “play it safe”:

My research basically looks at why managers may not always act in the best interests of shareholders, and what are things that investors can do to discourage bad behavior by managers. 

Generally speaking, we think of there as being three main ways in which managers behave poorly. One is that they may not exert enough effort — because effort is costly, and if we don’t monitor them as an investor, they won’t exert it. The second is that they may actually take actions that benefit themselves but not the shareholders. The third is where my research is focused, and that is that managers may do what my co-author and I call “play it safe” — they may not take the risks that are necessary to create value for the shareholders. 

Managers may not [take risks] because they have a lot tied up in these companies. If [business] goes south, their career could be adversely affected, and their personal wealth could be affected much more so than a diversified shareholder, so they’re going to want to take fewer risks. 

“This playing it safe behavior by managers … can have implications for a company’s overall value, investment and growth.”

My co-author and I were trying to determine whether playing it safe is a salient problem for investors. And the way in which we did that is we looked at what firms do when they become protected from a hostile takeover. In the U.S., several states passed laws that made it difficult to do a takeover of a company located in those states. Now that’s interesting, because we in finance think of a takeover as a sort of disciplining device on a manager. If a manager is performing poorly, and doing things that destroy shareholder value, that’s going to push down their share price and it’s basically going to make it easier for another group of investors to come in, buy out the company, fire the manager and improve value.  

So, if I’m a manager and I’m not worried about that anymore because my state just passed a law that protects me from a takeover, I can now act more [based] on my own interests rather than those of the shareholders. So the question is: What do managers do when they become protected? 

What my co-author and I found is that when managers became protected by these state-level laws, they took less risk. We observed stock volatility go down. We observed cash holdings go up. We also observed them doing more diversifying acquisitions, which prior research has shown is one way in which managers try to reduce their risk. And it doesn’t look like this behavior is in the interest of shareholders, either. We can see that these acquisitions [lead to] negative … returns. And we can also see that they’re concentrated among the companies where we would think that playing safe is more important, firms that have greater risk of distress and firms where the managers have more personal exposure to the company’s risk. 

On the key takeaways:

One of the key takeaways of our research is that this playing it safe behavior by managers, this incentive to not take on risk that may create value, can have implications for a company’s overall value, investment and growth. If you think about it, in order to create value for shareholders at some level you have to take risk. Products that have turned out to be great in the past — someone took a risk to create that product. If managers aren’t doing that, then they’re not necessarily creating value. 

Another takeaway is that playing it safe in general is probably going to be very hard to detect for a shareholder. [Shareholders] don’t observe the investments the manager is choosing between — what their expected returns are, what the risks are. We don’t know if managers may be avoiding certain projects that could create a lot of value, but they’re worried about the risk and the personal exposure to that risk. Or, we see these companies holding more cash. These companies say they’re holding cash because they’re trying to make sure they have the cash there to do an investment if it comes along. Is that true? Or is it that they’re holding the cash because they’re worried about distress, and they’re just trying to make sure that the company doesn’t run into problems in the future, and it’s not really creating value for the shareholder? That’s hard for a shareholder to know. But what our research is trying to point out is that managers may, in general, be trying to take on less risk than what we’d prefer them to do. And therefore, it might be important to actually encourage more risk taking. 

The most surprising conclusion:

I wouldn’t say it surprised me, but I suspect it would surprise others, that this sort of playing it safe behavior by managers was concentrated among those who had the largest ownership stakes in their companies. Typically, we would teach our students here at Wharton that if you want to encourage managers to work hard and not waste cash, you give them more stock in a company, more of an ownership stake. Now it’s true that that will make them work hard and not waste cash. But what is often overlooked in practice is that it can actually make some problems worse, particularly the playing it safe [behavior]. By giving them more ownership, you’ve just exposed them to even more of the company’s risk. You’ve given them more of an incentive to play it safe. 

“By giving [managers] more ownership … you’ve given them more of an incentive to play it safe.”

On the practical implications:

One of the practical implications of our findings is that as an investor, as a shareholder, if you don’t think the manager is taking on actions that are going to create shareholder value, it’s important to understand why they may not be doing that [in order] to solve it. I’ll give you an example. The Wall Street Journal ran a really nice article last summer where basically the author was bemoaning that firms and entrepreneurs in the U.S. had become soft on risk. And because these companies aren’t taking risks, U.S. growth and investment has been weak over the last five-10 years. The question is: Why aren’t they taking these risks? If we as shareholders think it’s because it just requires a lot of effort and the managers don’t want to exert that effort, well, then one solution is to give them more ownership in the company. 

On the other hand, if they’re not taking that risk because they want to play it safe and they’re worried about their careers, then the solution becomes quite different. You don’t necessarily want to give more ownership, because that just exposes them more to the firm’s risk. Instead you might want to think about other things like granting them options, which past research — including my own — has shown encourages risk taking. 

Where else might the research apply?

My guess is that this playing it safe is also salient for entrepreneurs. [For example,] think of students who graduate from Wharton. All of them are going to have an opportunity to go get a great job at a company that has a nice salary, good benefits and good health insurance. Now, some of these students may also have a great idea for a new company or a new product that they could [pursue] instead. But obviously starting your own company is risky. And I would guess that many of these individuals don’t do that, and instead they’re just going to go take the safe job that has a salary and the fixed health benefits rather than start a new company. And I would term that as potentially playing it safe. And I think it could be quite important. 

On dispelled misperceptions:

Probably the biggest misperception that our study might dispel is this idea that giving managers greater ownership stakes in their companies necessarily ensures that they behave in the best way. There’s a lot of attention paid [to this] recently because of the financial crisis — you want to give managers more ownership stake, you want to give them these restricted stocks that tie them to the long-term risk of the company. That’s probably going to get rid of some problems, but it could actually make other problems worse, in particular playing it safe. When they’re tied to the long-run risks of the company, they have a lot more to worry about. They may actually take on less risk than what we as shareholders want them to. They may forgo projects that would create a lot of value just because they’re risky. 

“My research is showing that managers may be exerting a lot of effort, but this effort is not directed in ways that are necessarily trying to create shareholder value.”

How the study stands apart:

One thing that is different about my research relative to other research on why managers might misbehave is that most past research is focused on the idea that managers don’t exert enough effort and that they want to live what we call the “quiet life” — they don’t want to work hard. Whereas my research is showing that in fact, managers may be exerting a lot of effort, but this effort is not directed in ways that are necessarily trying to create shareholder value. Rather, it’s effort directed at maybe reducing the company’s risk for the manager’s personal benefit, not that of the shareholders. 

What’s next?

One thing that I’ve been thinking about looking at next is whether the recent health care law has an effect on an individual’s choice to be an entrepreneur. If you think about it, prior to the health care law being passed, if you were an individual and you started a company, it was really hard to get health insurance as an individual. So, your alternative was to go get that 9-to-5 job where you can at least have health insurance. Now that the law has passed and we have the marketplace and it’s much easier for individuals, my guess is that you’re probably going to see a lot more people choosing to start their own companies, knowing that they can get this health insurance without having to go get that steady 9-to-5 job.