Negative Hedging: Performance Sensitive Debt and CEOs’ Equity Incentives

Abstract

We examine the relation between CEOs’ equity incentives and their use of performance-sensitive debt contracts. These contracts require higher or lower interest payments when the borrower's performance deteriorates or improves, thereby increasing expected costs of financial distress while also making a firm riskier to the benefit of option holders. We find that managers whose compensation is more sensitive to stock price volatility choose steeper and more convex performance pricing schedules, while those with high delta incentives choose flatter, less convex pricing schedules. Performance pricing contracts therefore seem to provide a channel for managers to increase firms’ financial risk to gain private benefits.