Why do Larger Firms Pay Executives More for Performance?

Transcription

1 Why do Larger Firms Pay Executives More for Performance? Performance-based versus Market-based incentives QUML Economics and Finance Workshop for PhD and Post-doc Students Bo Hu June 27, 2018 Tinbergen Institute, Amsterdam

2 Introduction

3 Introduction Managerial labour market and contract incentives Apple Inc Proxy Statement: experienced personnel in the technology industry are in high demand, and competition for executive talent is intense... (the contract incentives are designed) to attract and retain a talented executive team and align executives interests with those of shareholders... 1

4 Introduction Managerial labour market and contract incentives Apple Inc Proxy Statement: experienced personnel in the technology industry are in high demand, and competition for executive talent is intense... (the contract incentives are designed) to attract and retain a talented executive team and align executives interests with those of shareholders... How does the managerial labour market and pay incentives interact? 1

5 Introduction Managerial labour market and contract incentives Apple Inc Proxy Statement: experienced personnel in the technology industry are in high demand, and competition for executive talent is intense... (the contract incentives are designed) to attract and retain a talented executive team and align executives interests with those of shareholders... How does the managerial labour market and pay incentives interact? Why do larger firms pay executives more for performance? (firm size premium in performance-based incentives) 1

6 Motivating Facts A typical executive compensation package: fixed salary + performance-based pay (bonus, stocks, options, etc.) 30% 70% Performance-based incentives Stylized facts: delta = 1. delta increases in firm size, Wealth(in dollars) Firm Value(in percentage) 2

7 Motivating Facts A typical executive compensation package: fixed salary + performance-based pay (bonus, stocks, options, etc.) 30% 70% Performance-based incentives Stylized facts: delta = Wealth(in dollars) Firm Value(in percentage) 1. delta increases in firm size, controlling for total compensation 2

8 Motivating Facts A typical executive compensation package: fixed salary + performance-based pay (bonus, stocks, options, etc.) 30% 70% Performance-based incentives Stylized facts: delta = Wealth(in dollars) Firm Value(in percentage) 1. delta increases in firm size, controlling for total compensation [Size Premium in Performance-based Incentives] 2

9 Motivating Facts A typical executive compensation package: fixed salary + performance-based pay (bonus, stocks, options, etc.) 30% 70% Performance-based incentives Stylized facts: delta = Wealth(in dollars) Firm Value(in percentage) 1. delta increases in firm size, controlling for total compensation [Size Premium in Performance-based Incentives] 2. such firm size premium is larger in industries where the executive labour market is more active 2

10 dollar percent incentives (data) firm size total compensation 0.7 Sample: top 5 to 8 executives in S&P1500 firms from 1992 to 2015 Color (z): dollar-percent wealth-performance sensitivity 3

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13 0.9 Size Premium over age 0.8 size premiuim on performance based incentives age 6

14 Research Questions: How does the labour market shape contract incentives? Why do larger firms pay more for performance? 7

15 Research Questions: How does the labour market shape contract incentives? Why do larger firms pay more for performance? Main Story: Dynamic moral hazard problem + Frictional labour market Performance-based incentives + Market-based incentives Market-based incentives decrease with firm size, so larger firms need to provide more performance-based incentives. 7

16 What is the market-based incentive? Taking effort today improves managerial skills which are persistent and are appreciated in the labour market. 8

17 What is the market-based incentive? Taking effort today improves managerial skills which are persistent and are appreciated in the labour market. Why do market-based incentives decrease in firm size? 8

18 What is the market-based incentive? Taking effort today improves managerial skills which are persistent and are appreciated in the labour market. Why do market-based incentives decrease in firm size? Job ladder effect executives in larger firms are less likely to receive competitive outside offers 8

19 What is the market-based incentive? Taking effort today improves managerial skills which are persistent and are appreciated in the labour market. Why do market-based incentives decrease in firm size? Job ladder effect executives in larger firms are less likely to receive competitive outside offers Wealth effect executives in larger firms have a higher certainty equivalence level of wealth in the future, subjectively they are less sensitive to wealth variation (diminishing marginal utility) 8

20 What do I do? 1. Model 2. Reduced-form Evidence 3. Structural Estimation using SMM 4. Quantitative Analyses regulations on executive compensation spillover effect of corporate governance on executive compensation 9

21 What do I do? 1. Model 2. Reduced-form Evidence 3. Structural Estimation using SMM 4. Quantitative Analyses regulations on executive compensation spillover effect of corporate governance on executive compensation 10

22 Related Literature Assignment Models Edmans, Gabaix and Landier (2009), Edmans and Gabaix (2011) executives in larger firms value leisure more u(w g(e)). Moral Hazard Models Margiotta and Miller (2000), Gayle and Miller (2009), Gayle, Golan and Miller (2015) moral hazard problem is more severe / the quality of signal (about effort) is poor in larger firms Dynamic contract literature moral hazard: Spear and Srivastava (1987), etc. limited commitment: Thomas Worrall (1988, 1990), etc. Labour search literature sequential auction: Postel-Vinay and Robin (2002), etc. 11

23 The Model

24 Set Up: Moral Hazard Discrete Time, Infinite Periods Executives: risk averse, u(w) c(e), e {0, 1}, c(1) = c, c(0) = 0 effort e stochastically increases individual productivity z Z z is persistent, follows a Discrete Markov Chain process Γ(z, z ) if e = 1, Γ s (z, z ) if e = 0 likelihood ratio g(z, z ) = Γ s /Γ decreases in z die with δ (0, 1), the match breaks up, the job disappears Firms: firm size s S, exogenous and permanent production (cash flow) y(s, z) = αsz 12

25 Set Up: Search Market Search Market: on the job search with λ (0, 1) sample an outside firm s from F (s ) Sequential Auction: Bertrand competition between current firm s and outside firm s Each firm has a bidding frontier, W (z, s), defined by Π(z, s, W (z, s)) = 0 W (z, s) increases in z and s s > s leads to job turnovers 13

26 Timing 14

27 Contracting Problem Firms maximize profits [ Π(z, s, V ) = max αsz w + β ] Π(z, s, W (z, s )) F (s ) Γ(z, z ) s S w,w (z,s ) z Z subject to V = u(w) c + β W (z, s ) F (s )Γ(z, z ), z Z s S β W (z, s ) F (s )(1 g(z, z ))Γ(z, z ) c, z Z s S W (z, s ) min{w (z, s ), W (z, s)}, W (z, s ) W (z, s). (Promise Keeping) (IC) (PC-Executive) (PC-Firm) 15

28 The Equilibrium An stationary equilibrium is defined by value functions {W 0, W, Π}; optimal contracts σ = {w, e, W (z )} for z Z; Γ follows the optimal effort choice; a distribution of executives across employment states evolving according to flow equations. 16

29 The Optimal Contract

30 The Optimal Contract wage t 17

31 The Optimal Contract wage t 18

32 The Optimal Contract wage t 19

33 The Optimal Contract wage t 20

34 The Optimal Contract wage t 21

35 The Optimal Contract wage t 22

36 The Optimal Contract wage t 23

37 The Optimal Contract wage t 24

38 The Optimal Contract wage t 25

39 The Optimal Contract wage t 26

40 The Optimal Contract wage t 27

41 The Optimal Contract wage t 28

42 The Optimal Contract wage t 29

43 The Optimal Contract wage t 30

44 The Optimal Contract wage t 31

45 The Optimal Contract wage induced by sequential auctionwith outside firm t 32

46 The Optimal Contract wage t 33

47 The Optimal Contract wage t 34

48 The Optimal Contract wage t 35

49 The Optimal Contract wage t 36

50 Why do Market-based Incentives Decrease in Firm Size?

51 Incentive Compatibility Constraint What is the incentive out of W (z )? 37

52 Incentive Compatibility Constraint What is the incentive out of W (z )? { } I[W (z )] β W (z )Γ e=1 (z, z ) W (z )Γ e=0 (z, z ). z z 37

53 Incentive Compatibility Constraint What is the incentive out of W (z )? { } I[W (z )] β W (z )Γ e=1 (z, z ) W (z )Γ e=0 (z, z ). z z The incentive compatibility constraint is F (s )I[W (z, s)] + I[W (z, s )]F (s ) + F (s )I[W (z )] c. s M 1 s M 2 s }{{} M 3 }{{} Market-based Incentives Performance-based Incentives Sets of outside firms s : M 1 : s s, lead to job turnovers M 2 : s < s, improve compensation, no job turnovers M 3 : other or no outside firms 37

54 Incentives from W (z, s) decrease in s u I[W (z, s 2 )] I[W (z, s 1 )] s 1 z s 2 z w 38

55 Incentives from W (z, s) decrease in s Proposition I[W (z, s)] decrease in firm size s iff wu (w) u (w) > 1. Intuition [market competition effect] Higher s leads to higher certainty equivalence of W (z, s) Higher certainty equivalence leads to lower marginal utility of extra wealth 39

56 Why do market-based incentives decrease in s? Consider two executives with the same total compensation w. They work in different firms s 1 < s 2. Let s compare their market-based incentives. 40

57 s s 1 s 41

58 s M 1 : I[W (z, s 1 )] s 1 M 2 : I[W (z, s )] s(w) M 3 : 0 s 42

59 s s M 1 : I[W (z, s 1 )] M 1 : I[W (z, s 2 )] s 2 M 2 : I[W (z, s )] M 3 : 0 s 1 s(w) s(w) s s M 2 : I[W (z, s )] M 3 : 0 43

60 s s M 1 : I[W (z, s 1 )] M 1 : I[W (z, s 2 )] s 2 M 2 : I[W (z, s )] M 3 : 0 s 1 s(w) s(w) s s M 2 : I[W (z, s )] M 3 : 0 44

61 s s M 1 : I[W (z, s 1 )] M 2 : I[W (z, s )] M 3 : 0 s 1 > > = > s(w) = s 2 s(w) s s M 1 : I[W (z, s 2 )] M 2 : I[W (z, s )] M 3 : 0 45

62 s s Wealth Effect Job Ladder Effect s 1 s 2 Job Ladder Effect s(w) s(w) s s 46

63 Incentive Compatibility Constraint What is the incentive out of W (z )? { } I[W (z )] β W (z )Γ e=1 (z, z ) W (z )Γ e=0 (z, z ). z z The incentive compatibility constraint is F (s )I[W (z, s)] + I[W (z, s )]F (s ) + F (s )I[W (z )] c. s M 1 s M 2 s }{{} M 3 }{{} Market-based Incentives Performance-based Incentives Firm size premium in incentive pay Keep c constant, market-based Incentives decrease in s, thus performance-based Incentives increase in s 47

64 Examine Direct Evidence

65 Key implications of the model 1. The managerial labour market is active. 2. Managers climb job ladders towards larger firms. 3. Managers in larger firms tend to have less job-to-job transitions. [Job ladder effect] 4. Controlling for initial compensation, executives in larger firms tend to experience higher compensation growth. [Market competition effect] 48

66 Job-to-Job transitions Job-to-Job (JJ): leaves the current firm, and starts to work in another firm within 90/180 days Year JJ Rate (90 days) JJ Rate (180 days)

67 Key implications of the model 1. The managerial labour market is active. 2. Managers climb job ladders towards larger firms. 3. Managers in larger firms tend to have less job-to-job transitions. [Job ladder effect] 4. Controlling for initial compensation, executives in larger firms tend to experience higher compensation growth. [Market competition effect] 50

68 Climb the Job Ladder 51

69 Key implications of the model 1. The managerial labour market is active. 2. Managers climb job ladders towards larger firms. 3. Managers in larger firms tend to have less job-to-job transitions. [Job ladder effect] 4. Controlling for initial compensation, executives in larger firms tend to experience higher compensation growth. [Market competition effect] 52

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71 Key implications of the model 1. The managerial labour market is active. 2. Managers climb job ladders towards larger firms. 3. Managers in larger firms tend to have less job-to-job transitions. [Job ladder effect] 4. Controlling for initial compensation, executives in larger firms tend to experience higher compensation growth. [Market competition effect] 54

72 Starting years: 1994 to 2005 size premium in tdc obs frac_large tenure 55

73 Estimation

74 Moments and Estimation Moments Target Model Estimates Standard Error Exit Rate δ = EE Rate λ 1 = ˆρ z ρ z = Mean(z) µ w z = Var(z) σ z = Mean(log(wage)) µ s = Mean(log(size)) σ s = β wage size Mean(log(delta)) β delta size c = β delta wage σ = Mean(delta > 0)

75 Model Predictions dollar percent incentives (model simulated) firm size total compensation

76 Model Predictions v.s. Data dollar percent incentives (data) 9.6 dollar percent incentives (model simulated) firm size 4.5 firm size total compensation 0.7 total compensation

77 Conclusion

78 Summary Executives are motivated by performance-based incentives and market-based incentives. Market-based incentives are smaller in larger firms, so larger firms need more performance-based pay. The key mechanism of the model is supported by several reduced-form evidence The model can fit the size premium very well and generate the reasonable delta over firm size and total compensation. 59

79 Questions? 59

80 No Moral Hazard, Full Commitment wage t

81 Only Moral Hazard wage t

82 Only Limited Commitment wage t

83 Optimal Contract wage t

84 CEO s of "Small Firms" in S&P tdc1: total compensation delta: dollar-percentage incentive Company Market Cap tdc1 delta millions 000 s 000 s/% INCYTE CORP WESTROCK CO ENVISION HEALTHCARE CORP PRICELINE GROUP INC LKQ CORP REGENERON PHARMACEUTICALS SKYWORKS SOLUTIONS INC CENTENE CORP ALASKA AIR GROUP INC HOLOGIC INC ACUITY BRANDS INC ANSYS INC GARTNER INC

85 CEO s of "Large Firms" in S&P tdc1: total compensation delta: dollar-percentage incentives Company Market Cap tdc1 delta millions 000 s 000 s/% TIME WARNER INC CONOCOPHILLIPS UNITED PARCEL SERVICE INC VERIZON COMMUNICATIONS INC HOME DEPOT INC AT&T INC COCA-COLA CO PEPSICO INC CISCO SYSTEMS INC CHEVRON CORP INTL BUSINESS MACHINES CORP INTEL CORP WAL-MART STORES INC EXXON MOBIL CORP