By Tracy L Slater
New Study on CEO Compensation Is First to Provide Evidence that Firms Benchmark High for Market, not Self-Serving Reasons
A new study by Ana M. Albuquerque, Gus De Franco, and Rodrigo S. Verdi is the first to provide evidence that the “peer pay effect” (the tendency to benchmark to a set of peers with higher CEO pay) among corporate boards represents a reward for CEO talent, not self-serving motives or weak corporate governance.
Albuquerque is an assistant professor of accounting at Boston University School of Management. De Franco and Verdi are on the faculty of the Rotman School of Management at University of Toronto and MIT Sloan School of Management, respectively. Their new study, entitled “Peer Choice in CEO Compensation,” is forthcoming in the Journal of Financial Economics.
This paper offers data showing that when firms benchmark high against their peer group in order to offer higher total compensation to their incoming chief executive officers (called the “peer pay effect”), they 1) do so as a reward for CEO talent and not for self-serving reasons, and 2) tend to yield a better future return on investment (ROI) in terms of CEO performance. Thus, the research offers an argument against claims that firms benchmark high among their peers in order to justify flawed corporate compensation packages with excessive CEO pay.
Albuquerque et al use data from ExecuComp, including mostly firms that comprise the Standard and Poor’s 1500 index, for the fiscal years 2006 to 2008, focusing on Definitive Proxy Statements and their Compensation Discussion and Analysis sections which list peer companies used for benchmarking purposes. They define CEO talent by measuring data about a CEO’s historical abnormal stock and accounting performance, the market value of the firms that the CEO managed in the past, and the number of media mentions a CEO has accrued.
In contrast, they define self-serving behavior or poor oversight on the part of boards based on data about board structure (e.g., how busy are board members and thus how much time can they devote to effective oversight and monitoring?) anti-takeover provisions (e.g., how insular is the firm from the external market, which carries the potential threat of a takeover, and thus works as a strong external force for disciplining management?), and ownership concentration (e.g., how personally invested are individual board members in the firm’s future performance?).
Finally, the authors define future ROI as future accounting and stock performance.
From their data pool, the authors find that:
- the impact of benchmarking against highly paid peers for self-serving reasons on CEO compensation is positive in some, but not all, cases, and at a much lower magnitudes than for talent reasons;
- in terms of economic significance, the impact of the peer pay effect for talent reasons on CEO pay is from two to almost ten times larger than is the impact of the self-serving component of the peer pay effect; and, perhaps most crucially,
- firms that benchmark high to offer higher CEO compensation to more talented CEOs yield a better future ROI performance.
Thus, “Peer Choice in CEO Compensation” is an important contribution to the argument that high CEO compensation is crucial to attract top talent as well as to better motivate high-potential CEOs compared to their similarly-high-potential peers who end up with lower compensation due to more moderate benchmarking at their respective firms.
Ultimately, this new research provides evidence that firms who benchmark high do so not simply for self-serving reasons or to justify higher-than-needed CEO compensation, but because they understand the importance of offering a CEO package at the top end of their peer pool, in order to attract, retain, and motivate the best talent.
“The Impact of Regulatory Uncertainty on Renewable Energy Investments,” forthcoming in the Journal of Law, Economics, and Organization
Policy uncertainty—whether concerning the impending “fiscal cliff” or potential carbon taxes—is blamed for reducing investment and restraining economic growth. Does the same logic apply to investment in renewable energy generation?
In a new study, Boston University School of Management’s Kira Fabrizio finds that uncertainty about future regulatory policies does indeed negatively influence firms’ investments in new clean energy assets. Fabrizio is an assistant professor in strategy & innovation, and her paper, “The Impact of Regulatory Uncertainty on Renewable Energy Investments,” is forthcoming in the Journal of Law, Economics, and Organization.
Fabrizio’s study focuses on the enactment of state-level Renewable Portfolio Standard (RPS) policies in the US electric utility industry. The policies are designed to encourage investment in renewable electricity generation by requiring utilities to procure a certain percentage of electricity from renewable generation. She finds that, on average, “RPS enactment in a state did generate an increase in investment in new renewable generating assets, but investment increased significantly less in states with a history of regulatory reversal,” a mark of an uncertain policy environment.
With important implications for policy makers, the study suggests that government renewable-energy policy initiatives, when launched in less stable regulatory environments, 1) lead firms to perceive new investment in clean energy projects and assets as more risky, and 2) ultimately create fewer new investments in renewable generation assets, undermining the purpose of the policy.
Fabrizio’s research highlights the importance of regulators’ commitment to policy stability and predictability. Her study holds implications not just for renewable energy investment but other initiatives such as carbon tax/abatement policies, where long-lived investments depend on policies subject to future modification.
The study also touches on strategies for enhancing the credibility of RPS regulatory efforts and their perceived stability, thus reducing the apparent risk of renewable energy investment. These include:
- Regulatory support for investments dependent on renewable energy policies and requirements, whereby regulated utilities could recover the costs of investments in their rates if the value of these investments falls due to policy reversals.
- Adoption of requirements and procedures making the repeal or renegotiation of RPS policies more arduous.
Whatever strategies regulatory agencies undertake, Fabrizio urges, “Until policy makers are able to enact legislation and credibly commit to maintaining the policy they adopt, firms will be less willing to invest in developing and adopting new technologies.”
Banner image courtesy of flickr user daBinsi
For National Public Radio’s Morning Edition show, Boston University’s Barbara Bickart explains how marketers motivate consumer behavior on Black Friday. Bickart is an associate professor of marketing and Dean’s Research Fellow at the School of Management.
About holiday retail strategies such as “limited time offers,” Bickart tells NPR, “You’ve got to do it right away. It’s going to urge you, push you to behave, to act, to consume…So these things like ‘limited time offer,’ suggesting that something is scarce–you get caught up in the excitement of it, right? And they make you want to take action right away.”
On November 13, Boston University’s Mark Williams published his latest opinion piece in the Boston Herald. Williams is a master lecturer in finance at the School of Management, an expert on risk management, former Federal Reserve examiner, and author of the book Uncontrolled Risk: The Lessons of Lehman Brothers.
Dodd-Frank and consumers win big
Backstopped by President Obama’s re-election, the Elizabeth Warren U.S. Senate win in Massachusetts is a deal changer for the future of the Dodd-Frank Act.
Prior to Election Day, the financial reform law was threatened by death by a thousand cuts. Big banks, already lobbying furiously to weaken the act’s regulations, were spending millions to support Republican allies like Senator Scott Brown who vowed to render Dodd-Frank toothless. What a difference a day makes.
Along with Obama’s win, the solid defeat of Brown and the election of Warren—who helped create the consumer protection agency spawned by Dodd-Frank—reaffirm the effort to impose tighter regulation over the nation’s largest banks whose collective risk-taking helped spark the 2008 economic crisis.
Banks increasingly control the health of our economy. In the last three decades the U.S. economy has become financialized, building ever-growing profits for the “haves” within the banking system. Today the assets of the top five U.S. banks have increased fourfold and represent over 60 percent of GDP, largely through aggressive risk taking.
“The win by Warren will fortify the future of Dodd-Frank and eventually force big banks to retreat to more traditional banking practices—making loans and taking in deposits—which can usher in greater long-term economic stability.”
Warren will be tough on banks and banks fear it (note that bank stocks took a hit the day after Election Day). Big banks now will be kept in the spotlight and will need to scale down their level of risk taking. Corresponding profits tied to higher bank risk taking will also fall. Big banks will be forced to return to the boring business of banking and the “Too Big to Fail” problem can begin to get solved.
From the start of the campaign, Warren made it clear she was not a friend of big banks. Her election is a clear mandate to keep bankers in check and insure that our economy grows in a stable and safe manner. And sorely needed jobs will be created when banks begin lending and behaving in a responsible manner.
Warren’s election means a vocal watchdog will be holding big banks to a higher standard of conduct. Meantime, those large, FDIC-insured banks—including JPMorganChase, Bank of America, Citibank, and Wells Fargo—will be prohibited through the Dodd-Frank Act’s Volcker Rule from engaging in risky trading practices.
Bottom line, the win by Warren will fortify the future of Dodd-Frank and eventually force big banks to retreat to more traditional banking practices—making loans and taking in deposits—which can usher in greater long-term economic stability.
Consumers will be the big winners when the terms “trust, honesty, and integrity” again can be uttered in the same sentence as “banking.”
See this opinion piece online at the Boston Herald.
The Huffington Post‘s latest opinion piece by Boston University School of Management’s Stephen M. Davidson is titled “What Winning Means” and explores compromise, Congress, and Obama’s powers post-election to impact healthcare and more. Davidson is Professor of Markets, Public Policy, and Law at the School of Management and author of the book Still Broken: Understanding the U.S. Health Care System.
An excerpt from “What Winning Means” appears here:
…Now that the 2012 election is behind us, the first big question is whether or not the Republicans, having lost the White House and the Senate, will follow that tradition. Even more, it is whether John Boehner, as Speaker of the House can keep the members on his rightward fringe in check and be able both to craft compromises with the Democrats and to deliver enough votes that, when added to those of House Democrats, legislation can pass that moves the country forward on the many problems we face. If he cannot, how will the president respond? And what will he be able to do on his own, without legislation, to address those vexing problems…
On Medicare, both candidates proposed cutting spending–they even agreed on the amount. But the president, wanting to preserve the program’s value for seniors and others who depend on Medicare, proposed doing it without reducing benefits. Instead, he would save millions by ending the windfall that private insurers earn from the Medicare Advantage program and by reducing payments to some providers. He would also use Medicare policy to stimulate providers of services to find ways to improve the quality of care and keep down the costs. Republicans defined the Medicare problem more simply. They just want to limit federal spending, which they would do by capping it at a fixed amount and distributing those funds to Medicare beneficiaries in the form of vouchers. Then, the beneficiaries would apply the vouchers toward the purchase of coverage in the private health insurance marketplace. The main problem, of course, is that Republicans cannot guarantee that the voucher would cover all the services people need or that it would keep up with the rising cost of insurance. Inevitably, beneficiaries would wind up with less coverage than they have now.
It is fair to say that, to the extent that voters focused on policy issues like these, the majority voted for the president’s proposals and rejected those of Governor Romney and his fellow Republicans. So, why doesn’t the election result entitle the president to act on these matters as he said he would? And, to the extent that the Congress must act (e.g., on tax and spending legislation), why doesn’t it leave members of the House and Senate to make adjustments around the edges? Isn’t that what winning means?
“Moral credibility of organization matters more,” Post argues
On Bloomberg TV, Boston University’s James Post takes a hard line on whether sex scandals should become boardroom issues. Post is the John F. Smith, Jr. Professor in Management at Boston University and the recipient of the Aspen Institute’s 2010 Faculty Pioneer Award for Lifetime Achievement.
“Leaders are role models. They set the tone for the organization…so the boards have to be concerned,” Post says. In a related article for Bloomberg News, “Sex-Scandal CEOs Spark Surge of Notoriety in the C-Suite,” Post elaborates, saying, “[The] directors can’t excuse it, because the moral credibility of the organization simply matters more…We live in a time of great moral ambiguity…For someone who aspires to the corporate suite, there needs to be some serious introspection on what’s the price you’re willing to pay for that in terms of personal as well as professional behavior.”
See more commentary on this issue from James Post, in the article “Sex-Scandal CEOs Spark Surge of Notoriety in the C-Suite,” by Jeff Green, Bloomberg, November 13, 2012.
Enabling Investors to Capture More of the Upside of Innovation
In a new study titled “Innovation, Competition, and Investment Timing,” Yrjö Koskinen and Joril Maeland bring light to incentives that investors can deploy to limit cost inflation and speed investment time. Koskinen is a faculty member of the Boston University School of Management Finance Department, and Maeland of the NHH Norwegian School of Economics Department of Finance and Management Science.
In their new study, Koskinen and Maeland focus on the crucial role of competition in enabling investors to capture more of the upside of innovation. Using a real options framework, they build on past research about auction theory, optimal VC portfolio size, and investment triggers. They show that when innovators compete for funding, investors have a much better chance of gaining an accurate report of the innovators’ costs (effort and resources invested in the project’s development), thus avoiding falsely inflated prices and even enabling faster investments.
Motivating a Transparent Reporting of Costs
The authors explain the initial problem thus: “An innovator has an incentive to inflate the costs if he thinks he will be awarded the contract,” because by reporting a high output in time, effort, and resources for the project’s development, the innovator “can capture a difference between the declared and the true cost for himself.”
Conversely, if the investor has a choice of innovators vying for their contract and the number of innovators competing, the incentive to inflate costs diminishes dramatically, as competitors who report falsely high cost risk losing the contract to agents who more truthfully reveal a lower cost.
The result: the winner is only compensated for the actual costs, “enabling the investor to capture more of the upside of innovative activity.”
In the traditional model of one investor evaluating one innovator, time-cost becomes another crucial factor: the higher the cost, the more the investment decision is delayed. Since the cost might be artificially inflated, the investor has to delay expensive investments as a way of giving the innovator proper incentives to reveal the real cost.
With the competition model, however, competition for funding reduces these informational costs, because innovators have reduced incentives to inflate costs. When the investor can choose the number of innovators freely, Koskinen and Maeland show, investment options are exercised so that there is never any delay.
Read the entire study “Innovation, Competition, and Investment Timing.”
Bernile, G., & Lyandres, E. (2011). Understanding investor sentiment: The case of soccer. Financial Management, 40(2), 357-380.
Do investors hold biased expectations or have emotional reactions to events that in turn lead to inefficiencies in the stock market, such as a disparity between real and perceived value? Can the answer be found in soccer?
A recent award-winning paper by Gennaro Bernile and Evgeny Lyandres takes a sample of publicly traded European soccer clubs, analyzes their returns around important matches, and extrapolates outwards to the stock market at large, assessing the effect that investors’ biased expectations and irrational reactions have on the efficiency of stock prices.
Bernile is an assistant professor in finance at the School of Business, University of Miami, Coral Gables; Lyandres is an associate professor in finance at Boston University School of Management. Their paper, “Understanding Investor Sentiment: The Case of Soccer,” appeared in Summer 2011 in the journal Financial Management and was awarded First Place among the Pearson Prizes for the Best Papers in Financial Management, awarded by the Financial Management Association International and Pearson.
Using a Novel Proxy for Investor Expectations
In their award-winning study, the authors note that soccer provides a uniquely useful model for analyzing ex ante (pre-event) optimism and ex post (post-event) emotional reactions because sport results are frequent, value-relevant, and easily quantifiable, leading to observable expectations and reactions on the part of both fans and investors. Moreover, unlike many traditional corporate finance settings, the results of sporting events cannot be manipulated by firm insiders, inoculating the market outcome from investor fears around potential manipulation.
Within the context of soccer club investment, the authors uncover a unique proxy for investors’ expectations: contracts traded on betting exchanges, or prediction markets, a measure of investor expectations that has not been used before in published academic research. By analyzing these contracts, they find that a systematic bias in investors’ expectations before games leads to inefficient investment. “Investors are overly optimistic about their teams’ prospects pre-event,” they write,” and, on average, end up disappointed post-event, leading to negative postgame abnormal returns,” or a mean stock return of -0.9% on the days following important soccer matches.
Insights for Firms’ Investment Decisions, Control Transactions
This research offers important insights for corporate investment decisions and control transactions well beyond those involving public sports franchises. Its findings hold particular relevance for firms’ value-relevant actions, such as long-term investments and effort exertion, dependent on the efficiency of ex-ante and ex-post stock prices. ”Our evidence indicates that preevent stock prices are inefficient,” the authors conclude, but that postevent prices may be efficient.
Access the abstract or full article at Financial Management online.
Ren’s “How to Compete in China’s E-Commerce Market” Appears in Sloan Management Review, Fall 2012
In the most recent edition of Sloan Management Review (SMR), Xin Wang and Z. Justin Ren explore the world’s largest e-commerce market—and the failure of America’s most successful companies to crack it successfully.
Ren is an associate professor of operations and technology management and Dean’s Research Fellow at Boston University School of Management, as well as a research affiliate at MIT Sloan School of Management. Wang is an assistant professor of marketing at Brandeis University International Business School.
On the history of corporations reproducing their domestic successes abroad, Ren comments, “Big e-commerce companies often focus on scalability upon entering foreign countries and tend to undervalue or neglect local specifics that often clash with their business models at home. It is a fine balance they have to strike.”
Ren and Wang address this challenge in their SMR article “How to Compete in China’s E-Commerce Market.” “With more than half a billion Internet users,” the authors write, “China boasts the greatest number of Internet users in the world. Its online shopping market hit 766.6 billion yuan in 2011,” while by 2012, its e-commerce market is expected to be worth 2 trillion yuan, the approximate equivalent today of $320 billion.
“Big e-commerce companies often focus on scalability upon entering foreign countries and tend to undervalue or neglect local specifics that often clash with their business models at home. It is a fine balance they have to strike.” – Z. Justin Ren
So why, they ask, have companies such as Yahoo!, Groupon, and eBay failed to create the same successes in China as they have at home, or in other international markets? “After years of effort and millions of dollars spent, armed with the most sophisticated technology and premium brand names,” the authors write, “these Internet giants have all failed to claim a leadership role in China’s e-commerce.”
Wang and Ren address this market mystery by combining industry analysis, case studies, and insight from leaders in China’s e-commerce industry, with an examination of high-profile entry players in the Chinese e-commerce arena. “We identified four key ways,” they write, “in which U.S. e-commerce companies proverbially hit the Great Wall when they tried to enter the Chinese market.”
These fatal blunders include:
- a failure to modify the business model for Chinese customers,
- insistence on a standard global technology platform,
- a habit of overlooking the competition, and
- an inability to address challenges from Chinese authorities.
Tapping lessons from their research, the authors then offer practical advice to counter these errors and build success in the Chinese e-commerce market.
Banner image courtesy of flickr user DavidDennisPhotos.com.
From Kahn’s Blog for Psychology Today, “The Ostrich Effect”
Boston University School of Management’s Bill Kahn, author of the blog “The Ostrich Effect” for Psychology Today, has written a new piece about overcoming destructive relationship cycles in the workplace. Kahn is a professor of organizational behavior, and his blog is devoted to exploring the hidden sources of problems at work.
Moments of Truth
Pausing to Name the Truth is What Sets Us Free
The Ostrich Effect—the destructive cycles of relationships and work which occur when we avoid our true responses to situations—thrives when we follow our impulses without hesitation; it loses its grip when we stop and reflect. Reflection inserts a crucial pause between impulse and action. In the Ostrich Effect we are in full flight. When we temporarily suspend that flight and gather ourselves, we begin to release ourselves and others from the Ostrich Effect. The simple act of pausing to think about what is happening inside and around us can be profound….
“When people call timeouts they have not figured out all that needs to be figured out. They just know what is happening is somehow not right.”
Jim, the vice president of the accounting department at a pharmaceutical company, has been having trouble with Sophia, a vice president of one of the business units that he supports. After a particularly contentious meeting, in which Sophia showed open disdain for his suggestions in a task force meeting, Jim decided to call a timeout. He went to her office, closed the door, and asked for a few minutes of her time. Sophia nodded. Jim says that it seems that they aren’t getting along as well as they might.
With that simple, clear statement—just a sentence that describes what is plainly in front of them—Jim calls a timeout. He halts the destructive sequence of the Ostrich Effect that has gripped their relationship….When people call timeouts they have not figured out all that needs to be figured out. They just know that what is happening is somehow not right. They understand that some truth must be gotten at and they cannot do so by themselves. How do they begin? By naming that which is right in front of them: the too-much emotion in a given situation.
Read the full piece online at Psychology Today.
Banner photo courtesy of flickr user dphiffer.