Wednesday, March 14, 2007
Posted by Jeff Lipshaw
Lucien Bebchuk (Harvard), Martijn Cremers (Yale - Management), and Urs Peyer (INSEAD) have posted Pay Distribution in the Top Executive Team on SSRN. Here is the abstract, with some comments following.
We investigate the distribution of pay in the top executive team in public companies. In particular, we study the CEO's pay slice (CPS), defined as the fraction of the aggregate top-five total compensation paid to the CEO. The level of a firm's CPS might reflect the relative centrality of the CEO in the top executive team in terms of ability, contribution to the firm, or power.
We find that CPS has been going up over the past decade. During this period, CEOs have increased their fraction of both equity-based compensation and non-equity compensation. The level of CPS is associated with various characteristics of the top team and the firm's governance arrangements. Among other things, CPS is high when the CEO has long tenure; when the CEO chairs the board; when few other executives are members of the board; and when the firm has more entrenching provisions.
High CPS is associated with lower firm value as measured by Tobin's Q. Using a simultaneous equations approach yields findings consistent with the possibility that this negative correlation is at least partly due to high CPS, or the relative CEO centrality it might reflect, bringing about a lower Tobin's Q. Consistent with the negative correlation between high CPS and Q, high CPS is associated with a less favorable market reaction, and a higher likelihood of a negative market reaction, to acquisitions announced by the firm. We also find that high CPS is associated with lower variability of stock returns over time. Overall, our results indicate that the distribution of compensation in the top executive team is an aspect of pay arrangements and corporate governance that deserves researchers' attention.
This is an interesting paper, and a real learning experience to study on both a methodological and substantive basis.
First, what is Tobin's Q? It is the ratio (developed by James Tobin, above right, winner of the 1981 Nobel Prize in Economics) between a firm's enterprise value (its market capitalization and its debt) and the replacement value of its assets. Intuitively, we can understand what this is saying. If it would cost $100 million to replace all the assets of Company A today, but the market values Company A at $200 million, the management of Company A is doing something right with those assets! And that management team is doing a better job than the team at Company B, which has $50 million of replacement value assets, but whose enterprise value is $75 million (although Company B is still being rewarded by the market).
Both Company A and Company B are preferable to Company C, which has replacement value assets of $200 million, but whose enterprise value is $150 million. The management of Company C would appear to be destroying asset value. The Tobin's Q of Company A would be 2, that of Company B would be 1.5, and that of Company C would be .75.
That is one side of the correlation work. The other side is the chunk of pay that the CEO takes relative to a few of the other very senior executives. The SEC's rules for proxy disclosures for public companies for the last twenty years or so have required companies to disclose the compensation of the CEO and the next four most highly paid executives within the firm. So the study calculates CPS or "CEO Pay Slice" as a percentage of those highest paid executives.
Understand what is and is not being measured here. The measurement is NOT the extent to which there is pay differential within the entire company, nor is it even measuring the pay differential among the executives of the company. It is measuring simply the slice of pay the CEO takes of the top five who are reported.
And the study shows that there is a negative correlation between CPS and Tobin's Q. What does that mean? For some reason, as a rule, when there is a big relative pay difference between the CEO and the next few highest paid executives, the firm doesn't get as much market bang for the buck out of its assets.
Putting aside the highly theoretical question whether Tobin's Q is a good measure of firm performance (it is used in finance studies, and Bebchuk et al do appear to have done what is usually done to account for the fact that determining replacement value of assets, particularly intangible assets and assets that have been around for a long, is a dicey business), the conclusion is an fascinating one to me. What, if any, causal explanation is there? I like the phrase "the relative CEO centrality it might reflect." Does a firm that pays its CEO not necessarily too much or too little on an absolute scale, but a lot relative to the rest of the team, tend also to have, perhaps, command-and-control CEOs who do not exploit their human assets, much less their physical assets?
In my view, having hung out in that neighborhood, that is a really good question.