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Corporate Restructuring and Governance > 3. Executive Compensation > Flashcards

3. Executive Compensation Flashcards

1
Q

Why has Executive Compensation Attracted So Much Attention?

A
  • Executive pay is large.
  • Issue of fairness.
  • Concerns over whether they merit it
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2
Q

Equity and Efficiency

A
  • Is it fair that executives get paid so much more than employees? This is what attracts attention.
  • Senior executives have a bigger impact on firm performance than junior employees.
  • Does executive pay motivate intended behaviour? Do senior executives deserve their pay? Looking at this
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3
Q

How can we frame the debate of executive compensation?

A
  • Optimal contracting perspective v managerial power perspective
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4
Q

What are the LOs of Framing the Debate?

A
  • Explain the role of executive compensation as a corporate governance device.
  • Explain the optimal contracting v managerial power debate
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5
Q

What is the Optimal Contracting Perspective and why are compensation contracts are designed?

A
  • Create financial incentives to reduce moral hazard in a principal-agent relationship.
  • Compensation contracts are designed to satisfy a manager’s participation constraint and incentive compatibility constraint.
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6
Q

OCC: What are the exec remuneration contracts targets?

A
  • Attract talented individuals to a post (satisfies participation constraint)
  • Motivate managers to make decisions and take actions that maximise shareholder value (satisfies incentive compatibility constraint)
  • Reward managers for maximising shareholder value.
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7
Q

OCC: State-Contingent Contracts

A
  • Not possible
  • Pay packages contain components that link rewards to outcomes
    E.g. provide high-powered incentives
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8
Q

OCC: Stage Contingent Contract Definition

A
  • Agreement which states actions under certain conditions will result in certain outcomes.
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9
Q

Framing Debate: Managerial Power Perspective

A
  • Senior executives use their power to influence how much they are paid and pay compensation.
  • Managers receive: pay for non-performance and hidden pay
  • Greater managerial power results in greater excess pay e.g. rent extraction.
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10
Q

Executive Remuneration in Managerial Power Perspective

A
  • In excess of that required to attract talented individuals to a post.
  • In excess of that required to motivate managers.
  • Is weakly related to firm value.
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11
Q

What is the Pay-Performance Relationship in Optimal Contracting Perspective?

A
  • Predicts a strong pay-performance relationship e.g. reduce the agency problem managers pay is sensitive to share value.
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12
Q

What is the Pay-Performance Relationship in Managerial Power Perspective?

A
  • Predicts a weak-pay performance relationship e.g. managers extract rents that have no sensitivity to share value.
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13
Q

What do empirical studies concerned with in pay-performance relationship?

A
  • Determine and quantifying the pay-performance relationship.
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14
Q

What are the components of executive compensation packages?

A
  • Golden hello
  • Salary
  • Bonus
  • Executive stock option (ESO)
  • Restricted Stock
  • Long-Term Incentive Plan
  • Golden Parachute
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15
Q

LOs of the Components of Exec Compensation Packages

A
  • Explain different components of executive pay packages
  • Explain how components of executive pay packages impact on incentives.
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16
Q

Components of Exec Comp: Golden Hello

A
  • Lump-sum cash signing on payment.
  • Used to attract talent
  • Induces an individual to take a post, and shows the hiring firm’s commitment to an individual.
  • Compensates an individual if they will have to give up rights to unvested stock or options.
  • Not performance-related and provides no retention incentives.
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17
Q

Components of Exec Comp: Salary

A
  • Fixed pay awarded over a given period.
  • Executive is insured against fluctuating firm performance - attractive to risk-averse executives because they are bearing no risk.
  • To induce effort managers must bear risk and be compensated for bearing risk.
18
Q

Components of Exec Comp: Bonus

A
  • Can be paid in cash or shares.
  • Linked to accounting performance (sales, profits, EPS) or other metrics important to the firm (CPS, safety)
  • Usually a bonus hurdle and bonus gap with pay increasing with performance between these levels (incentive zone)
  • If alignment is successful, value of bonus paid should be related to performance target.
  • Below bonus hurdle incentive to inflate performance, above bonus cap incentive to slacken off or defer achievement to next period.
19
Q

Components of Exec Comp: Executive Stock Options (ESOs)

A
  • Option to buy stock at some future date at a price (exercise price) close to the market price at the time granted.
  • Normally a 7-year exercise window starts from 3 years after they have been granted.
  • Return = (Current Market Price - Exercise Price) - Transaction Costs)
  • If the share price is below exercise price, the manager does not have to bear the loss.
20
Q

Components of Exec Comp: ESO Incentives

A
  • Execs do not bear downside risk, only upside gains.
  • R’ship between SO’s and share price is non-linear, it is convex - magnifying the upside returns to ESOs
  • Provides risk-taking incentives to risk averse and loss averse execs.
21
Q

Components of Exec Comp: Comparing Stock and Stock Option Incentives

A
  • If exec is paid with stock, the relationship between CEO pay and stock price is linear.
  • If an exec is paid with stock options the relationship between CEO pay and stock price is convex.
22
Q

Components of Exec Comp: Problems with ESO

A
  • Potential for exploitation (rent-seeking) by self-serving execs e.g. spring load.
  • No penalty for underperformance.
  • Pump and dump - artificially inflating price before buying and selling.
  • When strike price is ‘in-the-money or ‘out-of-the-money, execs’ incentives could be distorted,
23
Q

Components of Exec Comp: Long Term Incentive Plans

A
  • Deferred payment of stock and/or cash when relative performance reached over a specified period of time.
  • Award of stock may be subject to trading restrictions in the short-term,.
  • After shares are awarded, manager exposed to down-side risk.
  • Incentive for executives to create longer-term performance gains.
24
Q

Components of Exec Comp: Problems with Long Term Incentive Plans

A
  • Complicated and less transparent than bonuses and ESOs - potential for execs to exert managerial power over pay.
  • Award linked to relative stock performance per se, so awards can be made even when the stock price is falling.
25
Q

Components of Exec Comp: Restricted Stock

A
  • Issuing stock with restrictions on trading (usually 2-3 years)
  • Sometimes linked to performance targets, vest when targets met.
  • Manager bears potential downside risk.
26
Q

Components of Exec Comp: Severance Pay (Golden Parachutes)

A
  • Rewards execs who have taken risky that have not paid off.
  • Discourages entrenchment and encourages under-performing execs to leave
  • Discourages under-performing execs from entrenching themselves and fighting a takeover.
  • Perceived as a reward for failure.
27
Q

Components of Exec Comp: Share of Pay Components for FTSE100 CEOs in 2021

A
  • Base pay = 22%
  • Long-Term Incentive Bonus = 38%
  • Bonus = 34%
  • Pension = 3%
  • Benefits = 2%
28
Q

Components of Exec Comp: Summary of Points

A
  • High-powered incentives link pay to performance, execs must bear risk.
  • Stock-related performance is determined by firm-specific factors in managers’ control and industry and market factors outside managers’ control.
  • Relative performance filters out factors beyond executives’ control.
29
Q

Relationship Between Exec Comp and Firm Behaviour LOs

A
  • Understand how to determine and quantify the pay-performance relationship in a simple empirical model.
  • Examine evidence concerning the impact of exec compensation components on performance, acquisitions, divestments.
30
Q

Empirical Model Pay-Performance Relationship

A
  • Estimate variations of the following empirical model.
  • See notebook
31
Q

Notations of Empirical Model for Pay-Performance Relationship

A
  • Beta1 measures the pay-performance relationship % return
  • Beta2 measures the pay-relative performance relationship % return
  • Beta3 measures the pay-size relationship (elasticity)
  • Control Variables can include person and firm characteristics.
  • Key issues for estimating this model are measuring pay and performance.
32
Q

The relationship between executive compensation and firm behaviour: Salary Performance (Evidence)

A
  • Early evidence on executive pay:
    Measured pay using salary + bonus only
    Weak pay-performance relationships often reported
    Strong pay-firm size relationship
  • Early studies found it difficult to obtain data on equity and options, impacting on sensitivity of estimates.
33
Q

The relationship between executive compensation and firm behaviour: Bonus Performance (Evidence)

A
  • Fattorusso et al 2007 find no link between bonus (short-term rewards) and shareholder return - consistent with managerial power perspective.
  • Find no link between transparency measures and the odds of a bonus payout - not consistent with managerial power perspective.
34
Q

The relationship between executive compensation and firm behaviour ESOs Performance (Evidence)

A
  • Studies show ESOs result in strong pay-performance relationship
  • e.g. main et al 1986 found a 10% increase in shareholder wealth led to a 7.2% increase in CEO Total pay package.
  • e.g. Hanlon et al 2003 found that $1 of ESO grant is associated with the generation $3.71 of operating income over the five years after the ESO grant.
  • Consistent with optimal contracting perspective.
35
Q

The relationship between executive compensation and firm behaviour: LTIP Performance (Evidence)

A
  • Buck et al 2003 find that LTIPs increase so does total compensation (managers being compensated for bearing more risk)
  • LTIP reduce pay-performance sensitivity
  • e.g. excluding LTIps a $1K increase in shareholder wealth is associated with 1.81p increase in CEO pay
  • Including LTIPs this falls to $1.55p
  • Consistent with LTIPs being part of the agency problem.
36
Q

The relationship between executive compensation and firm behaviour: Acquisitions

A
  • Sanders 2001 find that structure of pay package impacts on acquisition behaviour.
  • Firms whose CEOs are compensated with ESO are more likely to engage in acquisitions and divestments.
  • Firms whose CEOs own shares are less likely to engage in acquisitions and divestments.
37
Q

The relationship between executive compensation and firm behaviour: Acquisitions of firms that adopt general partners

A
  • Bebchuk et al 2014 find that firms experience a negative impact on stock returns when they are adopted.
  • Associated with higher acquisition premiums
  • Overall negative effect on shareholder wealth.
  • Consistent with managerial power perspective.
38
Q

The relationship between executive compensation and firm behaviour: Divestment

A
  • Way of reducing the scale and scope of a firm’s activities if it has grown beyond its optimal size and scope.
  • Haynes, Thompson and Wright 2007 find that CEOs are not directly awarded for voluntarily downsizing their firms via divestment.
  • Find a strong pay-size relationship
  • Little incentive for CEOs to voluntarily downsize.
39
Q

How do we assess executive compensation as a governance device?

A
  • Overarching framework: Optimal Contracting v Managerial Power
  • Consider theoretical arguments and what arguments the evidence is consistent with.
  • Impact of various pay components on behaviour.
  • How performance and pay are measured matters.
  • In practice, pay reflects individual and firm characteristics.
40
Q
A

Corporate Restructuring and Governance (8 decks)

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