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Modelling Executive Pay

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John Robertson

Tying executive pay to share price performance may not always facilitate improved shareholder outcomes. Prevailing market conditions will also be important.

More executive compensation packages require the beneficiaries to remain exposed to the consequences of their decisions via share ownership. Not only is equity is supplanting cash but clawback arrangements are becoming more frequent. Executives may lose benefits previously conferred if, with the benefit of hindsight, their decisions are construed as "bad" for the company.

Whether this is an effective means of empowering shareholders seems to depend on the prevailing institutional arrangements, according to a study published in Applied Financial Economics (Volume 20, Issue 4) this month.

A paper by Steffen Brenner entitled "Passive shareholders and active managers: an empirical test of Admati and Pfleiderer's hypothesis" seeks to throw light on how equity-based executive compensation packages are affected by market liquidity conditions and other institutional and legal constraints on executive behaviour.

There has been some debate over the years about how market liquidity affects executive behaviour. High liquidity which allows for more active trading of stock permits large shareholders to exit stock positions with relative ease if they feel managers are not behaving in their best interests.

Low liquidity, on the other hand, imposes higher transaction costs making it relatively less expensive for shareholders to monitor management and move against decisions they consider inappropriate.

For many years, it was thought that managers could be freed of a constraint on their activities knowing that potentially discontented shareholders would simply leave rather than intervene to make business changes.

This is where compensation tied to shares could play a role. Where a large proportion of executive remuneration is tied to share price movements, executives run the risk of discontented shareholders having a detrimental effect on share prices if they decide to sell. With payments in equity, managers will be more likely to take decisions after considering the wishes of shareholders or, at least, the wishes of the ones likely to have the most influence over their share prices.

More recent research has suggested an alternative investor model. On this modified view, investors may respond to lower liquidity by correspondingly reducing the size of their investments, limiting their incentive to monitor management behaviour. With higher liquidity, investors become more prepared to take larger positions encouraging them to monitor management decisions more closely.

The Brenner paper tries to take this one step further by looking at two types of possible management decisions. The first is a "bad" action which lowers firm value while conferring private benefits on the manager. A simple case of theft or of corporate resources being used for private purposes would be examples. The second type of decision is a "good" action which might be beneficial to shareholders but personally costly to the manager. An example of this might be a decision to shrink the size of the company to focus on a core business and raise the rate of return on capital employed.

The paper seeks to discover whether:
(a) market liquidity and equity-based CEO pay are complements across different countries; and,
(b) whether the conclusion differs depending on which type of executive behaviour is occurring.

The study also considers the possibility that large investors are more likely to have access to information about a company than small investors and that they are more likely to have early information about value enhancing, "good" decisions than "bad" decisions.

The author concludes, based on data from 27 developed and advanced developing countries, that market liquidity and equity-related compensation are strong complements.

The authors also conclude that when institutions that limit the possibility of "bad" actions are weak, liquidity lowers the relative importance of equity-related pay. The market reaction does not act as a constraining influence.

On the other hand, when institutions that encourage the choice of "good" management actions are weak, executives become more vulnerable to stock trading by the large investors. In other words, the market pushes executives toward the "good" decision.

The study also finds that access to information also affects how executives will be most effectively directed toward the type of behaviour which will be most beneficial to the company.

The paper offers some further evidence that we are dealing in shades of grey rather than black and white judgements in coming to conclusions about executive pay.

The link between compensation and business outcomes is far more nuanced than the public debate normally allows. Unfortunately, it might be too nuanced for a popularly driven political process to produce policy suited to the different potential situations.


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