CEO Contract Design: How Do Strong Principals Do It?

The following post comes to us from Henrik Cronqvist, Associate Professor of Finance at Claremont McKenna College and Rüdiger Fahlenbrach, Associate Professor of Finance at the Ecole Polytechnique Federale de Lausanne (EPFL) and affiliated with the Swiss Finance Institute.

In our paper, CEO Contract Design: How Do Strong Principals Do It?, forthcoming in the Journal of Financial Economics, we contribute a new perspective on executive compensation research by studying changes to CEO employment contracts implemented by some of the most sophisticated and financially savvy principals in U.S. capital markets: private equity sponsors. If the changes in a firm’s governance structure following a leveraged buyout (LBO) allow for arm’s-length bargaining between private equity (PE) sponsors, as ‘‘strong principals,’’ and the CEOs of the portfolio companies as their agents, we may observe changes to contract features of importance to the private equity sponsors.

Our objective in this paper is to answer three questions. First, do the strong principals redesign CEO contracts? If they do, which contract features do they change? We examine a comprehensive set of features of CEO contracts in addition to cash pay, such as perquisites, equity incentives, vesting conditions, and severance pay. Second, how do the CEO contracts designed by PE sponsors square with contracting theories? Finally, do the CEO contracts we study avoid some of the most criticized compensation practices in U.S. public firms? Regulators and shareholder interest groups should be interested in whether their proposals differ markedly from contracts where a shareholder with significant ownership and financial expertise bargains with a CEO.

While existing work has established that executives own a larger percentage of the equity after an, surprisingly little is known about whether PE sponsors change other features of CEO contracts. Baker and Wruck (1989) study the O.M. Scott & Sons Company, and Denis (1994) studies Safeway, pre- and post-LBO, but other than these case studies from the early 1980s LBO wave, we are not aware of any study of changes in CEO contracts that use data on private equity transactions.

We compile a new data set of CEO employment contracts, change-of-control agreements, equity incentive plans, and equity rollover agreements for a small sample of 20 large buyout transactions by the largest PE sponsors in U.S. capital markets (e.g., Black- stone, Carlyle, and Kohlberg, Kravis & Roberts).

We find that the private equity sponsors as strong principals redesign many, but not all, CEO contract features. First, we find increases in base salary and bonuses by 25%. Salary increases are concentrated in firms who appoint new executives and are potentially required to make the CEO take on the extra risk that working in a levered firm with a strong owner and a more performance-sensitive contract entails. Increases in target bonuses are observed across both retained and newly appointed CEOs. Consistent with principal-agent models, PE sponsors contract on several signals that likely correlate with CEO effort. They redesign contracts away from qualitative, nonfinancial, and earnings-based measures. Instead, they contract on cash flow-based measures, such as earnings before interest, taxes, depreciation and amortization (EBITDA) that may allow for less accounting discretion with respect to depreciation, amortization, and taxes. For longer-term performance, the principals contract on internal rates of return (IRRs) or multiples.

While we find no evidence of a change in the multiplier for CEO severance cash pay, a significant change is that unvested options and restricted stock are forfeited to a larger extent if a CEO is dismissed. Even though the PE sponsored firm is private, which restricts resales per se, the PE sponsors further restrict the resale market for vested shares for dismissed executives. In particular, they do so by a right of first refusal and by limiting the set of parties to which executives can sell their shares, making it practically impossible for dismissed CEOs to unwind equity. This evidence is consistent with theories predicting reduced severance pay contracts when governance is stronger.

Finally, perquisites such as personal usage of corporate aircraft and tax gross-ups, remain unchanged after the PE transaction. This result is particularly surprising given the bad reputation of these perks in the media, but is consistent with a ‘‘perks as productivity’’ argument. We find some evidence that private equity sponsors allow retained CEOs to carry over previously acquired perks, while the perquisites granted to newly appointed CEOs are smaller, although the economic magnitude of these changes is small.

The PE transactions we as financial economists analyze are not controlled or natural experiments with exogenous shifts in corporate control for random firms. As a result, at least two caveats apply to any study of LBOs. One is that PE sponsored firms are special (e.g., they may have significantly more cash flow than valuable investment opportunities). While this may have been the case for the 1980s, our sample consists of middle-aged firms in growing industries such as IT/telecom/media, healthcare, and services, consistent with Kaplan and Strömberg’s (2009) description of LBOs since 1990. Another concern is that the redesign of the CEO contract could be driven by the change in capital structure, not by the strong principal. We examine two matched samples, but do not find that the boards of public firms that undertake voluntary leverage changes (leveraged recapitalizations or large debt-financed acquisitions) comparable in magnitude to those of LBO-sponsored firms also change CEO contracts to those we find in our LBO sample.

The full paper is available for download here.

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