The Effect of Relative Performance Evaluation

In the paper, The Effect of Relative Performance Evaluation on Investment Efficiency and Firm Performance, which was recently made publicly available on SSRN, I examine the effect of explicit relative performance evaluation (RPE) on managers’ investment decisions and firm performance. Principal-agent theory suggests that firms can motivate managers to act in shareholders’ interest by linking their compensation to firm performance. However, firm performance is often affected by exogenous factors, and as a result, performance-based compensation may expose managers to common risk that they cannot directly control. In such cases, RPE enables the principal to compensate managers on their effort and events under their control by removing the effect of common shocks from measured performance, thus improving risk sharing and incentive alignment. However, RPE use as implemented in practice may not be effective in addressing agency costs because of potential peer group issues, such as availability of firms with common risk or a self-serving bias in peer selection. In addition, prior research also suggests that a large gap in ability between the RPE firm and peers (“superstar effect”) may actually reduce managers’ effort because the probability of winning is low. Therefore, the question of whether explicit RPE use in executive compensation does indeed reduce agency costs remains unanswered in the empirical literature.

Beginning in 2006, the Securities Exchange Commission (SEC) requires public companies to disclose RPE use and related information about performance benchmarks and peers in their proxy statements. I take advantage of the mandated disclosures to investigate firms that explicitly incorporate RPE into CEO compensation plans over the time period 2006 through 2012. In particular, I examine whether explicit RPE use affects managerial behavior by looking at investment efficiency and changes in shareholder wealth.

First, I find that RPE firms are generally less likely to over- or underinvest than non-RPE firms. One of the major firm decisions that managers can directly influence is investment in new projects, which includes capital expenditures, research and development, and acquisitions. Prior research suggests that managers whose incentives are misaligned with those of shareholders may either overinvest (e.g., managers accept low-value projects to increase firm size and “build an empire”) or underinvest (e.g., managers forego high-value investments to lower their personal risk or increase short-term income). My results show RPE firms are less likely to deviate from expected investment levels compared to non-RPE firms, consistent with RPE use improving decisions and incentive alignment with shareholders’ interests. Moreover, firms that invest more efficiently have higher future profitability and operating performance compared to those that underinvest or overinvest.

I also investigate whether RPE increases shareholder wealth by testing whether RPE firms have higher one-year and two-year total shareholder return (TSR) than non-RPE firms. After controlling for other fundamental determinants in corporate governance, firm characteristics, and investment opportunity set, I find that RPE firms do not generally perform better than non-RPE firms in the overall sample. However, RPE firms that specifically contract on TSR have higher performance than non-RPE firms. In addition, I find that RPE firms that choose peers with high common risk have higher returns than non-RPE firms: the positive effects of RPE on firm performance increase with the extent of common risk for firm and peer performance, which is consistent with the predictions of principal-agent theory. Together, these results suggest that RPE use in CEO compensation plans reduces agency costs and improves incentive alignment.

The full paper is available for download here.