Tag: Performance measures

The Effect of Relative Performance Evaluation

Frances M. Tice is Assistant Professor of Accounting at the University of Colorado at Boulder. This post is based on an article authored by Ms. Tice.

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.


CEO and Executive Compensation Practices: 2015 Edition

Matteo Tonello is Managing Director at The Conference Board, Inc. This post relates to CEO and Executive Compensation Practices: 2015 Edition, an annual benchmarking report authored by Dr. Tonello with James Reda of Arthur J. Gallagher & Co. For details regarding how to obtain a copy of the report, contact matteo.tonello@conference-board.org.

The Conference Board, in collaboration with Arthur J. Gallagher & Co., recently released the Key Findings from CEO and Executive Compensation Practices: 2015 Edition, which documents trends and developments on senior management compensation at companies issuing equity securities registered with the U.S. Securities and Exchange Commission (SEC) and, as of May 2015, included in the Russell 3000 Index.

The report has been designed to reflect the changing landscape of executive compensation and its disclosure. In addition to benchmarks on individual elements of compensation packages and the evolving features of short-term and long-term incentive plans (STIs and LTIs), the report provides details on shareholder advisory votes on executive compensation (say-on-pay) and outlines the major practices on board oversight of compensation design.


Long-term Incentive Grant Practices for Executives

The following post comes to us from Frederic W. Cook & Co., Inc., and is based on a publication by James Park and Lanaye Dworak. The complete publication is available here. An additional publication authored by Mr. Park on the topic of executive compensation was discussed on the Forum here. Research from the Program on Corporate Governance on long-term incentive pay includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried, discussed on the Forum here.

The use of long-term incentives, the principal delivery vehicle of executive compensation, has long been sensitive to external influences. A steady source of this influence has come under the guise of legislative reform with mixed results. In 1950, after Congress gave stock options capital gains tax treatment, the use of stock options surged as employers sought to avoid ordinary income tax rates as high as 91%. Some forty years later, Congress added Section 162(m) to the tax code in an attempt to rein in excessive executive pay by limiting the deduction on compensation over $1 million to certain executives. Stock options qualified for a performance-based exemption leading to a spike in stock option grants to CEOs at S&P 500 companies.

Fast forward twenty years and the form and magnitude of long-term incentives continues to be a hot button populist issue. The 2010 Dodd Frank Act introduced U.S. publicly-traded companies to Say on Pay giving shareholders a direct channel to voice their support or opposition for a company’s pay practices. Another legislative addition to the litany of unintended consequences, Say on Pay has magnified the growing number of interested parties, increased the influence of proxy advisory groups such as Institutional Shareholder Services (ISS) and Glass Lewis, heightened sensitivity to federal regulators, and provoked the increased interaction of activist investors.


Misalignment Between Corporate Economic Performance, Shareholder Return And Executive Compensation

The following post comes to us from Jon Lukomnik of the IRRC Institute and is based on the summary of a report commissioned by the IRRC Institute and authored by Mark Van Clieaf and Karel Leeflang of Organizational Capital Partners and Stephen O’Byrne of Shareholder Value Advisors; the full report is available here.

Investors, directors and corporate executive management share common interests when it comes to company performance and economic value creation.

Yet, whilst this commonality is laudable, a review of performance measurement and long-term incentive plan design for USA public companies identifies that current practice is less than clear in measuring and aligning these interests in a manner that is robust and meaningful.


Relative Total Shareholder Return Performance Awards

The following post comes to us from Frederic W. Cook & Co., Inc., and is based on the Executive Summary of a FW Cook publication by David Cole and Jin Fu. The complete publication is available here.

Since 2010, performance-contingent awards have been the most widely used long-term incentive (LTI) grant type among the Top 250 companies [1] and are now in use by 89% of the sample. The prevalence of performance awards and investor preferences have spurred considerable interest in relative total shareholder return (TSR) as a performance metric. Relative TSR measures a company’s shareholder returns [2] against an external comparator group and eliminates the need to set multi-year goals. Use of relative TSR performance awards among the Top 250 companies has increased from 29% in 2010 to 49% in 2014, and relative TSR is now the most prevalent measure used to evaluate company performance for performance awards.


Performance Terms in CEO Compensation Contracts

The following post comes to us from David De Angelis of the Finance Area at Rice University and Yaniv Grinstein of the Samuel Curtis Johnson Graduate School of Management at Cornell University.

CEO compensation in U.S. public firms has attracted a great deal of empirical work. Yet our understanding of the contractual terms that govern CEO compensation and especially how the compensation committee ties CEO compensation to performance is still incomplete. The main reason is that CEO compensation contracts are, in general, not observable. For the most part, firms disclose only the realized amounts that their CEOs receive at the end of any given year. The terms by which the board determines these amounts are not fully disclosed.


Indexing Executive Compensation Contracts

The following post comes to us from Ingolf Dittmann, Professor of Finance at Erasmus University Rotterdam; Ernst Maug, Professor of Finance at the University of Mannheim; and Oliver Spalt of the Department of Finance at Tilburg University.

Standard principal-agent theory prescribes that managers should not be compensated on exogenous risks, such as general market movements. Rather, firms should index pay and use contracts that filter exogenous risks (e.g., Holmstrom 1979, 1982; Diamond and Verrecchia 1982). This prescription is intuitive and agrees with common sense: CEOs should receive exceptional pay only for exceptional performance, and “rational” compensation practice should not permit CEOs to obtain windfall profits in rising stock markets. However, observed compensation contracts are typically not indexed. Specifically, stock options almost never tie the strike price of the option to an index that reflects market performance or the performance of peers. Commentators often cite this glaring difference between theory and practice as evidence for the inefficiency of executive compensation practice and, more generally, as evidence for major deficiencies of corporate governance in U.S. firms (e.g., Rappaport and Nodine 1999; Bertrand and Mullainathan 2001; Bebchuk and Fried 2004). This paper therefore contributes to the discussion about which compensation practices reveal deficiencies in the pay-setting process.


Are Hedge Fund Managers Systematically Misreporting? Or Not?

The following post comes to us from Philippe Jorion and Christopher Schwarz, both of the Finance Area at the University of California at Irvine.

The hedge fund industry has grown tremendously over the last two decades. While this growth is due to a number of factors, one explanation is that its performance-based compensation system creates incentives for managers to generate alpha. This incentive system, however, could also motivate some managers to manipulate net asset values or commit outright fraud. Due to the light regulatory environment hedge funds operate in and their secretive nature, monitoring managers is generally difficult for investors and regulators.

In response, recent research has attempted to infer malfeasance directly from the distribution of hedge fund returns. In particular, the finding of a pervasive discontinuity in the distribution of net returns around zero has been interpreted as evidence that hedge fund managers systematically manipulate the reporting of NAVs to minimize the frequency of losses. This literature, however, has not recognized that performance fees distort the pattern of net returns.

In our paper, Are Hedge Fund Managers Systematically Misreporting? Or Not?, forthcoming in the Journal of Financial Economics, we show that inferring misreporting based on a kink at zero can be misleading when ignoring incentive fees. Because these fees are applied asymmetrically to positive and negative returns, the distribution of net returns should display a natural discontinuity around zero. In other words, there is a mechanical explanation for the observed kink in the distribution of net returns. We demonstrate this effect by showing that funds without incentive fees have no discontinuity at zero until we add hypothetical incentive fees to their returns.


ISS Proposes Limited Updates to 2014 Voting Policy

The following post comes to us from Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication by Glen T. Schleyer and Marc Trevino.

Institutional Shareholder Services, the influential proxy advisory firm, has published for public comment two proposed changes to its proxy voting guidelines for U.S. companies. The proposals are limited and do not include any change related to the effect of longer board tenure on director independence. ISS had previously surveyed institutional investors and public companies on the topic of director tenure and received strong, but deeply split, responses from both constituencies. The proposed changes are:


CEO Compensation and Fair Value Accounting

The following post comes to us from Ron Shalev of the Department of Accounting at New York University, Ivy Zhang of the Department of Accounting at the University of Minnesota, and Yong Zhang of the School of Accounting and Finance at Hong Kong Polytechnic University.

In our paper, CEO Compensation and Fair Value Accounting: Evidence from Purchase Price Allocation, forthcoming in the Journal of Accounting Research, we investigate the influence of bonus intensity (i.e., the relative importance of bonus in CEO pay) and alternative accounting performance measures used in bonus plans on the allocation of purchase price post acquisitions. Upon the completion of an acquisition, the acquirer is required to allocate the cost of acquiring the target to its tangible and identifiable intangible assets and liabilities based on their individually estimated fair values. The remainder, namely, the difference between the purchase price and the fair value of net identifiable assets, is recorded as goodwill. The recognition of goodwill has different implications for subsequent earnings than that of other assets. Tangible and identifiable intangible assets with finite lives, such as developed technologies, are depreciated or amortized, depressing earnings on a regular basis. In contrast, goodwill is unamortized and subject to a periodic fair-value-based impairment test. As write-offs of goodwill impairment are infrequent (Ramanna and Watts, 2009), recording more goodwill generally leads to higher post-acquisition earnings.


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