Competition for Managers, Corporate Governance, and Incentive Compensation

In the paper, Competition for Managers, Corporate Governance, and Incentive Compensation, which was recently made publicly available on SSRN, my co-authors (Marc Gabarro and Paolo Volpin, both at London Business School) and I theoretically explore the joint role played by corporate governance and competition among firms to attract better managers. In our principal agent problem, there are two ways to induce the manager to make the right decision: paying compensation in case of better performance and investing in corporate governance to punish managers if things go badly. We show that when managerial ability is observable and managerial skills are scarce, competition among firms to hire better managers implies that in equilibrium firms will choose lower levels of corporate governance. Intuitively, the result follows from the fact that managerial rents cannot be influenced by an individual firm but instead are determined by the value of managers when employed somewhere else. Hence, if a firm chooses a high level of corporate governance, the remuneration package will have to increase accordingly to meet the participation constraint of the manager. It is therefore firms (and not managers) that end up bearing the costs of higher corporate governance with little benefit.

We provide novel empirical evidence supporting our model. Consistent with the presence of externality in corporate governance, executive compensation in a given firm is decreasing in the quality of firm’s own corporate governance as well as in the governance of a matched competitor firm. In support of the assumption that executive compensation and corporate governance are chosen as part of an optimal compensation package, executive compensation changes significantly when a new CEO is hired only if corporate governance is changed at the same time. Finally, the allocation of CEOs and firms is consistent with the model: we provided an empirical measure of managerial talent and found it is negatively correlated with indicators of corporate governance.

Our finding that corporate governance affects the matching between managers and firms has important implications for the debate on executive pay and governance. Specifically, while better governance may incentivize managers to perform better, it also reduces firms’ ability to attract the best managers. These two effects offset each other and may explain why it has proven so hard so far to find direct evidence that corporate governance increases firm performance. A notable exception is the link between governance and performance found in firms owned by private equity: Private equity ownership features strong corporate governance, high pay-for-performance but also significant CEO co-investment, and superior operating performance. Since private equity funds hold concentrated stakes in firms they own and manage, they internalize better (compared, for example, to dispersed shareholders) the benefits of investing in costly governance. Our model and empirical results can be viewed as providing an explanation for why there exist governance inefficiencies in firms that private equity can “arbitrage” through its investments in active governance.

The full paper is available for download here.