Internal vs. External CEO Choice and the Structure of Compensation Contracts

The following post comes to us from Frédéric Palomino of the Department of Economics at EDHEC Business School and Eloïc-Anil Peyrache of the Department of Economics and Decision Sciences at HEC Paris.

The dramatic and unprecedented increase in CEO pay in the 1980s and 1990s led to questioning the efficiency of CEO compensation packages. The debate concentrated first on the pay-performance sensitivity and then moved to the compensation level, given the observed widening gap between the pay level of executive officers and other employees. However, another important change regarding CEOs took place over the same period—their working experience prior to being appointed as a CEO. Increasingly, boards of directors have hired CEOs outside their firm.

In our paper, Internal vs. External CEO Choice and the Structure of Compensation Contracts, forthcoming in the Journal of Financial and Quantitative Analysis, we provide a rationale for the simultaneous increases in (i) CEO pay, (ii) use of equity in compensation schemes, and (iii) hiring of CEOs externally.

Our starting point is that the evolution of the economic environment observed over the last decades influenced the type of skills required for the CEO job. General managerial skills (i.e., the skills transferable across companies, or even industries) became relatively more important than firm-specific skill for the CEO job perhaps as a result of the steady progress in economics, management science, accounting, finance, and other disciplines, which, if mastered by a CEO, can substantially improve his ability to manage any company.

As a consequence, firms looking for a new CEO increasingly considered outsiders as candidates rather than just promoting an insider. The drawback of external candidates is that firms are less informed about their skills than they are about those of internal candidates (firms face adverse selection problems when considering such external candidates).

We derive (sufficient) conditions under which it is optimal for a firm facing both moral hazard and adverse selection problem to offer equity (stocks or stock-options) as part of the optimal contractual arrangement, even if optimal contracts are uniquely capped-bonus contracts in the pure moral hazard case. However, in order to have the same firm value delivered by an internally hired CEO and an externally hired CEO, the latter must receive a higher (expected) compensation.

Then, turning to the optimal CEO choice, we show that as the importance of general skills increases relative to firm-specific skills, the hiring of external candidates with high general skills but uncertain firm-specific skills increases (despite the higher compensation), and so does the use of equity in compensation contracts and the average CEO compensation level.

Our results are consistent with several pieces of empirical evidence. First, our results concerning the presence of both cash bonuses and equity in optimal compensation schemes are consistent with evidence showing that in some countries cash bonuses are an important component of variable pay. Second, our results are consistent with evidence showing that CEO hired externally earn more and get a higher fraction of their total compensation which is stock-based than CEO internally promoted.

The full paper is available for download here.

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