Print
E-MailAlex Edmans is Professor of Finance at London Business School; Vivian Fang is an Assistant Professor of Accounting at the University of Minnesota; and Allen Huang is Associate Professor at the Hong Kong University of Science and Technology. This post is based on a recent paper by Professor Edmans, Professor Fang, and Professor Huang. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance (discussed on the Forum here) and the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, both by Lucian Bebchuk and Jesse Fried.
In our paper, The Long-Term Consequences of Short-Term Incentives, which was recently made available on SSRN, we show that short-term stock price concerns induce CEOs to take value-reducing actions. We measure short-term concerns by the amount of a CEO’s equity that is scheduled to vest in a given quarter. Vesting equity is positively associated with the probability of a firm repurchasing shares, the amount of shares repurchased, and the probability of the firm announcing a merger and acquisition (M&A). When vesting equity increases, stock returns are more positive in the two quarters surrounding both repurchases and M&A, but more negative in the two years following repurchases and four years following M&A. These results are inconsistent with CEOs buying underpriced stocks or companies to maximize long-run shareholder value, but consistent with these actions being used to boost the short-term stock price and improve the conditions for equity sales. Overall, by identifying actions that carry clear value implications, this paper documents the long-term negative consequences of short-term incentives.
The short-termism of executive incentives is a major problem alleged by academics, practitioners, and policymakers—they lead to the CEO taking myopic actions that boost the short-term stock price at the expense of long-run value. However, critics’ allegations are rarely backed up by systematic evidence. Gathering such evidence is particularly challenging for two main reasons. First, it is very difficult to demonstrate a causal effect of short-run horizons since the CEO’s contract is endogenous. Second, even if one could show that CEO incentives cause particular actions, it is difficult to show that such actions are myopic, i.e., erode long-term value.
Edmans, Fang, and Lewellen (2017, “EFL”) address the first challenge by introducing a new measure of CEO incentives: the amount of stock and options scheduled to vest in a given quarter. Vesting equity depends on the magnitude and vesting schedule of equity grants made several years ago, and so is unlikely driven by current economic conditions. EFL show that vesting equity is significantly correlated with reductions in investment growth. They study investment since it is arguably a firm’s most important day-to-day decision. However, since we can only observe the level of investment and not its quality, it is difficult to assess the value implications of the investment cut and thus address the second challenge of showing that the cut is myopic. The scrapped investments might have been wasteful, in which case the investment cut is efficient. While EFL conduct cross-sectional tests that are suggestive of the myopia interpretation, they are unable to use long-run stock returns to study the long-term consequences of investment cuts, for three reasons. First, any association is unlikely to be causal, because long-term stock returns are likely affected by many firm decisions other than investment. Second, there is no announcement date for investment cuts, as firms are only required to report investment at a quarterly frequency. Third, their sample period is relatively short (2006-11).
This paper studies two corporate actions whose long-run consequences can be more accurately measured, enabling us to assess the long-term consequences of short-term incentives. The first is stock repurchases. Like investment cuts, repurchases boost the short-term stock price (Ikenberry, Lakonishok, and Vermaelen (1995)) and so CEOs with short-term concerns might have incentives to undertake them. Critically, unlike investment cuts, the long-term stock return can be used to diagnose the value implications of the repurchase even if it were not caused by the repurchase. The long-term stock return measures the return that the firm obtains from the repurchased stock.
The second corporate action is M&A, which has different advantages to repurchases. First, M&A has an announcement date, enabling us to cleanly calculate short- and long-term returns. Moreover, the announcement date is relevant—the majority of announced M&A is eventually completed. In contrast, firms are only required to make an announcement when they first establish a repurchase program, announced repurchases are often not completed (Stephens and Weisbach (1998)), and there are major problems with the standard data source used to approximate repurchase announcements. Second, M&A is a much more significant event than an investment cut (or repurchase)—it is arguably the most transformative corporate decision that a firm can undertake—and so it is likely that at least a significant portion of long-run stock returns is attributable to the M&A. Indeed, prior literature (e.g. Agrawal, Jaffe, and Mandelker (1992)) uses long-run stock returns to assess the long-term value implications of M&A.
We find that a one standard deviation increase in vesting equity is associated with a 1.2% increase in a firm’s likelihood of conducting a share repurchase in a given quarter (corresponding to an expected increase in shares repurchased of $1.5m for an average firm), controlling for other determinants of repurchase behavior and year-quarter fixed effects. This compares with the unconditional repurchase probability of 37.5%. When focusing on sizable repurchases, i.e. ones that exceed the sample mean, the increase is now 1.04% compared to an unconditional probability of 20%. These results are not driven by repurchases that result from investment cuts—instead, repurchases and investment cuts appear to be independent channels that a CEO may pursue to increase the stock price. We find similar results for M&A: a one standard deviation increase in vesting equity is associated with a 0.6% increase in a firm’s likelihood announcing an M&A in a given quarter, compared with the unconditional probability of 15.8%.
Our main results are the short- and long-term returns to repurchases and M&A. Again, we find a consistent picture across both corporate events: vesting equity increases short-term returns but reduces long-term returns, consistent with it inducing the CEO to take myopic actions with negative long-term consequences. A one standard deviation increase in vesting equity is associated with an annualized 0.61% higher return over the two quarters surrounding a repurchase, but a 1.11% (0.75%) lower return during the first (second) year after the repurchase. The results are similar for M&A although the negative association with long-run returns persists for longer. A one standard deviation increase in vesting equity is associated with an annualized 1.47% higher return over the two quarters surrounding an M&A announcement, but a 0.81%, 0.35% (insignificant), 0.72%, and 0.62% lower return in the first, second, and third, and fourth subsequent years.
Overall, our results suggest that short-term incentives lead CEOs to take actions with negative long-term consequences.
The complete paper is available for download here.
