CEO Attributes, Compensation, and Firm Value: Evidence from a Structural Estimation

T. Beau Page is Visiting Assistant Professor at Tulane University. This post is based on a recent article by Professor Page, forthcoming in the Journal of Financial Economics.

Researchers and regulators have long been interested in understanding chief executive officer (CEO) compensation contracts. This interest comes from the relatively large size of CEO compensation, in relation to other firm employees, and because of the important role the CEO has in running a firm. A striking finding is that variation in both the size and the makeup (equity ownership versus cash pay) of these contracts is not well-explained by the observable variables researchers routinely use to explain CEO pay. CEO-specific attributes, not firm-level variables, appear to explain most of the variation in both pay and equity ownership. What previous studies have left unanswered is “which CEO attributes explain differences across compensation contracts?” and “how important are these attributes to shareholder wealth?”

In this article, I estimate a dynamic structural model of CEO compensation and firm value to identify the CEO attributes that drive compensation, then explore the importance of these attributes for compensation and shareholder wealth. The model is one of moral hazard, in which a board of directors offers a compensation contract, made up of cash and an equity grant, to the CEO, who then chooses his level of effort given his contract and the firm’s productivity. The model is dynamic in that the game between the CEO and board is repeated over a number of years, and both the board of directors and the CEO are forward-looking decision makers. For the model, I propose four potential CEO attributes: risk aversion, effort aversion, influence with the board of directors, and an outside option (which I call the CEO’s “reservation value”). A key to understanding compensation is separately identifying these attributes and determining their individual effects on contracts and shareholder wealth.

Of the four CEO attributes, three (risk aversion, effort aversion, and influence) create agency frictions. Risk aversion measures how comfortable the CEO is with taking on risk. Within the model, it determines how willing the CEO is to accept equity exposure in the firm, versus receiving cash compensation. If the equity exposure is too low, because of the CEO’s unwillingness to take on that risk, his effort provision will also be low, harming shareholder wealth. Effort aversion measures how efficiently his effort creates value. At high levels, more effort produces less value than when effort aversion is low. As a result, high effort aversion requires more equity exposure to incentivize the CEO. Influence represents the CEO’s ability to push the board to give him a contract that increases his utility at the expense of shareholders. The last CEO attribute, reservation value, represents the CEO’s personal wealth or other outside opportunities that provides him with negotiating leverage with the board. It represents the next best option available to the CEO aside from working for the firm. It does not create an agency problem by itself, as, absent the above agency problems, a flat wage would meet the CEO’s participation constraint and the CEO would exert maximum effort.

With the CEO attributes identified for a typical firm, I estimate the shareholder cost associated with each of the agency frictions by comparing simulated shareholder wealth for the model including and excluding each friction. CEO influence has a significant effect on shareholder wealth. Without this influence shareholder wealth would be 1.74% larger ($41.75 million) for the typical firm. CEO influence primarily impacts the CEO’s equity exposure, as removing it decreases the average value by 37.90% ($9.63 million), leading to a decrease in total compensation of 16.85% ($0.93 million) and an increase in salary of 12.56% ($0.39 million). Making the typical CEO risk neutral would cause a 16.12% ($386.28 million) increase in shareholder wealth for the typical firm. Removing all agency costs would increase shareholder wealth by 28.99% ($694.62 million). These two estimated agency costs are large. However, while risk and effort aversion lead to real costs to shareholders, I argue it is unlikely shareholders can eliminate them entirely.

The above results are the absolute impact of these attributes for the typical firm-CEO pair. To better understand the heterogeneity in contracts, I estimate the model for firms in multiple industries, as well as for groups of firms sharing similar firm size, return volatility, and market-to-book ratios. The estimation results for all of these groups make up a cross section of estimated CEO attributes, which I then use to explore how much variation exists in CEOs, and how that variation drives differences in contracts. There is significant cross-sectional variation in the estimated CEO attributes, and I show how changes in these attributes affect the level of pay, equity exposure, and shareholder wealth. Changes in the CEO attributes have large effects on the compensation variables and smaller effects on value. Changes in the model’s other parameters have a much smaller effect on compensation, but large effects on shareholder wealth.

I also examine the importance of CEO attributes in explaining the cross section of CEO pay contracts is by comparing the variation in contracts between simulations with and without CEO heterogeneity. Without heterogeneity in CEO attributes, the cross-sectional variation in total compensation decreases by half, and the variation in equity exposure decreases by two-thirds. For comparison, keeping heterogeneity in CEO attributes, but removing it for the remaining model parameters significantly increases variation in total compensation, and slightly increases variation in equity exposure. In relation to shareholder wealth, removing CEO heterogeneity alone slightly increases the variation in shareholder wealth, while removing the model’s non-CEO heterogeneity removes almost all of the variation in shareholder wealth.

The complete article is available here.

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