| dc.description.abstract | In this study, 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 that simultaneously affect peer firms’ performance, and therefore, performance-based compensation may expose managers to common risk that they cannot control. In such cases, theoretical models show that firms can improve risk sharing and incentive alignment by compensating managers on performance relative to peers to remove the effect of common shocks. However, RPE may be ineffective in addressing agency costs in practice because firms may select suboptimal peer groups, whether because appropriate peers are unavailable or because managers choose underperforming peers for self-serving reasons. Therefore, the question of whether explicit RPE use in executive compensation reduces agency costs remains unanswered in the empirical literature. I take advantage of expanded disclosures mandated in 2006 by the Securities Exchange Commission to examine whether explicit RPE improves managerial performance as measured by investment efficiency and changes in shareholder wealth.
After controlling for selection bias, I find that RPE firms are generally less likely to over- or underinvest than non-RPE firms, consistent with RPE improving decisions and aligning managers’ incentives with shareholders’ interests. Moreover, firms that invest more efficiently have higher future profitability and operating performance than those that underinvest or overinvest. Second, I find that RPE firms do not generally have higher one-year or two-year total shareholder return (TSR) than non-RPE firms in the overall sample after I control for other fundamental determinants. However, RPE firms that specifically contract on TSR have higher performance than non-RPE firms. Finally, I find that RPE firms that choose peers with high common risk have higher returns than non-RPE firms: the positive effects of RPE on firm performance increase with the extent of common risk captured by peers, consistent with the predictions of principal-agent theory. Together, these results suggest that RPE use in CEO compensation plans reduces agency costs and improves incentive alignment. | en |
