Rising CEO pay has become one of the prickliest issues in the wake of the global downturn. How can steep increases be justified in terms of the actual financial performance of firms? How do we justify the growing divergence of CEO pay and average employee pay growth? These are valid concerns over equity of pay, but very little detailed attention has been given to other factors that could have played their part – and continue to have an impact – on the increases for senior executives. It’s too easy to reduce the situation to a matter of greed.
We looked at data from 2,755 US firms between 1993 and 2011, tracking levels of remuneration against reports of CEO dismissals from licensed databases and news reports. This shows a significant relationship between levels of risk of dismissal and pay. The more “risky” the position is – in other words, the more likely it is to be a short-lived and highly pressurised role – then the more that pay goes up. More specifically, based on our formula, each percentage point increase in risk leads to a 3% premium in pay.
Various theories have been put forward to explain the growth in CEO pay in recent decades. Some studies suggest that recent growth in CEO pay may be attributed to the growth in average US firm size. Some others highlight the possibility that CEOs can influence their own CEO pay. The results of our study suggest that the rise in CEO pay is partially due to compensation for an increase in the risk of dismissal. This result is suggestive of a more efficient pay design for CEOs than we conventionally like to believe. There have been high-profile cases of rampant abuse of the governance mechanism by greedy CEOs, but it is still far from being the norm.
Another stylised belief is that CEOs are typically hungry for acquisitions to build their empire. A larger firm, generates both pecuniary and non-pecuniary rewards for the CEO – even at the cost of returns for shareholders. One way to increase the firm size is to undertake acquisitions and the theory goes that this may encourage a CEO to pursue a deal which may not be in the interests of the shareholders. There is another motivation too from the fact that a completed acquisition serves as a signal of managerial ability and may have an impact on the long-term earnings of the CEO.
Consistent with the above hypothesis, some studies have found that the CEOs of acquiring firms enjoy a post-acquisition pay premium. One reports that the CEO of an acquiring firm receives a 10.5% pay premium compared to a CEO in a comparable firm not undertaking an acquisition. On the contrary, our research has highlighted that CEOs are more likely to be punished as a result of “bad” takeovers.
A case in point is Carly Fiorina, a Republican Candidate for 2016 US Presidential Election. During her tenure as the CEO of Hewlett Packard (HP), Fiorina pushed through a deal to acquire Compaq in 2002, despite strong opposition from board member Walter Hewlett. HP struggled with the acquisition, profits fell sharply in the immediate aftermath, and Fiorina was eventually dismissed in January, 2005.
The narrative of M&A being something of a fool’s errand is not without evidence. We can assess how a merger announcement is received by tracking the response of the stock market over a seven day period, and working out the “abnormal” returns by comparing it to the rest of the market. The results reveal that just 38% of the acquisitions in a sample of 932 firms making acquisitions over 13 years had positive abnormal returns. The remaining 62% were associated with negative abnormal returns.
It is telling that of those 932 firms, some 46% dismissed their CEO (compared with 18% among the other organisations) within two years of an acquisition. Now, if we ignore the likelihood of a CEO being fired, the acquisition pay premium was around 4%. But our research shows that CEOs are 35% more likely to lose their job post-acquisition, and taking that into account using an instrumental variable approach, the actual acquisition pay premium for CEOs is just 1.6%. But that’s only when the acquisition is a “good” one as defined by the market reaction above. There is a penalty of a 2.1% reduction in earnings for “bad” acquisitions, rising to 3% over the longer-term. These figures are similar for measures of pay with and without bonuses.
International, cross-border acquisitions, which might be considered to be more high-profile and adventurous, had no impact on the level of pay awards. Nevertheless, they were more likely to lead to a CEO dismissal.
Notwithstanding the above results, we can’t simply conclude that incentives for CEOs are well balanced and efficient. Bosses routinely undertake risky and value-destroying acquisitions, which can have profound impacts on employment, production, and competition within the industry. These impacts are often not factored in the calculations of value-destroying acquisitions. Our research implies that the incentives for undertaking acquisitions can be for motivations other than pay increases, such as CEO hubris, strategic advantages, or simply imperfect decision making.
Public discourse is rife with controversy on CEO pay, but it is reductionist in approach. It implicitly assumes that CEOs do not face strong retribution for their greed and ignores that their pay necessarily incorporates this. Our research shows that (at least in two circumstances), CEOs can be and are disciplined through the mechanism of dismissal. If bad decisions are still being made with this sanction in place then discussions on executive pay must take note of this as we evolve new and more effective governance policies.