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Abstract:
This paper analyzes the relationship between employee satisfaction and long-run stock returns. A portfolio of the "100 Best Companies to Work For in America" earned an annual four-factor alpha of 4% from 1984-2005. The portfolio also outperformed industry- and characteristics-matched benchmarks, and the results are robust to the removal of outliers and other methodological changes. Returns are even higher in the 1998-2005 sub-period, even though the list was widely publicized by Fortune magazine. The Best Companies also exhibited significantly more positive earnings surprises and stronger earnings announcement returns. These findings have three main implications. First, consistent with human capital-centered theories of the firm, employee satisfaction is positively correlated with shareholder returns and need not represent excessive non-pecuniary compensation. Second, the stock market does not fully value intangibles, even when independently verified by a highly public survey on large firms. Third, certain socially responsible investing ("SRI") screens may improve investment returns.

Employee satisfaction, intangibles, market efficiency, short-termism, managerial myopia, human capital, human resource management, socially responsible investing

Abstract:
This paper investigates the stock market reaction to sudden changes in investor mood. Motivated by psychological evidence of a strong link between soccer outcomes and mood, we use international soccer results as our primary mood variable. We find a significant market decline after soccer losses. For example, a loss in the World Cup elimination stage leads to a next-day abnormal stock return of -49 basis points. This loss effect is stronger in small stocks and in more important games, and is robust to methodological changes. We also document a loss effect after international cricket, rugby, and basketball games.

Football, sports, soccer, sentiment, mood, stock returns, behavioral finance

Abstract:
We document significant persistence in the average announcement returns to acquisitions advised by an investment bank. Advisors in the top quintile of returns over the past two years outperform the bottom quintile by 1.04% over the next two years, compared to a full-sample average return of 0.72%. Persistence continues to hold after controlling for the component of returns attributable to the acquirer. These results suggest that advisors possess skill, and contrast earlier studies which use bank reputation and market share to measure advisor quality and find no link with returns. Our findings thus advocate a new measure of advisor quality – past performance. However, acquirers instead select banks based on market share, even though it is negatively associated with future performance. The publication of league tables based on value creation, rather than market share, may improve both clients’ selection decisions and advisors’ incentives to turn away bad deals.

Investment Banking, Persistence, Mergers & Acquisitions

Abstract:
This paper analyzes how blockholders can exert governance even if they cannot intervene in a firm's operations. Blockholders have strong incentives to monitor the firm's fundamental value, since they can sell their stakes upon negative information. By trading on private information (following the "Wall Street Rule"), they cause prices to reflect fundamental value rather than current earnings. This in turn encourages managers to invest for long-run growth rather than short-term profits. Contrary to the view that the U.S.'s liquid markets and transient shareholders exacerbate myopia, I show that they can encourage investment by impounding its effects into prices.

Blockholders, market efficiency, myopia, short-termism, intangible investment, Wall Street Rule, voting with your feet

Abstract:
This paper presents a united framework for understanding the determinants of both CEOincentives and total pay levels in competitive market equilibrium. It embeds a modified principal-agent problem into a talent assignment model to endogenize both elements of compensation. The model s closed form solutions yield testable predictions for how incentives should vary across arms under optimal contracting. In particular, our calibrations show that the negative relationship between the CEO s executive equity stake and arm size is quantitatively consistent with e¢ ciency and need not re ect rent extraction. Ourmodel and data both also imply that the dollar change in wealth for a percentage change in arm value, scaled by annual pay, is independent of arm size. This may render it an attractive incentive measure as it is comparable between arms and over time. The theory also predicts a positive relationship between pay volatility and rm volatility, and that risk and effort affect total pay along the cross-section but not in the aggregate. Finally, we demonstrate that incentive compensation is executive at solving large agency problems, such as selecting corporate strategy, but smaller issues such as perk consumption are best addressed through direct monitoring.

Abstract:
This paper presents a unified framework for understanding the determinants of both CEO incentives and total pay levels in competitive market equilibrium. It embeds a modified principal-agent problem into a talent assignment model to endogenize both elements of compensation. The model's closed form solutions yield testable predictions for how incentives should vary across firms under optimal contracting. In particular, our calibrations show that the negative relationship between the CEO's effective equity stake and firm size is quantitatively consistent with efficiency and need not reflect rent extraction. Our model and data both also imply that the dollar change in wealth for a percentage change in firm value, scaled by annual pay, is independent of firm size. This may render it an attractive incentive measure as it is comparable between firms and over time. The theory also predicts a positive relationship between pay volatility and firm volatility, and that risk and effort affect total pay along the cross-section but not in the aggregate. Finally, we demonstrate that incentive compensation is effective at solving large agency problems, such as selecting corporate strategy, but smaller issues such as perk consumption are best addressed through direct monitoring.

Abstract:
This paper presents a unified theory of both the level and sensitivity of pay in competitive market equilibrium, by embedding a moral hazard problem into a talent assignment model. By considering multiplicative specifications for the CEO's utility and production functions, we generate a number of different results from traditional additive models. First, both the CEO's low fractional ownership (the Jensen-Murphy incentives measure) and its negative relationship with firm size can be quantitatively reconciled with optimal contracting, and thus need not reflect rent extraction. Second, the dollar change in wealth for a percentage change in firm value, divided by annual pay, is independent of firm size and therefore a desirable empirical measure of incentives. Third, incentive pay is effective at solving agency problems with multiplicative impacts on firm value, such as strategy choice. However, additive issues such as perk consumption are best addressed through direct monitoring.

Executive compensation, multiplicative preferences, pay-performance sensitivity, incentives, perks, optimal contracting, calibration

Abstract:
Contracts in a dynamic model must address a number of issues absent from static frameworks. Shocks to firm value may weaken the incentive effects of securities (e.g. cause options to fall out of the money), and the impact of some CEO actions may not be felt until far in the future. We derive the optimal contract in a setting where the CEO can affect firm value through both productive effort and costly manipulation, and may undo the contract by privately saving. The optimal contract takes a surprisingly simple form, and can be implemented by a "Dynamic Incentive Account." The CEO’s expected pay is escrowed into an account, a fraction of which is invested in the firm’s stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO’s employment and after he quits, to deter short-termist actions before retirement.

Contract theory, executive compensation, incentives, manipulation, principal-agent problem, private saving, vesting

Abstract:
Contracts in a dynamic model must address a number of issues absent from static frameworks. Shocks to firm value may weaken the incentive effects of securities (e.g. cause options to fall out of the money), and the impact of some CEO actions may not be felt until far in the future. We derive the optimal contract in a setting where the CEO can affect firm value through both productive effort and costly manipulation, and may undo the contract by privately saving. The optimal contract takes a surprisingly simple form, and can be implemented by a Dynamic Incentive Account. The CEO's expected pay is escrowed into an account, a fraction of which is invested in the firm's stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO's employment and after he quits, to deter short-termist actions before retirement.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
Contracts in a dynamic model must address a number of issues absent from static frameworks. Shocks to firm value may weaken the incentive effects of securities (e.g. cause options to fall out of the money), and the impact of some CEO actions may not be felt until far in the future. We derive the optimal contract in a setting where the CEO can affect firm value through both productive effort and costly manipulation, and may undo the contract by privately saving. The optimal contract takes a surprisingly simple form, and can be implemented by a "Dynamic Incentive Account." The CEO's expected pay is escrowed into an account, a fraction of which is invested in the firm's stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO's employment and after he quits, to deter short-termist actions before retirement.

Contract theory, executive compensation, incentives, principal-agent problem, manipulation, private saving, vesting

Abstract:
Traditional theories argue that governance is strongest under a single large blockholder, as she has large incentives to undertake value-enhancing interventions (engage in "voice"). However, most firms are held by multiple small blockholders. This paper shows that, while such a structure generates free-rider problems that hinder voice, the same co-ordination difficulties strengthen a second governance mechanism: disciplining the manager through trading (engaging in "exit"). Since multiple blockholders cannot co-ordinate to limit their orders and maximize combined trading profits, they trade competitively, impounding more information into prices. This strengthens the threat of disciplinary exit, inducing higher managerial effort. The optimal blockholder structure depends on the relative effectiveness of manager and blockholder effort, the complementarities in their outputs, information asymmetry, liquidity, monitoring costs, and the manager's contract.

Multiple blockholders, corporate governance, market efficiency, exit, voice, free-rider problem, Wall Street rule, voting with your feet

Abstract:
Bebchuk and Fried (2004) argue that executive compensation is set by CEOs themselves rather than boards on behalf of shareholders, since many features of observed pay packages may appear inconsistent with standard optimal contracting theories. However, it may be that simple models do not capture several complexities of real-life settings. This article surveys recent theories that extend traditional frameworks to incorporate these dimensions, and show that the above features can be fully consistent with efficiency. For example, optimal contracting theories can explain the recent rapid increase in pay, the low level of incentives and their negative scaling with firm size, pay-for-luck, the widespread use of options (as opposed to stock), severance pay and debt compensation, and the insensitivity of incentives to risk.

Abstract:
Bebchuk and Fried (2004) argue that executive compensation is set by CEOs themselves rather than boards on behalf of shareholders, since many features of observed pay packages may appear inconsistent with standard optimal contracting theories. However, it may be that simple models do not capture several complexities of real-life settings. This article surveys recent theories that extend traditional frameworks to incorporate these dimensions, and show that the above features can be fully consistent with efficiency. For example, optimal contracting theories can explain the recent rapid increase in pay, the low level of incentives and their negative scaling with firm size, pay-for-luck, the widespread use of options (as opposed to stock), severance pay and debt compensation, and the insensitivity of incentives to risk.

Executive compensation, pay-performance sensitivity, rent extraction, optimal contracting

Abstract:
Existing theories advocate the use of equity-like instruments in executive compensation. However, recent empirical studies have documented the prevalence of debt-like instruments such as pensions. This paper justifies the use of debt as efficient compensation. Inside debt is a superior solution to the agency costs of debt than the solvency-contingent bonuses and salaries proposed by prior literature, since its payoff depends not only on the incidence of bankruptcy but also the firm's value in bankruptcy. Contrary to intuition, it is typically inefficient to align the manager with firm value by granting him equal proportions of debt and equity. In most cases, an equity bias is desired to induce effort. However, if effort is productive in increasing liquidation value, or if bankruptcy is likely, a debt bias can improve effort as well as deterring risk shifting. The model generates a number of empirical predictions consistent with recent evidence.

Agency costs of debt, asset substitution, risk shifting, corporate governance, executive compensation, liquidation, pensions

Abstract:
Asset prices both affect and reflect real decisions. This paper provides evidence of this two-way relationship in the takeover market. We find that a firm's discount to its potential value significantly attracts takeovers (the "trigger effect") -- but market expectations of an acquisition cause the discount to shrink (the "anticipation effect"). By controlling for the simultaneous anticipation effect, we document a markedly stronger trigger effect from prices to takeover probabilities than prior literature -- an inter-quartile change in the discount leads to a 4 percentage point increase in acquisition likelihood (compared to a 6% unconditional takeover probability). This implies that financial markets may discipline managerial agency by triggering takeover threats, but the anticipation effect reduces the effectiveness of this process.

Takeovers, mergers and acquisitions, market valuation, feedback effects, financial and real efficiency, merger waves

Abstract:
The option to terminate a manager early minimizes investor losses if he is unskilled. However, it also deters a skilled manager from undertaking long-term projects that risk low earnings. This paper introduces a novel role of debt that allows it to overcome this tension. Leverage concentrates equityholders' stakes, creating incentives for them to learn the cause of low earnings. If they result from investment (poor management), the firm is continued (liquidated). Therefore, unskilled managers are terminated and skilled managers can invest without fear of termination. Unlike models of managerial discipline based on total payout, here dividends are not a substitute for debt. Dividends only achieve termination upon non-payment; debt also leads to concentration, ex post monitoring by the investor and thus ex ante investment by the manager. Debt is dynamically consistent as the manager benefits from monitoring by a concentrated investor. In traditional theories, monitoring constrains the manager; here it frees him to take long-term projects.

Termination, liquidation, managerial myopia, long-term investment, ownership concentration, monitoring, corporate governance, leverage, private equity

Abstract:
This paper identifies a class of multiperiod agency problems in which the optimal contract is tractable (attainable in closed form). By modeling the noise before the action in each period, we force the contract to provide sufficient incentives state-by-state, rather than merely on average. This tightly constrains the set of admissible contracts and allows for a simple solution to the contracting problem. Our results continue to hold in continuous time, where noise and actions are simultaneous. We thus extend the tractable contracts of Holmstrom and Milgrom (1987) to settings that do not require exponential utility, a pecuniary cost of effort, Gaussian noise or continuous time. The contract's functional form is independent of the noise distribution. Moreover, if the cost of effort is pecuniary (multiplicative), the contract is linear (log-linear) in output and its slope is independent of the noise distribution, utility function and reservation utility. In a two-stage contracting game, the optimal target action depends on the costs and benefits of the environment, but is independent of the noise realization.

Contract theory, executive compensation, incentives, principal-agent problem, dispersive order, subderivative

Abstract:
Bebchuk and Fried (2004) argue that executive compensation is set by CEOs themselves rather than boards on behalf of shareholders, since many features of observed pay packages may appear inconsistent with standard optimal contracting theories. However, it may be that simple models do not capture several complexities of real-life settings. This article surveys recent theories that extend traditional frameworks to incorporate these dimensions, and show that the above features can be fully consistent with efficiency. For example, optimal contracting theories can explain the recent rapid increase in pay, the low level of incentives and their negative scaling with firm size, pay-for-luck, the widespread use of options (as opposed to stock), severance pay and debt compensation, and the insensitivity of incentives to risk.

Abstract:
This paper identifies a broad class of situations in which the contract is both attainable in closed form and detail-neutral. The contract's functional form is independent of the noise distribution and reservation utility; moreover, when the cost of effort is pecuniary, the contract is linear in output regardless of the agent's utility function. Our contract holds in both continuous time and a discrete-time, multi-period setting where action follows noise in each period. The tractable contracts of Holmstrom and Milgrom (1987) can thus be achieved in settings that do not require exponential utility, Gaussian noise or continuous time. Our results also suggest that incentive schemes need not depend on complex details of the particular setting, a number of which (e.g. agent's risk aversion) are difficult for the principal to observe.The proof techniques use the notion of relative dispersion and subdifferentials to avoid relying on the first-order approach, and may be of methodological interest.