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Abstract:
We study the determinants of firms’ choice of peers, how the choice of peers impacts CEO compensation and how it is related to future firm performance. Our sample includes 1,046 firms (1,764 firm-years) that disclose peers following the new SEC disclosure rules for executive compensation. Competitive benchmarking predicts that peer choice will be explained by similarity in firm characteristics that capture similarity in the labor market for executives. In contrast, the self-serving view predicts that firms will opportunistically choose peers to maximize managerial compensation. We find evidence consistent with both competitive benchmarking and self-serving views, although support for the latter is modest in terms of the effect on CEO pay. Firms are likely to choose peers based on economic factors such as similarity in industry, size, performance, investment tangibility, and past return covariance. Firms also tend to choose peers that pay their CEOs more, which in turn translates into firms paying their CEOs more. This “peer-pay-effect” reflects both higher CEO talent and opportunistic behavior. When it reflects CEO talent, it is positively associated with future performance whereas it is negatively associated when it reflects opportunism.

Benchmarking, Peers, CEO Compensation, Regulation

Abstract:
Relative performance evaluation (RPE) in CEO compensation provides insurance against external shocks and yields a more informative measure of CEO actions. I argue that empirical evidence on the use of RPE is mixed because previous studies rely on a misspecified peer group. External shocks and flexibility in responding to the shocks are functions of, for example, the firm's technology, the complexity of the organization, and the ability to access external credit, which depend on firm size. When peers are composed of similar industry-size firms, evidence is consistent with the use of RPE in CEO compensation.

Abstract:
This paper hypothesizes that the use of relative performance evaluation (RPE) as an incentive mechanism varies negatively with a firm's level of growth options. I study two mechanisms by which the level of growth options affects RPE usage: (i) for firms with high levels of growth options, peer performance is a less informative measure of external shocks outside of the CEO's control; and (ii) RPE implementation in high growth options firms is subject to larger influence costs. The evidence supports the hypothesis. The tests use three alternative proxies for growth options, market-to-book value of assets, research and development expenses scaled by assets, and a factor obtained from principal component analysis and control for factors known to affect pay for performance sensitivities.

Executive Compensation, Relative Performance Evaluation, Growth Options