CEO Contract Design: How Do Strong Principals Do It?

Abstract

We study changes in chief executive officer (CEO) contracts when firms transition from public ownership with dispersed owners to private ownership with strong principals in the form of private equity sponsors. The most significant changes are that a significant portion of equity grants performance-vests based on prespecified measures and that unvested equity is forfeited by fired CEOs. Private equity sponsors do not reduce base salaries, bonuses, and perks, but redesign contracts away from qualitative measures. They use some subjective performance evaluation, do not use indexed or premium options, and do not condition vesting on relative industry performance. We compare the contracts to predictions from contracting theories, and relate our results to discussions of executive compensation reform.

Keywords: LBOs, employment contracts, contracting theory, executive compensation

JEL Classification: G30, G34, J33