Explicit Relative Performance Evaluation and Managerial Decision-Making: Evidence from Firm Performance and Risk-taking Behavior
64 Pages Posted: 19 Aug 2015 Last revised: 29 Oct 2020
Date Written: October 2020
This study examines the effect of relative performance evaluation (RPE) on firm performance and risk-taking behavior. Agency theory suggests that RPE use in executive compensation plans improves risk sharing and strengthens incentive alignment when firm performance is exposed to common shocks. I find that among firms with high common risk exposure, RPE firms are associated with higher firm performance than non-RPE firms. However, among firms with low common risk exposure, I find no evidence of a difference in performance between RPE and non-RPE firms. My results also suggest that RPE firms are associated with greater more firm risk and lower likelihood of underinvesting, but only when exposed to high common risk. Finally, I document evidence that, conditional on high common risk exposure, RPE firms that choose peers with more common risk are associated with higher firm performance and higher risk-taking behavior compared to non-RPE firms. Together, my study provides evidence that RPE is associated with better risk sharing and stronger incentive alignment when (1) RPE firms are exposed to high common risk, and (2) RPE peers are effective in removing common risk for performance evaluation, consistent with agency theory.
Keywords: Relative performance evaluation, executive compensation, agency costs, peer groups
JEL Classification: G30, J33, M41, M52
Suggested Citation: Suggested Citation