The Role of Common Risk in the Effectiveness of Explicit Relative Performance Evaluation

Abstract

I examine the effect of relative performance evaluation (RPE) on firm performance and risk-taking behavior. Agency theory suggests that, for firms that experience common shocks, RPE in executive compensation plans improves risk sharing and strengthens incentive alignment by providing more information about managerial effort than firm performance alone. In practice (i.e., in the presence of a finite number of peers), RPE effectiveness depends on the extent of firms’ common risk exposure and the amount of common risk captured by RPE peers. I develop a simple model that builds on Holmstrom (1982) and predict that the benefit of using RPE exceeds the cost of adding noise from peers when the amount of common risk removed is large. Consistent with predictions, I find empirically that RPE firms perform better than similar non-RPE firms when there is high common risk exposure and when the common risk removed by the selected peers is high. I also find that in these circumstances the use of RPE is associated with greater firm risk and a lower likelihood of underinvesting. Overall, 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.

Keywords: Relative performance evaluation, executive compensation, agency costs, peer groups

JEL Classification: G30, J33, M41, M52