Explicit Relative Performance Evaluation and Managerial Decision-Making: Evidence from Firm Performance and Risk-taking Behavior
52 Pages Posted: 19 Aug 2015 Last revised: 21 Jul 2019
Date Written: June 2019
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 affected by common shocks. However, RPE in practice may not be effective in addressing agency costs when selected peers do not share common risk with the RPE firm. I find that RPE firms are associated with higher firm performance than non-RPE firms only when they choose peers with high common risk. My results also suggest that these RPE firms are associated with more firm risk and lower likelihood of underinvesting. Finally, I document some evidence that RPE firms had less investment volatility than non-RPE firms during the Global Financial Crisis when the RPE peers captured high common risk. Together, my study provides evidence that RPE is associated with better risk sharing and stronger incentive alignment when RPE is 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