Performance-Based Vesting Compensation and Debt Contracting

Abstract

This paper examines whether the risk-taking incentives induced by performance-based vesting (p-v) compensation influence bank loan contracting and credit ratings. Consistent with our risk-shifting hypothesis, we find that the p-v based compensation, as measured by the proportion of grant date fair value of p-v based compensation to total compensation, significantly increases loan spreads and encourages more no price protection such as performance pricing and secured by collateral. We also find that p-v based compensation increases loan maturity while reduces the covenant strictness as a trade-off. Next, we subcategorize p-v based compensation by its performance type, instrument use, and performance metric. Consistent with previous literature, we find that the loan spread is negatively (positively) associated with accounting (stock price)-based compensation. We also find a tradeoff effect between the price- and non-price features of bank loan contracts such as performance pricing and restrictive covenants, as the positive effect of incentives induced by p-v based compensation on the cost of bank loans is offset by more restrictive features in loan contracts. Next, we perform the analysis using the Chief Financial Officer (CFO)’s p-v compensation and obtain the similar results. Last, we perform the analysis to determine the effects of p-v based compensation on firms’ credit rating. We find the incentive induced by p-v based compensation carry out to the credit rating market by reducing the firm’s credit rating.

Keywords: performance-based vesting compensation, bank loans, cost of debt, executive compensation, CEOs, risk-taking

JEL Classification: M52, M55, J33, G34, G32, G13, M41