Relative Performance Evaluation and the Peer Group Opportunity Set

Abstract

We develop an algorithm that constructs custom peer groups for use in relative performance evaluation (RPE) grants, and use this algorithm to understand firms’ RPE choices. We find that firms are more likely to use RPE when our algorithm is better able to construct a peer group that closely matches the firm’s risk profile. When no such peer group can be constructed, firms are more likely to forgo RPE. Some firms choose not to use RPE in a manner consistent with optimal risk sharing (e.g., forgoing RPE despite the availability of an effective peer group or choosing to use a peer group that is less effective than an available alternative). We find that this behavior can often be explained by competitive sabotage concerns and/or rent extraction.

Keywords: relative performance evaluation, peer groups, executive incentive-compensation, optimal contracting, strategic interaction

JEL Classification: G30, J33, L1, M12, M52