Relative Performance Evaluation and the Peer Group Opportunity Set

61 Pages Posted: 28 May 2021

See all articles by Matthew J. Bloomfield

Matthew J. Bloomfield

The Wharton School of the University of Pennsylvania

Wayne R. Guay

University of Pennsylvania - Accounting Department

Oscar Timmermans

London School of Economics & Political Science (LSE)

Date Written: May 25, 2021

Abstract

We develop an algorithm that mimics the relative performance evaluation (“RPE”) peer selection process used for CEOs’ incentive plans. Our algorithm constructs the portfolio of peer firms that exhibits the highest in-sample stock performance correlation with the focal firm, which we then use as a counterfactual to better understand firms’ actual RPE choices. We find that most firms use RPE in a manner consistent with optimal risk-sharing; firms are more likely to use RPE when a viable peer group is available, and they construct peer groups that are about as effective as possible at shielding CEOs from outcome risk. However, some firms choose not to use RPE even when an effective peer group is available; non-reliance on RPE in these cases appears to be related to competitive sabotage concerns. Other firms choose to use RPE, but benchmark against a peer group that is not effective from a risk-sharing perspective; reliance on RPE in these cases appears to be related to rent-extraction. Collectively, our study improves the understanding of firms’ ex ante ability to construct an effective peer group, and thereby sheds new light on why firms do—and perhaps more importantly, why some firms do not—use relative performance evaluation in their CEOs’ incentive plans.

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

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

Suggested Citation

Bloomfield, Matthew J. and Guay, Wayne R. and Timmermans, Oscar, Relative Performance Evaluation and the Peer Group Opportunity Set (May 25, 2021). Available at SSRN: https://ssrn.com/abstract=3853940 or http://dx.doi.org/10.2139/ssrn.3853940

Matthew J. Bloomfield

The Wharton School of the University of Pennsylvania ( email )

1325 Steinberg-Dietrich Hall
3620 Locust Walk
Philadelphia, PA PA 19103-1724
United States
6073513042 (Phone)
6073513042 (Fax)

Wayne R. Guay (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
1329 Steinberg-Dietrich Hall
Philadelphia, PA 19104-6365
United States
215-898-7775 (Phone)
215-573-2054 (Fax)

Oscar Timmermans

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

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