Company bosses are human too – even if they may not realise it
Companies persist in signing off remuneration packages that risk encouraging decisions that benefit the short-term interests of their executives more than the longer-term prospects of the business itself
You may need little convincing that company bosses are all too human – especially if you read our recent piece Five famous chief executive gaffes – and yet this is apparently still news to the bosses themselves.
Time and again, management teams sign off remuneration packages that risk encouraging decisions that benefit the short-term interests of company executives more than the longer-term prospects of the businesses they run.
Are we being unfair? Not according to a recent paper by London Business School professor Alex Edmans and US-based academics Vivian Fang and Katherina Lewellen. In ‘Equity Vesting and Investment’, they study the link between real company investment decisions and the shorter-term share price concerns a chief executive might have as a result of stock options or other bonus arrangements.
Causation vs. correlation
One of the problems facing researchers in this area – as Edmans himself points out in this article in the Harvard Business Review – is it is very hard to establish causation as opposed to mere correlation.
“Say we found that a CEO cuts investment and then sells their shares,” he continues. “One interpretation is that they cut investment to cash out. But another is that their firm’s long-term outlook is poor.
“This causes the CEO (correctly) to cut investment and also (rationally) to sell their shares. So, there’s correlation between investment and sales, but no causation.” Rather than looking at how many shares the CEO sells, then, Edmans and his co-authors’ approach was to consider how many shares were scheduled to vest once a ‘lock-up’ period, during which a CEO cannot sell their shares, has expired.
Once their lock-up expires, the reasoning goes, a CEO will worry about the stock price – but a lock-up expiring today is driven by the board’s decision to grant the shares, which will have been taken some years previously.
“The decision to grant shares back then, and thus the fact that shares are vesting today, is unlikely to be driven by factors that also determine investment,” Edmans explains.
“By focusing on when shares vest rather than when CEOs sell shares, we are able to show causation – not just correlation – from CEOs’ personal wealth concerns to cuts in investment.”
And does this change things? It does not. The paper cannot escape the conclusion that the more equity CEOs have vesting in a given quarter, the more they cut investment.
Vesting equity is positively correlated with the CEO
What is more, the paper finds, vesting equity is positively correlated with the CEO “just barely meeting analyst earnings forecasts”, which suggests it causes the CEO to focus on short-term earnings rather than long-term investment. Still, while that result may be consistent with short-term behaviour, the paper does offer CEOs the benefit doubt by considering an alternative interpretation.
“Could the investment cuts actually be efficient?” asks Edmans.
“Perhaps stock price concerns are motivating, because they induce the CEO to make tough decisions, such as cutting wasteful investment. If so, we would expect the CEO to improve efficiency in other ways as well, such as increasing sales growth or cutting other expenses. And we find no evidence of that.”
Edmans goes onto highlight a new paper he has co-authored that sets out “more precisely to document the long-term consequences of short-term incentives”. This involves studying share buybacks and merger and acquisition (M&A) activity as, in contrast to investment cuts, it is possible to measure the long-term returns to such actions as a result of their clear announcement date.
Once again, the conclusion is the more vesting equity the CEO has in a given quarter, the higher the likelihood is of both buybacks and M&A activity. “Like investment cuts, buybacks and M&A could be good rather than bad,” says Edmans, “but we find that vesting equity leads to the bad type. It is associated with higher short-term returns to both decisions – but significantly lower long-term returns.”
“In short,” he concludes, “vesting equity encourages CEOs to take actions with destructive long-term consequences” – a fact of investment life those analysing businesses would do well to bear in mind even if it often appears to something that has passed those running those businesses by.
The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.
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