CEOs’ Outside Opportunities and the Presence of Relative Performance Evaluation in Compensation Contracts*

We offer a novel explanation for the use of relative performance evaluation (RPE) in CEO compensation contracts. Unlike traditional models, RPE in our setting is not used to reduce noise, but to offer competitive compensation for CEO talent. To avoid costly renegotiation, firms commit to meeting CEO future participation constraints through the use of RPE. In a competitive equilibrium, CEO compensation for talent does not simply depend on the CEO performance relative to the average industry performance. Rather, it is based on the entire distribution of talent in the industry (Sattinger, 1979, Tervio, 2003, 2008, Gabaix and Landier, 2008). This implies that RPE should take a more complex, non-linear form, and be based on the ranking of the CEO relative to peers. We also show that common industry shocks do not perturb the ranked-order relation. We empirically test the predictions of the model on a sample of CEO compensation contracts and find support for it. Our model helps explain why firms use RPE in a ranked-order form and why CEO compensation should positively depend on both CEO ranking relative to the industry and on average industry performance. We also empirically show why, in contrast to the prevailing practice, prior studies found weak evidence with respect to RPE. * An earlier version of this paper was circulated as “How is Relative Performance Evaluation Incorporated in CEO Compensation Contracts? ” We thank David Aboody, Kerry Back, Kevin Crotty, Andrew Ellul (discussant), Gustavo Grullon, Ronen Israel, Ron Kaniel, Sébastien Michenaud, and Kevin Murphy for helpful discussions, and seminar participants at University of Amsterdam, IDC Herzliya, and the Bar Ilan University Ackerman conference on executive compensation for helpful comments and suggestions. All remaining errors are our own. 2 The apparent lack of relative performance evaluation (RPE) in CEO compensation contracts has attracted a lot of academic attention, and many studies have proposed explanations for that puzzle. For the most part, all these explanations hinge on the fact that RPE is the efficient way to elicit effort but that other considerations reduce its effectiveness. In this study we offer a novel explanation for the use of RPE. Our explanation is based on the fact that the CEO participation constraint depends on both industry conditions and on CEO perceived talent relative to the industry. To avoid costly renegotiation, firms commit to meeting CEO future participation constraints through the use of RPE. We show that relative performance arises naturally in this setting. RPE in our setting has a different purpose than in the traditional setting (e.g., Holmstrom, 1979, 1982, Holmstrom and Milgrom, 1987). It is not used to reduce noise, but to offer competitive compensation for CEO talent. This also implies that the way RPE is incorporated into the CEO contract should differ. In a competitive equilibrium, CEO compensation for talent does not simply depend on the CEO performance relative to the average industry performance. Rather, it is based on the entire distribution of talent in the industry (Sattinger, 1979, Tervio, 2003, 2008, Gabaix and Landier, 2008). Therefore, RPE takes a more complex, non-linear form, and depends on the ranking of the CEO relative to peers. This feature helps explain why RPE does exist in CEO compensation contracts but in a rather complex form – based on the ranking of the CEO relative to peers – and why prior studies have not found the use of RPE where in fact it has been used for many years. Our theoretical setting is similar to Oyer (2004). In his setting workers’ reservation wage changes over time and it is costly for the firm to renegotiate with its workers. Confining himself to contracts that are solely based on firm performance, Oyer shows that option compensation is a second-best solution to meeting the reservation utility of the worker. We apply Oyer’s insight to the case of CEOs and extend Oyer’s framework in two important ways. First, we incorporate the possibility that CEO talent also affects her reservation wage. Second, we allow firms to contract on