title: Design of CEO Equity-based Compensation and Investment Efficiency
Creators: name: Qu, Xin
Publisher: name: Griffith University
Year: 2017
Subjects: subject: Investment efficiency
subject: Agency conflicts
subject: Performance incentives
subject: Executive compensation
subject: Cash flow

description: The role of executive compensation contracts in providing managerial incentives is topical in academic research. Since the last decade, there have been intense debates over whether executive compensation is set optimally to align the interests of managers and those of shareholders. The significance of the global financial crisis (GFC) also sheds light on reviewing equity-based compensation granted to senior managers. The traditional perspective of equity awards holds that these equity mechanisms can attract and retain employees as well as encourage managerial effort exertion (Guay et al., 2002). However, more recently a large body of empirical studies expresses concern about the efficiency of these incentive contracts by arguing compensation may represent agency problems (Bebchuk, 2009). Since the real problem in the research for incentive compensation is ‘not how much you pay, but how’ (Jensen and Murphy, 2010), the primary focus of this study is how to design chief executive officer (CEO) equity-based compensation that can strengthen managerial incentives for making rationality-based corporate decisions. In particular, the corporate decisions considered in this study are investment decisions. Investment decisions of a firm should be independent of its financial situation (Jensen, 1986). However, the sensitivity of investment to cash flow indicates an agency problem of free cash flow. The efficiency of investment is a cause for concern because inefficient investments affect firm performance, leading to a reduction of firm value and economic growth. Within the agency framework, shareholders must find ways to alleviate investment-related agency problems that may result from deviations of firm investments from their optimal level. While there is prior evidence in the literature that corporate governance can influence managerial investment decisions, the evidence is less clear on the impact of specific design features of executive compensation on investment efficiency. In response, this study aims to fill this gap in the literature by examining the setting of CEO equity-based compensation that can improve investment efficiency, consistent with the efficient contracting perspective. Arising from these motivations, three research questions are proposed in this research: (1) Do firms that grant CEO equity-based compensation invest more efficiently than the others? (2) How do firms design CEO time-vesting conditions to reduce investment-related agency problems? (3) How do firms design CEO performance-vesting conditions to reduce investment-related agency problems? These research questions are considered to be timely and of interest to academics, analysts and shareholders. Using a sample of the ASX 300 Australian firms over the period 2010 to 2015, this study investigates the association between the design features of CEO equity-based compensation and investment efficiency. As discussed earlier, in perfect or complete markets, investment decisions of a firm should be independent of its financial situation (Jensen, 1986). However, when managers have access to internal funds, they may tend to over-invest to derive private benefits (empire building) or under-invest to avoid private costs (managerial shirking) (Aggarwal and Samwick, 2006). Thus, the investment-cash flow sensitivity is employed as a proxy for investment inefficiency. Adopting multivariate regression procedures, the regression results document the significant moderating effect of CEO equity design features on the sensitivity of investment to cash flow. Specifically, firms that grant equity-based compensation to their CEOs have lower investment-cash flow sensitivity as compared to others. The sensitivity also decreases as the weight placed on equity-based compensation increases. These results indicate that adopting equity-based compensation enhances the interest alignment between management and shareholders in making proper investment decisions. While there are several types of equity-based compensation favoured by firms, the study also considers how to structure the CEO equity-based compensation to provide more incentives. By testing the use of share options, share rights, restricted shares and a combination of equity grants individually, share options are found to have more importance in shaping the investment-cash flow sensitivity. On the testing of the horizon incentives derived from CEO equity-based compensation, the investment-cash flow sensitivity decreases when a longer vesting duration and a graded vesting pattern are adopted. The results suggest that lengthening vesting periods can extend the useful life of equity incentives, and thus lead to managerial actions that are advantageous to the firm in the long run. Additionally, making the equity grants vest progressively (graded-vesting feature) during the vesting period allows the firm to more efficiently rebalance the CEO’s incentives and encourages the CEO to invest more efficiently in the shareholders’ best interest. Regarding the investigation of performance-vesting conditions, the findings note that the investment-cash flow sensitivity becomes higher when firms attach performance hurdles to CEO equity grants. In contrast to the argument about performance hurdles that enhance pay-performance link, the result, however, supports the managerial entrenchment perspective. Basing CEO compensation on the achievement of performance targets reduces the incentive effects and may even incentivise CEOs to game the system at the cost of shareholder wealth, thus leading to higher agency costs. The study also reports that if firms intend to improve investment efficiency, they can design performance hurdles with a relative evaluation basis. Performance can be evaluated as a comparison to a market index or industry comparator group performance, rather than setting the performance target on a specific improvement rate. The final result shows the adoption of relative hurdles has an adverse moderating effect on the investment-cash flow sensitivity. Overall, the results are consistent with the predictions by agency theory, indicating that firms can strategically design CEO equity-based compensation to reduce investment-related agency problems. The study adopts the latest available data collected manually for the design features of CEO equity-based compensation. By properly structuring CEO equity-based compensation and designing the vesting conditions, equity awards can help overcome the agency conflicts resulting from the separation of ownership and control. The study provides insights into the impact of effort, horizon and performance incentives on the quality of investment decisions, and contributes to the understanding of the role of CEO incentives in a firm’s policy-making.