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Why Do Shareholders Condone Seemingly “Excessive” Executive Pay

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Common Ownership, Competition, And Top Management Incentives

Miguel Anton
IESE Business School, Universidad de Navarra

Florian Ederer
Yale University – School of Management; Yale University – Cowles Foundation

Mireia Gine
The University of Pennsylvania; IESE Business School of the University of Navarra

Martin C. Schmalz
University of Michigan, Stephen M. Ross School of Business

July 1, 2016


Standard corporate finance theories assume the absence of strategic product market interactions or that shareholders don’t diversify across industry rivals; the optimal incentive contract features pay-for-performance relative to industry peers. Empirical evidence, by contrast, indicates managers are rewarded for rivals’ performance as well as for their own. We propose common ownership of natural competitors by the same investors as an explanation. We show theoretically and empirically that executives are paid less for own performance and more for rivals’ performance when the industry is more commonly owned. The growth of common ownership also helps explain the increase in CEO pay over the past decades.

Common Ownership, Competition, And Top Management Incentives – Introduction

The level and structure of top management pay has been the subject of a fiery public debate for a long time, most recently by all major presidential candidates. Corresponding to the public interest, a large academic literature has examined its determinants. Much of it has focused on how board characteristics determine the extent to which pay packages are competitive, as opposed to reflective of unresolved agency problems.1 More recently, the public debate has moved to questioning the role of many firms’ most powerful shareholders in bringing about, or at least condoning, what some perceive as “excessive” compensation packages. In particular, a small set of very large mutual fund companies find themselves asked why they systematically vote “yes” on compensation packages that guarantee high levels of pay but are only weakly related to the (relative) performance of the firm executives run.2 Performance-insensitive pay not only defies common sense, but also the established economic theory on optimal incentive provision. Why then do the largest and most powerful shareholders of many firms support such pay packages?

Deepening the puzzle, the approval of the seemingly sub-optimal contracts does not seem to be due to inattention. To the contrary, BlackRock (BLK), the largest shareholder of about one fifth of all American corporations (Davis, 2013), recognizes that “executive compensation that is disconnected from company performance is a symptom of broader governance failures,” which it is committed to rectify. Indeed, almost half of the hundreds of engagement meetings the firm conducts every year feature discussions about executive compensation (Melby, 2016).

A perceived lack of power, i.e., inability to influence pay packages, does not seem be an obstacle either. BLK’s leaders claim to have power to influence firm behavior far beyond pay structure. A quick Google search brings up Larry Fink saying “We can tell a company to fire 5000 employees tomorrow…” (Rolnik, 2016) while Reuters reports “When BlackRock calls, CEOs listen and do deals” (Hunnicutt, 2016), etc. To bring about change, “being able to talk to boards” in private engagement meetings “is [BLK’s] most important tool,” and more powerful than voting alone (BlackRock, 2015; Booraem, 2014). Indeed, “we only vote against management when direct engagement has failed” (BlackRock, 2016), or, more colorfully: “engagement is the carrot, voting is the stick.” Judging from the voting patterns on pay, shareholders seem to think that the carrot is effective.3 Given these shareholders’ attention to executive pay and their apparent power to affect it, it seems perplexing to many observers why they “wield [their] outsized stick like a wet noodle” (Morgenson, 2016) and rubber-stamp (if not encourage) compensation contracts that contradict fundamental predictions of incentive theory.

The present paper provides a rationale for why large diversified managers should indeed support pay packages that promise high unconditional salaries that are less related to firm performance and more related to aggregate performance. Our explanation combines common ownership of firms by an overlapping set of investors and imperfect product market competition. In theory, “common shareholders,” including widely diversified asset managers such as BLK and Vanguard, will aim to maximize the value of their entire stock portfolio, rather than the performance of individual firms within that portfolio. (The reason is that mutual fund families earn money by charging their investors a fixed percentage of total assets under management.) They should therefore optimally structure executive pay such that managers have weakened incentives to compete aggressively against their industry rivals, thereby competing away industry profits.

This explanation also generates testable predictions about the cross-sectional variation in payperformance sensitivities and the level of pay: increasing common ownership concentration should lead to reduced pay-performance sensitivity, less relative performance evaluation, and higher unconditional CEO pay. These predictions find strong support in the data. Our findings support the notion that broadly diversified investors do not challenge performance-insensitive compensation packages simply because letting them pass is in their economic interest.

Common Ownership, Competition, Top Management Incentives

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