Compensation Contagion: The Role of Peer Benchmarking

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Presentation transcript:

Compensation Contagion: The Role of Peer Benchmarking Gonul Colak Hanken School of Economics Jun Yang Indiana University Pengfei Ye Virginia Tech

Motivation The Compensation Contagion Hypothesis (Gabaix and Landier, 2008) Competition for managerial talent can cause an upward contagion in CEO compensation. If 10% of firms double their CEO compensation, the compensation of all CEOs doubles. In contrast, if 10% of firms halve CEO compensation, aggregate CEO compensation decreases by 9%. This hypothesis is never formally tested. This Paper’s Goals: Crack the black box of compensation contagion Highlight the roles of peer benchmarking in compensation contagion. Identify three mechanisms that facilitate compensation contagion. Direct competition for managerial talent Star-chasing behaviors of some companies The peer-of-peer effect Investigate how internal governance and labor unions affect compensation contagion. Verify that contagion effect is asymmetric and offer an explanation.

Empirical Setting and Findings Use companies that join the S&P 500 as an example of “small number of firms that trigger the contagion” (event companies) Use non-event firms’ self-selected compensation peer companies to identify their exposures to positive pay shocks at event companies. Findings Contagion occurs through three channels embedded in the peer benchmarking practice. Direct Competition Channel: contagion driven by the force of direct competition Star-Chasing Channel: contagion resulting from firms’ tendency to add event companies to their peer groups Peer-of-Peer Channel: contagion through the indirect impact of peers that are exposed to the event companies’ influences. Pseudo peers do not have contagious effects. Internal governance and labor unions affect the speed and level of contagion Depend on the specific contagion channel; Could have opposite effects. We illustrate why the impact of negative pay shocks on other firms is limited (the asymmetry of contagion).

Data Initial sample period: 2006-2013 Sample firms must be Compensation peer data become publicly available starting on Dec. 15, 2006. We collected compensation peer companies from firms’ proxy statements (DEF-14A filings) from 2006 to 2013. Peers matched with CRSP, Compustat, and ExecuComp. Sample firms must be Covered by CRSP, Compustat, and ExecuComp database (this means only current and previous S&P 1500 firms are considered); Reporting compensation peers. Data on governance are from ExecuComp (CEO ownership), RiskMetrics (board characteristics), and Thomson Reuter 13F (institutional ownership). Actual sample used for each test varies with the research question.

1. Event Companies vs. Non-Event Firms Two sets of firms: event companies and non-event firms. Event companies: triggers of compensation contagion (133), firms that Join the S&P 500 Index from 2006 to 2012, and Remain as the S&P 500 member at the end of 2013; Have complete financial information required for the baseline compensation analysis; Have CEO compensation data from ExecuComp for at least one year before and one year after the event; No “back-and-forth” cases (added to, then dropped from, and added back to the index at a later date). Non-event firms The subjects of compensation contagion; Include all other S&P1500 firms that have necessary information for our empirical analysis.

Table 1. Event Companies vs. Non-Event Firms   Event Companies Non-event firms DIF N Mean Median St. Dev. TDC1 ($thousand) 929 7,914.73 6,227.41 6,311.04 6,035 4,970.74 3,366.76 4,784.87 2,943.99*** 2,860.65*** Sales ($million) 5,677.27 3,770.92 7,120.87 6,250.64 1,284.74 15,789.77 -573.37 2,486.18*** ROA 0.17 0.16 0.10 0.13 0.09 0.04*** 0.03*** Ret 0.22 0.48 0.12 0.08 0.45 0.10*** 0.08*** Sales Growth 0.11 0.19 0.06 0.18 0.05*** M/B 3.86 2.84 3.20 2.73 1.97 2.63 1.13*** 0.88*** StDev 0.04 -0.02*** -0.01*** Leverage 0.14 0.15 0.02*** 0.02* CEO Chair 0.55 1.00 0.50 0.53 0.02 0.00 CEO Tenure 11.20 9.00 8.11 10.46 7.00 7.99 0.74*** 2.00*** IO 0.85 0.88 0.82 0.84 IO HHI 0.03 0.05 Governance Score 2.18 2.00 1.15 2.36 1.16 -0.18** 0.00* Unionization (%) 8.37 4.50 8.73 7.90 3.80 9.10 0.47 0.70** Sample period: 2007-2013

2. Event Companies as the Triggers Firm that join the S&P 500 tend to have Improved firm performance (Denis, McConnell, Ovtchinnikov, and Yu, 2003); Increased investor visibility (Chen, Noronha and Singal, 2004); and Increased CEO compensation. Sample: all firms that have financial information for analysis (including both event companies and non-event firms) Key variable: After-Addition = 1 if a firm is an event company post-addition, and 0 otherwise. No causality claims: we do not distinguish whether the increase in CEO compensation is caused by the index addition, or by changes in the event company’s fundamentals that coincide with the index addition.

Table 2. Increases in CEO Compensation after joining the S&P 500   Ln(TDC1) S&P 500 Additions over 2006–2012 S&P 500 Additions over 1992–2012 (1) (2) (3) (4) Event Company i 0.42*** 0.10** 0.39*** 0.08*** (8.14) (2.45) (18.85) (4.38) After Addition i,t 0.20*** 0.09* 0.10*** (3.04) (1.92) (15.35) (4.22) Constant 6.90*** 3.70*** 7.49*** 3.83*** (8.26) (6.18) (36.45) (18.97) Baseline Controls No Yes Year F. E. Industry F. E. Observations 6,964 35,262 33,003 R-squared 0.16 0.56 0.20 0.52

3. Measure Non-event Firms’ Exposures We focus on non-event firm’s peer companies to identify possible contagion mechanisms Most corporate boards use peer companies to benchmark CEO compensation; Peer companies “represent the market for executive talent in which the company has historically competed” (Colgate Palmolive’s 2006 proxy statement); Ideal for testing compensation contagion driven by labor market competition (Gabaix and Landier, 2008); The selection of peer companies could suffer from upward biases (Faulkender and Yang, 2010, 2013; Bizjak, Lemmon, and Nguyen, 2011) Suggestive of potential non-competition based contagion channels.

3. Measure Non-event Firms’ Exposures Three types of relationships between event companies and non-event firms Direct competitors: event companies are compensation peers of non-event firms before and after the addition event. Aspirational peers: event companies that are added to the non-event firm’s peer group only after they join the S&P 500 Peers of peers: event companies that are not the peers of a non-event firm, but are peers of the non-event firm’s compensation peers. The presence of each type of peers in a non-event firm’s peer group represents one possible contagion channel. Instant exposure vs. cumulative exposure - Instant exposure: measures the exposure of a non-event firm to last year’s event companies through peer relation. - Cumulative exposure: measure the exposure of a non-event firm to all event companies starting in 2006.

4. The Direct Competition Channel Sample: all non-event firms that report compensation peer companies For each non-event firm in each year, we count the number of direct-competing post-addition event- companies and construct the following variables Instant Direct Competition Exposure = No. of direct competing event companies (joined the S&P last year) in peer group Total no. of peer companies Cumulative Direct Competition Exposure = No. of direct competing event companies (joined the S&P in previous years) in peer group Total no. of peer companies The greater the exposure, the more sensitive is the non-event firm to event companies’ positive pay shocks.

Table 3. Compensation Contagion through the Direct Competition Channel Panel A. Direct Competition Exposure of the Non-Event Firms   Instant Measure Cumulative Measure No. Mean Median St. Dev. Non-Event Firms with Direct Competition Exposure 681 0.0657 0.0588 0.0316 1,481 0.0714 0.0578 0.0881 All Non-Event Sample Firms 6,035 0.0074 0.0000 0.0233 0.0216 0.0475 Pane B. Compensation Contagion through the Direct Competition Channel   Ln(TDC1) (1) (2) Instant Direct Competition Exposurei,t 1.28*** (3.78) Cumulative Direct Competition Exposure i,t 1.19*** (7.06) Baseline Control Variables Yes Year F. E. Industry F. E. Observations 6,035 R-squared 0.59

5. The Star-Chasing Effect When an event company joins the S&P 500, more firms start including it as their compensation peers. - Two years prior to the addition, eight companies consider an event company as their peers. - Two years after the event, 13 companies select the event company as compensation peers. - Popularity increases by 62.5%! Tests of the Star-Chasing Effect - We use Faulkender and Yang (2013)’s discrete-choice peer selection model to formally test the star-chasing effect. - The sample includes all possible pairs of non-event firm-potential peer company (self-exclusive). - The dependent variable is Chosen as Peer = 1 if a company is selected by a non-event firm as its peer, = 0 otherwise. - Include 24 variables that model various economic factors related to the CEO labor market matching process. - Key variable of interest: Potential Peer Company is After Addition = 1 if a potential peer is an event company and the year is post addition = 0 otherwise

Table 4. The Star-Chasing Effect Chosen as Peer Potential Peer is an Event Company 0.05**   (2.53) Potential Peer is After Addition 0.09*** (4.05) WPS within one SD 0.20*** (13.50) Match (Two-Digit Industry) 0.94*** (36.82) Match (Three-Digit Industry) 0.57*** (20.64) Absolute Difference in Ln(Sales) -0.38*** (-24.87) Sales within 50–200% 0.01 (0.90) Assets within 50–200% 0.19*** (19.90) Market Cap within 50–200% 0.05*** (5.33) ROA within one SD & Positive -0.01 (-0.33) ROA within one SD & Negative 0.03 (0.68) Ret within one SD & Positive (11.29) Ret within one SD & Negative 0.10*** (14.03) Volatility within one SD 0.12*** (12.05) Match (Multiple Business-Segments) 0.05***   (4.32) Match (Single Business-Segment) 0.04** (2.50) Match (Multiple Geo-Segments) 0.21*** (14.90) Match (Single Geo-Segment) 0.29*** (12.66) Match (DJIA 30 Membership ) 1.01*** (8.96) Match (SP500 Membership) 0.42*** (24.57) Match (SP400 Membership) 0.08*** (4.26) Match (CEO is Chair) 0.09*** (7.86) Match (CEO is not Chair) -0.03** (-2.53) Talent Flows 0.34*** (5.82) Peer Selected Firm 1.36*** (72.07) Number of Peers 0.02*** (18.20) Constant -3.27*** (-60.75) Year F. E. Yes Observations 10,571,918 Pseudo R2 0.39

5. The Star-Chasing Channel Testing the Star-Chasing Effect on Compensation Contagion Sample: all non-event firms that report peer groups For each non-event firm in each year, we count the number of star event companies in its peer group and construct the following variables Instant Star-Chasing Exposure = No. of aspirational peers that joined the S&P last year Total no. of peer companies Cumulative Star-Chasing Exposure = No. of aspirational peers that joined the S&P in previous year𝑠 Total no. of peer companies The greater the exposure, the more sensitive is the non-event firm to event companies’ pay shocks.

Table 5. Compensation Contagion through the Star-Chasing Channel Panel A. Non-Event Firms’ Star-Chasing Exposure   Instant Star-Chasing Exposure Cumulative Star-Chasing Exposure No. Mean Median St. Dev. Non-Event Firms with Star-Chasing Exposure 297 0.0596 0.0556 0.0302 1,503 0.0974 0.0703 0.0714 All Non-Event Sample Firms 6,035 0.0029 0.0000 0.0145 0.0243 0.0548 Panel B. Compensation Contagion through the Star-Chasing Channel   Ln(TDC1) (1) (2) Instant Star-Chasing Exposure i,t 0.83 (1.47) Cumulative Star-Chasing Exposure i,t 0.55*** (3.57) Baseline Controls Yes Year F. E. Industry F. E. Observations 6,035 R-squared 0.58

6. The Peer-of-Peer Channel Sample: all non-event firms that report peer group information For each non-event firm in each year, we count the number of peers that include event companies in their peer groups, and construct the following variables Instant 2-Lag PoP Exposure = No. of non−event peers whose previous year′s peers include event companies two years ago Total no. of peer companies Cumulative 2-Lag PoP Exposure = No. of non−evnet peers whose previous year′s peers include past event companies Total no. of peer companies The greater the exposure, the more sensitive is the non-event firm to event companies’ positive pay shocks.

Table 6. Compensation Contagion through the Peer-of-Peer Channel Panel A. Non-Event Firms’ Peer-of-Peer Exposure   Instant Measure Cumulative Measure N Mean Median St. Dev. Non-Event Firms with 2-Lag Peer-of-Peer Exposure 3,234 0.2166 0.1667 0.1614 4,276 0.3782 0.3333 0.2419 All Non-Event Firms 5,252 0.1334 0.0769 0.1647 0.3079 0.2500 0.2632 Panel B. Compensation Contagion through the Peer-of-Peer Channel   Ln (TDC1) (1) (2) Instant 2-Lag Peer-of-Peer Exposure i,t 0.27*** (4.96) Cumulative 2-Lag Peer-of-Peer Exposure i,t 0.39*** (8.77) Baseline Controls Yes Year F. E. Industry F. E. Observations 5,252 R-squared 0.59

Table 7. Three Compensation Contagion Mechanisms: A Horse Race   Ln(TDC1) (1) (2) (3) (4) Instant Direct Competition Exposure i,t 1.04*** 0.025 (2.99) Instant Star-Chasing Exposure i,t 1.33 0.019 (1.26) Instant 2-Lag Peer-of-Peer Exposure i,t 0.25*** 0.042 (4.56) Cumulative Direct Competition Exposure i,t 0.79*** 0.038 (4.17) Cumulative Star-Chasing Exposure i,t 0.19** 0.010 (2.14) Cumulative 2-Lag Peer-of-Peer Exposure i,t 0.30*** 0.082 (5.77) Constant 3.59*** 3.63*** (39.70) (40.26) Baseline Controls Yes Year F. E. Industry F. E. Observations 5,252 R-squared 0.59

7. Does Compensation Contagion Propagate through Non-compensation Peer-Based Mechanisms? Is it possible that compensation contagion propagates through other connections among firms? Two falsification tests: Pseudo peers that are similar to actual compensation peers in industry and size; Pseudo peers that are randomly generated, following the sample distribution of each exposure measure. Is it possible the compensation contagion is mainly driven by competition in product markets instead competition for managerial talent? Horse race between exposures constructed based on product market peers and compensation peers.

Table 8. Pseudo Peers Based on Actual Compensation Peers’ Industry-Size   Ln(TDC1) Direct Competition Star-Chasing Peer-of-Peer Instant Measure Cumulative Measure (1) (2) (3) (4) (5) (6) Exposure Through Pseudo Peers 0.31 0.16 0.09 -0.06 (0.96) (1.15) (1.10) (-1.08) Exposure Through Actual Peers 0.90** 0.49*** 0.90 0.24*** 0.42*** (2.42) (2.79) (1.42) (4.18) (8.26) Constant 4.23*** 4.19*** 4.66*** 4.79*** (36.65) (36.85) (41.45) (41.99) Baseline Controls (same as Table 3, Panel B) Yes Year F. E. Industry F. E. Observations 5,230 4,447 R-squared 0.56 0.59

Table 8. Pseudo Peers Based on Randomly-Generated Peers Following Sample Distribution   Ln(TDC1) Direct Competition Star-Chasing Peer-of-Peer Instant Measure Cumulative Measure (1) (2) (3) (4) (5) (6) Exposure Through Random Pseudo Peers 0.01 0.00 0.03 0.02 (0.06) (0.07) (0.09) (0.01) (0.08) Exposure Through Actual Peers 1.29** 1.18*** 0.84 0.56*** 0.25*** 0.36*** (3.78) (7.06) (1.46) (3.55) (4.95) (8.74) Constant 4.72*** 4.73*** 4.71*** 4.75*** 3.59*** 3.60*** (45.77) (45.89) (45.86) (45.38) (36.63) (35.49) Baseline Controls (same as Table 3, Panel B) Yes Year F. E. Industry F. E. Observations 5,230 4,447 R-squared 0.58 0.59 0.57 0.60

Table 9. Industry Peers of Non-event Firms Panel A. Direct Competition Channel   Ln(TDC1) Instant Measure Cumulative Measure (1) (2) (3) (4) Direct Competition Exposure Through Industry Peers 0.52 0.23 0.43** 0.08 (1.29) (0.56) (1.98) (0.35) Direct Competition Exposure Through Compensation Peers 1.29*** 1.19*** (3.56) (6.54) Constant 3.18*** 3.19*** 3.23*** (27.36) (27.52) (27.25) (27.72) Baseline Controls (same as Table 3, Panel B) Yes Year F. E. Industry F. E. Observations 5,745 R-squared 0.57 0.58

Table 9. Industry Peers of Non-event Firms Panel B. Star-Chasing Channel   Ln(TDC1) Instant Measure Cumulative Measure (1) (2) (3) (4) Star-Chasing Exposure Through Industry Peers -1.73 -1.82 0.19 -0.09 (-1.62) (-1.52) (0.74) (-0.32) Star-Chasing Exposure Through Compensation Peers 0.76 0.60*** (1.30) (3.60) Constant 3.16*** 3.17*** 3.18*** 3.08*** (27.40) (27.45) (27.26) (25.30) Baseline Controls (same as Table 3, Panel B) Yes Year F. E. Industry F. E. Observations 5,745 R-squared 0.57 0.58

Table 9. Industry Peers of Non-event Firms Panel C. Peer-of-Peer Channel   Ln(TDC1) Instant Measure Cumulative Measure (1) (2) (3) (4) 2-Lag Peer-of-Peer Exposure Through Industry Peers 0.06 -0.01 0.13** 0.00 (0.85) (-0.10) (2.18) (0.06) 2-Lag Peer-of-Peer Exposure Through Compensation Peers 0.28*** 0.39*** (4.76) (7.76) Constant 5.09*** 5.12*** 5.15*** 5.27*** (12.61) (13.01) (12.75) (12.74) Baseline Controls (same as Table 3, Panel B) Yes Year F. E. Industry F. E. Observations 4,962 R-squared 0.57 0.58

8. Does Weak Governance Amplify Compensation Contagion? Five governance quality measures - Classified board = 1 if the non-event firm has a classified board. - Co-opted board = 1 if the percentage of co-opted directors is above the sample median. - High G-Index = 1 if the GIM Index is above the sample median. - Low CEO ownership = 1 if the non-event firm’s CEO ownership is below the sample median. - Low IO HHI = 1 if the non-event firm’s institutional ownership concentration metric is below the sample median Governance Score = 5 – (Classified Board + Co-Opted Board + High G-Index + Low CEO Ownership + Low IO HHI). A non-event firm is said to have strong governance if its corporate governance score is at or above the sample median.

Table 10. Corporate Governance and Compensation Contagion   Direct Competition Star-Chasing Peer-of-Peer (1) Instant Measure (2) Cumulative Measure (3) (4) (5) (6) Direct Competition Exposure *Weak Governance 0.71 1.08*** (1.64) (5.27) Direct Competition Exposure *Strong Governance 1.94*** (3.99) 1.36*** (5.76) Star-Chasing Exposure *Weak Governance 1.21 0.73*** (3.92) Star-Chasing Exposure *Strong Governance 0.52 0.29 (0.64) (1.23) 2-Lag Peer-of-Peer Exposure *Weak Governance 0.26*** 0.40*** (4.24) (8.63) 2-Lag Peer-of-Peer Exposure *Strong Governance 0.28*** 0.38*** (3.85) (7.04) Baseline Controls Yes Year F.E. Industry F.E. Observations 6,035 5,252 R-squared 0.59 0.58 F-Stat.: Strong Governance = Weak Governance 3.96** 1.00 0.40 3.78** 0.12 0.26

7. Do Labor Unions Mitigate Compensation Contagion? Huang, Jian, Lie, and Que (2016) show that firms with strong labor unions tend to pay their CEO less. Following prior studies (Klasa, Maxwell, and Ortiz-Molina, 2009; and Huang, et al., 2016), we use the industry-level unionization rate as a proxy for the power of labor unions at a firm. Unionization rate = the percentage of industry’s total labor force as employee union members (industry is defined at 2-digit SIC level). A firm has High Unionization if its industry’s unionization rate is above the sample median, and Low Unionization otherwise.

Table 11. Labor Unions and Compensation Contagion   Direct Competition Star-Chasing Peer-of-Peer (1) Instant Measure (2) Cumulative Measure (3) (4) (5) (6) Direct Competition Exposure * High Unionization 0.81* 0.66*** (1.93) (2.89) Direct Competition Exposure * Low Unionization 1.65*** 1.54*** (3.33) (6.71) Star-Chasing Exposure * High Unionization 0.54 0.70*** (0.77) (3.62) Star-Chasing Exposure * Low Unionization 1.20 0.43* (1.33) (1.94) 2-Lag Peer-of-Peer Exposure * High Unionization 0.30*** 0.41*** (4.32) (8.05) 2-Lag Peer-of-Peer Exposure * Low Unionization 0.22*** 0.35*** (3.24) (7.15) Baseline Controls Yes Year F.E. Industry F.E. Observations 6,035 5,252 R-squared 0.59 F-Stat.: Low Unionization = High Unionization 1.72 8.05*** 0.35 0.98 1.87 1.45

Final Question: Is Compensation Contagion Asymmetric? According to Gabaix and Landier (2008), compensation contagion is asymmetric. - If 10% of firms double their CEOs’ compensation, the compensation of all CEOs doubles. - If 10% of firms half their CEOs’ competitors, the compensation of all CEOs decreases by a merely 9%. We focus on companies removed from the S&P 500 to test this effect. Companies that are removed from the S&P 500 lower their CEOs’ compensations (not surprising). These companies’ impact on other firms’ CEO compensation is very limited: - Fewer firms consider them as their equal (or aspirational peers) in the CEO labor market; - The contagiousness of these deleted companies in the peer network reduces significantly.

Table 12. Is Contagion Asymmetric? Panel A. Decreases in CEO Compensation after Deletion from the S&P 500   Ln(TDC1) (1) (2) Deleted Company 0.16*** 0.14*** (3.50) (9.69) After Deletion -0.17*** -0.21*** (-2.98) (-7.69) Constant 3.47*** 3.50*** (37.87) (17.78) Baseline Controls Yes Year F. E. Industry F. E. Observations 11,163 33,003 R-squared 0.56 0.52

Table 12. Is Contagion Asymmetric? Panel B. Reduced Likelihood of Being Benchmarked by Other Firms after Deletion from the S&P 500 Chosen as Peer Potential Peer is a Deleted Company 0.11*   (1.76) Potential Peer is After Deletion -0.19*** (-2.99) Constant -6.52*** (-52.74) Controls (Same as Table 4) Yes Year F. E Observations 10,571,918 R-squared 0.38

Table 12. Is Contagion Asymmetric? Panel C. The Asymmetric Nature of Compensation Contagion   Ln(TDC1) (1) Direct Competition (2) Star-Chasing (3) Peer-of-Peer Cumulative Direct Competition Exposure to Addition Events 1.18*** (6.91) Deletion Events 0.16 (0.45) Cumulative Star-Chasing Exposure to Addition Events 0.55*** (3.52) Cumulative Star-Chasing Exposure to Deletion Events 0.09 (0.12) Cumulative Peer-of-Peer Exposure to Addition Events 0.36*** (7.47) Cumulative Peer-of-Peer Exposure to Deletion Events 0.10 (1.51) Baseline Controls (same as Table 3, Panel B) Yes Year F.E. Industry F.E. Observations 6,035 5,252 R-squared 0.59 0.58 F-stat: Exposure to Addition Events = Exposure to Deletion Events 5.41** 3.41* 8.10***

Concluding Remarks This paper shows a few highly successful and visible firms can elevate the compensation level of other firms. It highlights the importance of peer benchmarking in contributing to compensation contagion. We identify three contagion channels in shaping the CEO compensation. We show how governance and labor unions affect compensation contagion. Finally, it is one of the first papers to empirically verify the asymmetric nature of compensation contagion.