Academics, practitioners, and policymakers fret over the short-termism of executive incentives. A bane highlighted by Bebchuk and Fried (2004) is that CEOs are rewarded for short-term increases in the stock price. Their main proposal for pay reform was to escrow the CEO’s equity for longer (Bebchuk and Fried 2010). In August 2017, the UK government’s response to its green paper on corporate governance reform also proposed increasing the minimum vesting period of equity, from three to five years.
Critics of short-term incentives argue that they lead the CEO to take myopic actions that boost the short-term stock price at the expense of long-run value. These critics however, rarely back this up with rigorous evidence. This is partly confirmation bias – willingness to accept 'evidence' that confirms one’s prior belief, no matter how flimsy. Since the current political environment is distrustful of businesses, people may be more willing to accept 'evidence' that CEOs act in ways that destroy value for personal gain. For example, a recent McKinsey study showed that firms that invested more have enjoyed superior long-run returns, and interprets this finding as “finally, evidence that managing for the long term pays off” (Barton et al. 2017).
This study has become highly influential, and been widely publicised, potentially because the results confirm prior beliefs. It is equally plausible, however, that causality is in the other direction. A basic Finance 101 class tells us that firms with better future prospects should invest more today.
Gathering evidence of the long-term consequences of short-term incentives is challenging for two main reasons:
- Endogeneity: It is difficult to demonstrate a causal effect of short-run horizons since the CEO’s horizon is endogenous. For example, showing that CEOs cut investment when they sold shares would not imply that selling shares caused the CEO to cut investment. It could be that future prospects were poor, which caused the CEO to both sell shares and cut investment.
- Were CEO actions myopic? Even if one could show that CEO incentives caused particular actions, it is difficult to show that such actions eroded long-term value.
The effect of short-term incentives
Edmans et al. (2017a) address the first challenge by introducing a new measure of CEO incentives: the amount of stock and options scheduled to vest in a given quarter. They show that CEOs sold equity in the same quarter that it vested, so vesting equity has led to short-term stock price concerns. In addition, how much equity vests in a given quarter depends on a decision taken several years previously. For example, if in Q4 2014, the board gave the CEO equity with a three-year vesting period, it would vest in Q4 2017. Since the CEO expects to sell this equity in Q4 2017, the CEO wants to maximise the stock price in Q4 2017. But, the stock price concerns were caused by a decision taken in Q4 2014, when the board would have been unlikely to have known the firm’s prospects as of Q4 2017. Thus, any action in Q4 2017 (such as an investment cut) was likely caused by vesting equity, rather than future prospects.
The authors also show that vesting equity was correlated with reductions in investment growth. Since one can only observe the level of investment, and not its quality, it is difficult to assess the value implications of any investment cut. This makes it difficult to decide whether the cut was myopic. If the scrapped investments would have been wasteful, the implication of short-term stock price concerns is very different – far from inducing myopia, the CEO reined in empire-building or excess expenditure. The authors conduct cross-sectional tests that suggest myopia, but are unable to use long-run stock returns to study the long-term consequences of investment cuts, because long-term stock returns would be affected by many firm decisions other than investment.
Short-term incentives and long-term value
In our most recent work on the topic (Edmans et al. 2017b), we study the long-term consequences of short-term incentives by examining two corporate actions with similarities to investment cuts, but whose long-run consequences could be measured more accurately:
- Repurchases: These boost the short-term stock price (Ikenberry et al. 1995). CEOs with short-term concerns might have incentives to undertake them. Also like investment cuts, repurchases can either be myopic (if financed by scrapping valuable projects) or efficient (if financed by free cash that would otherwise have been wasted). The long-term stock return measures the return that the firm obtains from the repurchased stock. So, unlike investment cuts, the long-term stock return can be used to diagnose the value implications of the repurchase, even if the return was not caused by the repurchase.
- M&A: This has different advantages to repurchases. First, M&A has an announcement date, allowing us to cleanly calculate short- and long-term returns. Second, M&A is a much more significant event than an investment cut (or repurchase) – it is arguably the most transformative corporate decision that a firm can undertake – and so it is likely that at least a significant portion of long-run stock returns would be attributable to the M&A. Indeed, prior research (e.g. Agrawal et al. 1992) has used long-run stock returns to assess the long-term value implications of M&A.
We study the relationship between vesting equity and repurchases, and vesting and M&A announcements, between 2006 and 2015. This is a longer sample period than previous research, which allows us to study long-term returns. In the data, a one-standard-deviation increase in vesting equity is associated with a 1.2% increase in a firm’s likelihood of conducting a share repurchase in a given quarter, compared to the unconditional repurchase probability of 37.5%. This translates into $6.16m annualised, compared to the finding in Edmans et al. (2017a) of an annualised fall in investment of $1.8m. While economically meaningful, this magnitude is also plausible: a too-large, myopic repurchase may have prompted the board to step in and block it.
We find similar results for M&A. A one-standard deviation increase in vesting equity is associated with a 0.6% increase in a firm’s likelihood of announcing an M&A in a given quarter, compared with the unconditional probability of 15.8%.
The short- and long-term returns to repurchases and M&A
Again, we find a consistent picture across both corporate events. Vesting equity increases short-term returns, but reduces long-term returns. We would expect this result if the CEO has taken myopic actions with negative long-term consequences.
A one-standard-deviation increase in vesting equity is associated with an annualised 0.61% higher return over the two quarters surrounding a repurchase, but a 1.11% (0.75%) lower return during the first (second) year after the repurchase. For M&A, the negative association with long-run returns persists for longer. A one-standard-deviation increase in vesting equity is associated with an annualised 1.47% higher return over the two quarters surrounding an M&A announcement, but a 0.81%, 0.35% (insignificant), 0.72%, and 0.62% lower return in the first, second, and third, and fourth subsequent years.
The long and the short of it
The results are consistent with Graham et al. (2005), who used a survey to find that 78% of executives would sacrifice long-term value to meet earnings targets. We studied a CEO’s actual behaviour and found that short-term incentives indeed have negative long-term consequences. The current debate on CEO pay typically focuses on how big it is. As a consequence, in the UK and US, there will soon be disclosure of pay ratios. Our results suggest that the horizon of CEO incentives is a more important dimension to reform. For an example of potential reforms, see Edmans and Gabaix (2009).
Agrawal, A, J F Jaffe, and G N Mandelker (1992), “The post‐merger performance of acquiring firms: A re‐examination of an anomaly,” Journal of Finance 47(4): 1605–1621.
Bebchuk, L A and J M Fried (2004), Paying without performance, Harvard University Press.
Bebchuk, L A and J M Fried (2010), “Paying for long-term performance,” University of Pennsylvania Law Review 158(7): 1915–1959.
Barton, D, J Manyika, and S K Williamson (2017), “Finally, evidence that managing for the long term pays off,” Harvard Business Review, 7 February.
Edmans, A, V W Fang, and A H Huang (2017), “The Long-term Consequence of Short-term Incentives,” ECGI Finance Working Paper No. 527/2017.
Edmans, A, V W Fang, and K A Lewellen (2017), “Equity vesting and investment,” Review of Financial Studies 30(7): 2229–2271.
Edmans, A and X Gabaix (2009), “Incentive accounts: A solution to executive compensation”, VoxEU.org, 24 June.
Graham, J R, C R Harvey, and S Rajgopal (2005), “The economic implications of corporate financial reporting,” Journal of Accounting and Economics 40(1-3): 3–73.
Ikenberry, D, J Lakonishok, and T Vermaelen (1995), “Market underreaction to open market share repurchases,” Journal of Financial Economics 39(2-3): 181–208.