Research

The rationale behind CEO compensation

Studies show that CEOs face a significant risk to their future earnings and employment prospects when taking a job at a company with existing, or potential financial problems. But new research by accounting Professor Steve Hillegeist and co-authors shows that such executives can expect to be compensated, often handsomely, for putting their human capital at risk.

2013-03-14

Taking the helm of a company with financial challenges could be the opportunity of a lifetime or a career-ending misstep for an ambitious chief executive officer.

A successful turn-around can cement a CEO’s reputation as a skilled corporate leader with significant upside to future earning power, or so-called human capital. But failure, particularly if a bankruptcy is involved, could land a top executive out of a job with a tainted reputation and dismal prospects for future employment — even if the circumstances were largely out of his or her control.

Studies show that CEOs face a significant risk to their future earnings and employment prospects when taking a job at a company with existing, or potential financial problems. But new research by Accounting Professor Stephen Hillegeist and co-authors shows that such executives can expect to be compensated, often handsomely, for putting their human capital at risk.

The paper provides the first empirical evidence that CEOs can demand and receive higher salaries as compensation for risking their human capital when agreeing to lead financially risky companies, Hillegeist said.

The findings have broad human resource implications in that they show companies with existing, or possible, financial problems must expect to pay a premium to obtain talented leaders. The research also suggests that regulatory efforts to limit executive compensation at financially distressed firms could backfire.

The high risk premium

In his paper, “Human Capital Risk and CEO Compensation,” Hillegeist reports that top executives who go to work for companies with more financial distress risk are often paid a substantial premium for putting their careers on line.

Hillegeist and his research associates surveyed 2,032 new CEOs hired at U.S. corporations between 1992 and 2007 and concluded that those who joined firms with even a moderate risk for financial distress received first-year compensation packages that were 18.4 percent higher than those offered to executives at companies with little or no financial risk. And, those CEOs who went to work for companies with higher levels of financial risk received a whopping 27.5 percent compensation premium.

The dollar amounts are significant. With a median first-year compensation package worth $2.19 million, an 18.4 percent premium translates to an additional $403,000 and 27.5 percent into an additional $602,000.

While earlier studies examined the compensation of executives who joined already financially-distressed firms, Hillegeist said they ignored the possibility that new CEOs may require a substantial compensation premium in order to bear even low levels of risk to their human capital.

“Affected firms could wind up with lower quality managers since the most talented candidates will have better options elsewhere,” Hillegeist said.

Finally, the study finds some rationale behind the seemingly irrational compensation packages some CEOs receive.

“Our research shows that part of what may appear to be an exorbitantly high compensation package may actually be a reasonable risk premium,” Hillegeist said.

Unpacking CEO pay

Hillegeist worked on the project with Rachel Hayes, a chaired professor of accounting at the University of Utah in Salt Lake City and Woo-Jin Chang, an assistant professor of accounting at INSEAD’s European campus near Paris, where Hillegeist worked between 2005 and 2010.

During his career, Hillegeist has developed a growing interest in executive compensation and the various components and rationales that make up the soaring pay packages offered many top CEOs.

“I am intrigued by what might be driving these seemingly exorbitant salaries,” he said. “Is it bad governance and they are simply being paid too much? Or are there economically efficient explanations?”

Earlier research by Hillegeist, “The Incentives of Compensation Consultants and CEO Pay,” studied the premise that compensation consultants have an incentive to recommend higher executive pay levels in order to obtain additional work from the CEO down the line. He found no evidence that potential conflicts of interests by compensation consultants were associated with either higher CEO compensation or lower incentives.

It was a desire to make some sense out of soaring executive salaries that drew Hillegeist and his colleagues to their current research project.

“We wanted to see if human capital risk was a factor in CEO compensation,” Hillegeist said.

Earlier studies demonstrated that executives who join firms with shaky financial prospects face considerable risk to their human capital, described as a combination of future employment opportunities and expected compensation levels.

Most CEOs lose their jobs in a bankruptcy. Studies in 1989 and 1995 concluded that CEO turnover rates after a bankruptcy range from 70 percent to 90 percent. Research in 2004 found that only 12 percent of dismissed CEOs land comparable positions with other public companies. And, if they do, it is likely at a much smaller firm at a greatly reduced salary. The studies found that leaders of bankrupt firms are often viewed as “tainted and incompetent” regardless of the circumstances leading to the firm’s financial difficulties.

Indelible stain

In “Human Capital Risk and CEO Compensation” Hillegeist points to George Shaheen, CEO of bankrupt Internet grocer Webvan Inc. Despite leading Andersen Consulting during a period of record annual revenue growth before moving to Webvan, Shaheen was unable to find another executive position. He blamed Webvan’s demise. “I will never bounce back,” he said. “That’s the law of the jungle.”

Demonstrating that executives often receive a substantial compensation premium for subjecting themselves to such career risks proved to be a daunting multi-year long process for Hillegeist and his colleagues. It included sifting through an enormous amount of data, much of it by hand, and controlling for a myriad of external factors that impact executive compensation packages.

They started by culling Standard & Poor’s ExecuComp databases that track executive compensation at major U.S. corporations. That yielded a list of 2,032 new CEOs that were hired at those firms between 1992 and 2007.

Next they examined the companies themselves to determine which ones showed signs of existing or potential financial distress risk at the time the CEO was hired. They used a formula based on the Black-Scholes-Merton option pricing model that Hillegeist earlier developed to estimate a firm’s probability of bankruptcy. The research also looked at each firm’s Standard & Poor’s credit rating and their O-Score, which is an accounting-based measure of bankruptcy risk.

Firms that showed signs of financial trouble were divided into two categories: those with moderate distress risk and those with a greater than moderate risk.

One of the biggest challenges, according to Hillegeist, was identifying and controlling for the myriad of factors that influence executive compensation other than human capital risk due to a firm’s financial distress.

“We had to try to eliminate other possible explanations,” Hillegeist said. The team looked at various salary determinants that were specific to the CEO and to the companies.

CEO-specific pay determinants included age, whether the executive was hired from within or outside the company and whether the CEO would also serve as chairman.

Interestingly, new CEOs who are older tend to be less highly compensated than their younger counterparts are while those hired from outside the firm receive a substantial premium compared to those who are internally promoted. Those whose job also included serving as chairman received higher pay levels. These factors had to be taken into consideration in their research design.

An executive’s skill level also influences compensation and Hillegeist’s group used a number of factors to asses an executive’s ability, including (1) media mentions, or “hits”, (2) future return on assets and (3) meeting or beating earnings forecasts. The study also looked at jobs held less than two-years as an inverse measure of a CEO’s skills. Such short-tenures may reflect situations that failed to work out due a manager’s lack of ability.

The research used seven firm-specific variables to control for other economic factors that have a bearing on CEO compensation. The study used the firm’s stock return volatility as well as its leverage, measured by the ratio of long-term debt to total assets.

Because larger firms with greater growth potential and strength require higher quality and more highly-compensated managers, additional measures were used to control for company size and growth opportunities.

“Human Capital Risk and CEO Compensation” used sales to control for a firm’s size and the book-to-market ratio and lagged annual sales growth to proxy for a firm’s investment potential. It also took into account the return produced by the firm’s stock for the 12 months prior to the CEO’s start date. Such trailing returns are thought to be positively associated with compensation levels, particularly for internally-hired CEOs, which represented 78 percent of Hillegeist’s sample.

Finally, the study looked at the ratio of cash flow from operations to total employees in order to identify and control for any cash flow constraints that may affect a firm’s compensation levels.

Even moderate risk drives compensation

“We kept asking ourselves is there anything else that could be impacting our findings and how to control for it,” Hillegeist said.

At the end of the day, Hillegeist believes his group was able to eliminate the other likely factors that could be causing a spike in new-CEO pay levels at companies at risk for financial distress, leaving only one likely explanation. The higher pay levels were a result of a compensation premium being paid to executives for putting their human capital on the line in accepting a position at a company with existing or potential risk for financial distress.

“I am confident we have solid research design,” Hillegeist said. “Companies need to realize that even a moderate amount of risk will require higher pay for a given level of talent.”

“Human Capital Risk and CEO Compensation” is now under review for publication in a leading management journal.

Meanwhile, Hillegeist has moved on to his next research project. He is looking at the long-term performance consequences for companies that creatively manage their earnings to avoid violating provisions of their debt covenants.

Bottom line

• CEOs who join financially-troubled companies put their future earnings prospects and career opportunities on the line.
• If a firm deteriorates into bankruptcy, most CEOs lose their jobs.
• Their reputations are often “tainted” and many are unable to find comparable executive positions.
• Their career plights are often irrespective of whether the circumstances were beyond their control.
• For putting their human capital on the line, executives often demand and receive a substantial risk premium.
• The size of the premium increases with the amount of financial risk facing the employer.

Accounting Behavioral Managerial Accounting