The “short-termism” induced by executive pay schemes is a major problem for firms and investors. Allen H. Huang of HKUST, together with overseas colleagues, provides important new insights into the negative consequences of executive myopia. The researchers examined the share repurchasing and mergers-and-acquisitions (M&A) behavior of firms whose CEOs have vesting equity. The results suggest that CEOs initiate such actions to inflate short-term stock prices and thus make selling equity more lucrative. This has negative long-term consequences for firm value.
Executive short-termism—an excessive emphasis on short-term performance at the expense of long-term interests—is widely studied. “The concern with short-term pay incentives,” say the researchers, “is that they lead the CEO to take myopic actions that boost the stock price at the expense of long-run value.” However, although contracts that encourage executive myopia are widely believed to be harmful, this is difficult to prove. To explore the links between CEO compensation, short-term stock prices, and long-term value, Huang and colleagues focused on “two corporate actions whose long-term consequences can be estimated”: share repurchases and M&A.
Equity that vests during CEO tenure is a classic short-term incentive. As the authors explain, “we use vesting equity as our measure of short-term incentives because executives are likely to sell equity upon vesting to diversify their risk.” By tying CEOs’ compensation to the stock price upon selling, vesting equity arguably encourages myopic behavior. To test this assumption, the authors analyzed data on actual repurchases from 10-Q and 10-K filings. The results supported their hypothesis: between 2006 and 2015, equity scheduled to vest was correlated with the probability of share repurchasing and of M&A.
Stock repurchases are not always myopic; they can also be efficient. However, the authors found that increases in vesting equity were also associated with lower returns for up to four years after repurchases and M&A announcements. Clearly, vesting equity as a form of short-term compensation is linked to value-destroying CEO actions. The persistence of this effect implies that investors do not recognize the risk. “If the market were fully efficient,” the authors say, “the long-term impact would immediately be capitalized upon announcement.”
Further evidence of the myopic nature of these actions came from trends in stock returns before repurchases. Theoretically, repurchases could increase because CEOs with vesting equity identify and purchase underpriced stock, benefiting the firm. However, the data ruled this out. According to the researchers, “vesting equity is associated with significantly higher stock returns in the month prior to repurchases, inconsistent with the CEO buying back underpriced equity.”
Vesting equity was found to only increase the likelihood of cash-financed M&A. M&A deals that were fully or partly financed by equity, rather than cash, were not correlated with equity vestment dates. The authors propose that cash-financed deals receive the most positive market reactions, as they “avoid the dilution associated with equity financing.” Only M&A deals with high announcement returns are useful for boosting short-term stock prices, irrespective of their long-term consequences.
The researchers also identified a mechanism by which vesting-induced M&A hurts long-term value: goodwill impairment. Equity vesting-linked M&A deals were associated with goodwill losses in the following years, suggesting that equity vesting induces CEOs to “overpay for acquisitions, generating goodwill that is subsequently written down.”
The study supports the widespread but unproven concerns around short-term CEO benefits. To curb this problem, the authors recommend enforcing board scrutiny of CEO actions around vestment dates and spreading out large equity grants across the year.