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Review of Quantitative Finance and Accounting

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01.10.2007 | Original Paper

Changes in CEO compensation structure and the impact on firm performance following CEO turnover

verfasst von: David W. Blackwell, Donna M. Dudney, Kathleen A. Farrell

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 3/2007

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Abstract

We document changes in compensation structure following CEO turnover and relate them to future performance. Compared to outgoing CEOs, incoming CEOs derive a significantly greater percentage of their compensation from option grants and new stock grants. The voluntary turnover sample shows similar changes in compensation structure while the forced turnover sample results suggest that new stock grants drive the significant increase in incentive compensation following turnover. Post-turnover performance is positively associated with new stock grants as a percentage of total compensation in the full sample and when analyzing forced and voluntary turnovers separately. We find limited evidence that future operating income is positively associated with option grants following forced turnover. Post-turnover improvement in operating income is positively associated with an increase in new stock grants for the incoming relative to the outgoing CEO.

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Several studies examine the poor performance hypothesis, which states that effective corporate boards replace CEOs when firm performance is poor. Coughlan and Schmidt (1985), Warner et al. (1988), Weisbach (1988), and Blackwell et al. (1994) find that the probability of a CEO change is inversely related to the firm’s performance.

We also analyze total stockholdings in place of new stock grants since total stockholdings provide incentives although they are not part of the current compensation package. When we measure the percentages of total compensation based on salary and bonus, total stockholdings and option grants our results differ. Total CEO stockholdings are significantly higher for the outgoing CEO relative to the incoming CEO. Option grants remain significantly greater for the incoming CEO relative to the outgoing CEO but total incentives become significantly lower for the incoming CEO relative to the outgoing CEO.

Murphy and Zimmerman (1993) note that sample selections based on the Forbes 500 may bias a sample toward large, surviving, and growing firms. In an attempt to address this bias, we allow firms to enter or exit the panel over time. In addition, arguably we could choose a sample of turnovers after the passage of OBRA of 1993 to avoid the possibility of firms adjusting compensation structure due to the legislation. We did not choose this sample period since it would reduce the time horizon available for turnover. Since we require compensation data 1 year after turnover and firm performance data 2 and 3 years after turnover, our turnover sample period would be much shorter (1994–1999) and still may capture the effect of the legislation as more firms approach the $1 million salary cap.

We define regulated industries similarly to Fama and French (1986) and DeFusco et al. (1991). We analyze only industrial firms to economize on data collection costs without unduly limiting the generalizability of our results. Smith and Watts (1992) and Gaver and Gaver (1993) argue that regulated firms have systematically different compensation schemes because regulation restricts the investment opportunity set.

For comparison, Huson et al. (2001) define 20% of their CEO turnovers as forced departures over the sample period 1983–1994. Denis and Denis (1995) classify between 18% and 21% of top executive changes as forced depending on the data restrictions applied.

Our approach is similar to Gaver and Gaver (1995) and Collins et al. (1995).

We estimate restricted grants by analyzing changes in the number of shares held during a given time period. If the number of shares held by a CEO decreased during the fiscal year, stock grants were assumed to be zero for that year.

We do not use number of shares granted in our analysis since our focus is on percentages of total compensation which requires us to value the individual compensation components.

We also analyzed changes in compensation structure using total CEO stockholdings in place of our proxy for the value of restricted stock grants. Total CEO stockholdings are significantly higher for the outgoing CEO relative to the incoming CEO. Option grants remain significantly greater for the incoming CEO relative to the outgoing CEO but total incentives become significantly lower for the incoming CEO relative to the outgoing CEO. These results are likely driven by the difference in firm tenure between the incoming and outgoing CEO. The incoming CEO has an average firm tenure of 20.8 years (median is 23). The average firm tenure for the outgoing CEO is 29.7 years (median is 33).

We also analyzed changes in compensation structure for forced and voluntary turnover using total CEO stockholdings in place of our proxy for the value of restricted stock grants. The results for each subsample are very similar to the full sample results discussed in footnote 9. Note also that 9 of the 30 forced turnovers resulted in an outside replacement, while only 1 of the 95 voluntary turnovers resulted in an outside replacement which will likely impact total stockholdings due to shorter firm tenures for outside replacements. The average firm tenure for the incoming CEO is 22.8 years in the voluntary departure sample and 14.3 years in the forced departure sample. The average firm tenure for the outgoing CEO is 31.4 years (voluntary sample) and 24.2 years (forced sample).

See Smith and Watts (1992), Gaver and Gaver (1993), Mehran (1995), and Yermack (1995) among others.

Using this performance measure eliminates the typical type of ‘big bath,’ which may affect accounting measures of performance that rely on net income. Most ‘baths’ involve write offs that impact net income but not operating income. As a robustness check, we also measure accounting performance using return on assets (ROA) measured as net income divided by total assets (e.g., Blackwell et al. 1994; Mehran 1995). The ROA results are qualitatively the same as the operating income results unless otherwise noted. All of the ROA results are available from the authors.

We use this method because the Manufacturing Sector Master File data used to compute the traditional Tobin’s Q is available only through 1987. Chung and Pruitt (1994) found no significant differences between the Tobin’s Q calculated using the traditional and the approximation methods. Barnhart and Rosenstein (1998) also used the Chung and Pruitt method for approximating Tobin’s Q.

Allgood and Farrell (2000) document that approximately 26% of CEOs turn over within the first 3 years of CEO tenure. Since we control for the same CEO remaining in office 3 years after turnover, we do not extend our performance analysis beyond 3 years since we would lose additional sample firms.

Mehran (1995) measures the standard deviation over a 10-year horizon. However, for the early turnovers in the sample, we do not have sufficient Compustat data to capture a 10-year horizon.

Our approach is similar to Parrino (1997) who argues that the likelihood of voluntary turnover appears to increase once a CEO reaches the age of 60, but does not increase linearly beyond the age of 60. We argue that the horizon problem is likely to become relevant as a CEO approaches retirement and would seem to increase once a CEO reaches the age of 60.

Also using operating income as the proxy for performance, Huson et al. (2004) find that performance improvements after CEO turnover tend to be in those firms that hire the incoming CEO from outside the firm.

If we partition the sample between inside and outside replacements, the inside replacement results more closely mimic those of the full sample as reported in Table 5. The outside replacement results are more difficult to interpret given the small sample sizes. The positive relation between new stock grants and future firm performance tends to be more similar to the forced turnover results reported in Table 6. The only notable difference is size of the coefficients and that a positive relation between new stock grants and ROA in year +2 is not significant in the outside replacement sample. We also find a negative relation between option grants and future firm performance.

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Titel: Changes in CEO compensation structure and the impact on firm performance following CEO turnover
verfasst von: David W. Blackwell
Donna M. Dudney
Kathleen A. Farrell
Publikationsdatum: 01.10.2007
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 3/2007
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-007-0034-y

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