Management Accounting Section Midyear Meeting

Relative Performance Evaluation and CEOs' Incentives for Strategic Differentiation

• In Event: Relative Performance Evaluation

Abstract

Do CEOs stick with industry-common strategies and avoid differentiating their firms' strategies when their compensation contracts entail relative performance evaluation (RPE)? Our theoretical and empirical findings suggest so. We integrate a CEO's strategic differentiation decision into a moral hazard model. Differentiation can improve firm performance but decreases the exposure to peer-group common risk factors. The model predicts that CEOs of RPE firms will choose a sub-optimally low level of differentiation because RPE protects them from peer-group common risks but not from risks associated with strategies that are innovative to the peer group. Hence, to realize gains from differentiation, shareholders do not fully filter peer-group performance from CEO compensation. Consistent with predictions from our model, we observe empirically that RPE firms' exposure to peer-group common risk increases. We address concerns about factors that jointly affect firms' RPE adoption and future peer-group correlation levels with a two-stage-least-squares procedure. We exploit variance in RPE usage that is exogenously induced by compensation consultancies' distinct styles. The effect of RPE on exposure to peer-group risk is more pronounced if the benchmark in RPE contracts is a specific peer group instead of a broad market index and is less pronounced if benefits from differentiation are likely to be high. Finally, we find that RPE CEOs change their resource allocation strategies and more strongly adapt resource allocation strategies of peer firms.

Author

• Peter Schaefer, Technische Universität München