Dirk Jenter

CEO Turnover and Relative Performance Evaluation

This paper shows that CEOs are fired after bad firm performance caused by factors beyond their control. Standard economic theory predicts that corporate boards filter out exogenous industry and market shocks from firm performance before deciding on CEO retention. Using a hand-collected sample of 3,365 CEO turnovers from 1993 to 2009, we document that CEOs are significantly more likely to be dismissed from their jobs after bad industry and, to a lesser extent, after bad market performance. A decline in industry performance from the 90th to the 10th percentile doubles the probability of a forced CEO turnover.

Employee sentiment and stock option compensation

Abstract The use of equity-based compensation for rank-and-file employees is a puzzle. We analyze whether the popularity of option compensation may be driven by employee optimism, and show that optimism by itself is insufficient to make option compensation optimal. The crucial insight is that firms compete with financial markets as suppliers of equity to employees and that employees’ access to the equity market restricts firms’ ability to profit from employee optimism. Firms must be able to extract some of the implied rents even though employees can purchase company equity in the financial markets. Such rent extraction becomes feasible if employees prefer the stock options offered by firms to the equity offered by the market, or if the traded equity is overvalued. We provide empirical evidence that firms use broad-based option compensation when boundedly rational employees are likely to be excessively optimistic about company stock, and when employees are likely to strictly prefer options over stock.

Understanding High-Powered Incentives

This paper analyzes the effect of restricted stock options and restricted stock grants on managerial effort incentives. The combination of low managerial valuations of options and inefficient incentive creation makes options inferior means of inducing managerial effort incentives. The negative covariance of the option delta or pay-for-performance with marginal utility reduces ex-ante effort incentives substantially, and the more so the higher the volatility of stock returns. Pay-for-performance is shown to be a biased measure of managerial incentives. It systematically understates the incentives generated by equity holdings relative to the incentives generated by option grants. The bias is again increasing in the volatility of stock returns, offering a potential explanation for the empirical finding that pay-for-performance does not decrease with volatility as predicted by the optimal contracting framework. The private trading behavior of managers is shown to be crucial for the optimal design of compensation contracts. Assuming that managers invests only into the riskless asset makes option compensation look considerably more effective than it is: The cost of compensating the executive is underestimated, and incentive effects are overestimated. The benefit of indexing compensation schemes to market or industry returns is reduced or even eliminated when the manager is able to freely trade the index through her private account.