Financial Distress Risk, Executive Compensation and the Executive Labour Market

Abstract

This paper analyses the effect of financial distress risk on executive compensation and executive labour market in UK. We find that financial distress risk has a negative and significant impact on the level of total compensation and the fraction of equity-based compensation for executives, who are newly hired from either outside or inside the firm. This negative impact is accentuated in firms with high bank debt suggesting that banks as creditors play an active monitoring role in determining executive compensation packages in firms with high financial distress risk. Further, our results indicate that firms with financial distress risk are less likely to hire CEOs with prior CEO experience. These results support the Edmans and Gabaix (2011)’s model that firms with high risk hire less skilled (i.e., less experienced) CEOs since the premium that more skilled CEOs demand to work in a high risk firm can be high.