Relative Performance Evaluation and Strategic Differentiation

Abstract

ABSTRACTI predict that relative performance evaluation (RPE) CEOs avoid strategic differentiation and increase the correlation of their firms’ returns with that of their peers. This prediction follows from a moral hazard model integrating strategic differentiation decisions: Differentiation enhances performance but exposes firms to risks not shared with peers, and the weakening RPE’s risk-shielding effect. Consistent with my prediction, I find evidence that changes in peer-group correlation are higher for RPE than non-RPE firms. This effect is more pronounced if benefits from differentiation are low, RPE benchmarks are industry specific, or RPE grants are large. Additional analyses provide direct evidence that RPE CEOs differentiate strategies less from industry-common strategies than non-RPE CEOs. To address endogeneity concerns, I present a two-stage least-squares approach exploiting variance in RPE usage induced by compensation consultants’ distinct styles. My analyses suggest strategic differentiation decisions to help explain why many boards do not completely filter peer performance from CEO compensation.Data Availability: All data are obtained from commercially available databases, including Compustat, CRSP, Execucomp, I/B/E/S, and ISS Incentive Lab.JEL Classifications: M12; M21; M41; M52.