Relative Performance Evaluation and the Peer Group Opportunity Set

Abstract

We develop an algorithm that mimics the relative performance evaluation (“RPE”) peer selection process used for CEOs’ incentive plans. Our algorithm constructs the portfolio of peer firms that exhibits the highest in-sample stock performance correlation with the focal firm, which we then use as a counterfactual to better understand firms’ actual RPE choices. We find that most firms use RPE in a manner consistent with optimal risk-sharing; firms are more likely to use RPE when a viable peer group is available, and they construct peer groups that are about as effective as possible at shielding CEOs from outcome risk. However, some firms choose not to use RPE even when an effective peer group is available; non-reliance on RPE in these cases appears to be related to competitive sabotage concerns. Other firms choose to use RPE, but benchmark against a peer group that is not effective from a risk-sharing perspective; reliance on RPE in these cases appears to be related to rent-extraction. Collectively, our study improves the understanding of firms’ ex ante ability to construct an effective peer group, and thereby sheds new light on why firms do—and perhaps more importantly, why some firms do not—use relative performance evaluation in their CEOs’ incentive plans.