Abstract
This study examines the effect of relative performance evaluation (RPE) on managers’ investment decisions and firm performance. Principal-agent theory suggests that RPE use in CEO compensation plans can improve incentive alignment when firm performance is affected by common shocks, thus motivating managers to increase shareholder wealth. I test this theory using contract details explicitly disclosed in proxy statements. I find that RPE firms are generally less likely to over- or under-invest than non-RPE firms, consistent with RPE use improving incentive alignment. I also find some evidence that RPE firms have higher total shareholder return (TSR) than similar non-RPE firms when contracting specifically on TSR. In addition, the positive effects of RPE on firm performance increase with the extent of common risk for firm and peer performance. Together, these results suggest that RPE use in CEO compensation plans reduces agency costs and improves incentive alignment.
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