Incentive Alignment Mechanisms Research Articles

Ancestral connections and corporate alliances

This paper studies how culture works as an implicit incentive alignment mechanism in corporate alliances. We measure the ancestral connection between different corporate headquarters places, using historical immigration from different countries to different areas of the U. S. When forming business alliances, the ancestral composition of the area where firms locate plays an important role in their choices of partners and the location of new ventures. Exploiting immigration to U.S. cities induced by WWI and the immigration acts of the 1920s, we find that ancestral connection driven by the supply-push component of historical immigrant inflows is associated with an increase in alliance intensity today. Finally, partnering firms experience significantly better performance when the ancestral connection between their headquarters or between their inventors is stronger. Shared values and beliefs between firms' key stakeholders likely underlie the role of ancestral connection.

HQ controls, agency costs, and procedural justice

AbstractResearch SummaryMonitoring, incentive alignment, and social controls are used to minimize the agency costs to headquarters (HQ) resulting from subsidiaries' opportunistic behaviors by aligning subsidiaries' behaviors and interests with those of the HQ. Subsidiaries' motivation to comply with these controls, however, is contingent on the social context that links the subsidiary to the HQ. In this context, we propose to identify procedural justice as a motivational contingency that shapes the conditions under which agency‐driven controls can effectively minimize agency costs. Our results show that monitoring and social control reduce agency costs when procedural justice is high, whereas the use of incentive alignment mechanisms can have the opposite effect.Managerial SummaryThe headquarters (HQ) of multinational corporations use control mechanisms to ensure the alignment of their subsidiaries with the organization's interests and goals. However, these mechanisms do not always provide value to the corporation since subsidiaries may exhibit varying levels of motivation to comply with such controls, resulting in behaviors that range from resistance to compliance and ceremonial compliance to genuine compliance. We argue that the procedural justice applied by the HQ influences subsidiaries' motivation to comply with the controls implemented by the HQ. We find that in subsidiaries that operate in such a climate of fairness, monitoring based on rules, processes and procedures as well as social control can provide value, whereas the use of incentive alignment can lead to the opposite results.

CEO INCENTIVE ALIGNMENT: INTENSITY AND TIME HORIZON

Incentive design is a key feature of corporate governance and strategic leadership to ensure that CEOs' and shareholders' interests are aligned. A primary focus to date has been on incentive intensity, the strength of the alignment between CEO compensation and firm performance. We examine a new facet, the CEO-incentive time horizon, the degree to which CEO compensation is aligned with performance horizons. After controlling for incentive intensity, we assess positive and negative performance outcomes and find that firms with longer CEO-incentive time horizons exhibit significantly greater total shareholder returns, ROA growth, and reduced financial misconduct. We also find when investor time horizons are longer, and also when information asymmetry between managers and shareholders is higher, relationships between CEO-incentive time horizon and financial misconduct, as well as long-term performance, are stronger. Considering the time horizon in compensation provides a deeper explanation of the relationship between executive incentives and firm performance. "…the efficacy of granting equity to the CEO in order to achieve incentive alignment…is far from settled, leaving unanswered questions regarding the conditions under which incentive alignment mechanisms achieve their intended goal". - Martin, Wiseman, & Gomez-Mejia (2019)

Leverage, competition and financial distress hazard: Implications for capital structure in the presence of agency costs

Does leverage or product-market competition increase or decrease financial distress risk? The existing literature provides conflicting and largely a-theoretical answers. Drawing on agency theory, we hypothesize that leverage and competition are incentive-alignment mechanisms with non-monotonic and substitute effects on financial distress hazard. Using an unbalanced panel of 13,896 listed firms from 1992 to 2014 and a multi-level hazard model that takes account of frailty and endogeneity, we find that leverage or competition have a hazard-reducing effect when the discipline effect dominates the agency-cost effect. In contrast, they have a hazard-increasing effect when the agency-cost effect dominates the discipline effect. Furthermore, the level of leverage that minimizes financial distress risk is higher in less competitive industries. Finally, long-term debt is a stronger disciplining device compared to short-term debt; and the financial distress predictors widely used in the literature explain only a small fraction of the distress hazard after controlling for leverage and competition.

Portfolio Manager Ownership and Mutual Fund Risk Taking

This paper studies the effect of portfolio manager ownership (i.e., “skin in the game”) on mutual fund risk taking. Using holdings-based risk change measures that capture managers’ ex ante risk choices, we find that portfolio manager ownership reduces both intrayear and across-year risk-taking activities. The relationship between ownership and risk reduction is particularly strong among managers with high agency issue–induced risk-taking incentives—for example, managers who face a more convex flow-performance relationship, have poor past performance, or are not compensated based on long-term fund performance. Funds with greater managerial ownership are also associated with lower levels of total risk and downside risk. Overall, portfolio manager ownership serves as an incentive alignment mechanism and has important implications for mutual fund investors. This paper was accepted by Amit Seru, finance.

Executive labor market segmentation: How local market density affects incentives and performance

I study how the density of executive labor markets affects managerial incentives and thereby firm performance. I find that U.S. executive markets are locally segmented rather than nationally integrated, and that the density of a local market provides executives with non-compensation incentives. Empirical results show that in denser labor markets, executives face stronger performance-based dismissal threats as well as better outside opportunities. These incentives result in higher firm performance in denser markets, especially when executives have longer career horizons. Using state-level variation in the enforceability of covenants not to compete, I find that the positive effects of market density on incentive alignment and firm performance are stronger in markets where executives are freer to move. This evidence further supports the argument that local labor market density works as an external incentive alignment mechanism.

Managerial incentives and strategic choices of firms with different ownership structures

We examine how ownership structure affects managerial incentive alignment mechanisms and strategic objectives. We compare large Indian firms with dispersed equity ownership with business-group affiliates operating within the same institutional frameworks. We find that the performance sensitivity of CEO pay and turnover differ significantly across group affiliates and stand-alone firms. The strategic choices of firms also differ in response to managerial incentives. However, we find that, regardless of those differences, firm performance is similar for both types of firms. Overall, this paper suggests that ownership structure and managerial incentives can adjust to optimize strategic choices and firm performance.

Agency hazard, managerial incentives, and the wealth effects of joint venture investments

Grounded in agency theory, this study explores whether the separation of ownership (by shareholders) and control (by managers) in firms is an essential determinant of the valuation effect of joint ventures (JVs). This is achieved by examining the efficacy of incentive alignment mechanisms and their contingency effects. Based on a sample of 963 U.S. firms' JV investments, the results show that poor JV performance is linked to lower levels of executive ownership and reduced equity compensation. The possibility of managers acting for their own self-interest in corporate JV investments is further supported by the stronger positive performance effect of incentive alignment mechanisms documented when firms have a higher level of free cash flow or undertake JVs in unrelated business domains. Both performance measures of short-run announcement effects and long-run stock returns yield similar results. Our results underscore the importance of governing executives' self-interested actions in their JV engagements.

The Interactive Effect of Monitoring and Incentive Alignment on Agency Costs

The effectiveness of monitoring and incentive alignment as mechanisms for controlling agency costs have been explored separately and in combination, with monitoring substituting for weaknesses in incentive alignment and vice versa; this equates to positive substitution when describing how monitoring and incentive alignment interact to influence shareholder agency costs. We draw upon behavioral agency theory and findings from finance research to offer further theoretical insight into how these mechanisms interact to influence agency costs. Our results suggest that CEO earnings management aimed at preserving their equity wealth (an incentive alignment mechanism) is accentuated by higher levels of concentrated institutional ownership, thereby imposing agency costs on less informed investors. Thus, in addition to being substitutes in controlling agency costs, as previously suggested, monitoring may accentuate the perverse effects of incentive alignment, equating to negative reinforcement, rather than positive substitution. Yet this effect is negated in the absence of CEO power due to dual occupation of the board and CEO roles. We discuss implications of these findings for theory and practice.

Carrots and Sticks: Equilibrium Incentives in Firms with Different Equity Holding Structures

This paper examines how the structure of corporate holding impacts managerial incentive alignment mechanisms, and strategic objectives. Using data from 500 large Indian firms, we compare firms with dispersed equity ownership and business-group affiliates within the same institutional framework. We find that performance sensitivity of CEO pay and turnover are different in group affiliates and stand-alone firms. The strategic choices of firms differ in response to managerial incentives. However, firm performance is similar for both types of firms, irrespective of the differences in incentive structures and strategic choices. Overall, this paper suggests that corporate holding structures and managerial incentives adjust to optimize strategic choices and firm performance.

Executive Market Segmentation: How Local Density Affects Incentive and Performance

I study how the density of executive labor markets affects managerial incentives and thereby firm performance. I find that U.S. executive markets are locally segmented rather than nationally integrated, and that the density of a local market provides executives with non-compensation incentives. Empirical results show that in denser labor markets, executives face stronger performance-based dismissal threats as well as better outside opportunities. These incentives result in higher firm performance in denser markets, especially when executives have longer career horizons. Using state-level variation in the enforceability of non-compete clauses, I find that the positive effects of market density on incentive alignment and firm performance are stronger in markets where executives are freer to move. This evidence further supports the argument that local labor market density works as an external incentive alignment mechanism.

Portfolio Manager Ownership and Mutual Fund Risk Taking

This paper studies the effect of portfolio manager ownership (i.e., skin in the game) on mutual fund risk-shifting behavior. Previous literature suggests that risk shifting can hurt fund performance and impose costs on fund investors. We find that portfolio manager ownership can mitigate managers’ incentive to engage in such risk-shifting behavior. In particular, using holdings-based risk-shifting measures, we find that portfolio manager ownership reduces both intra-year and across-year risk-shifting activities. Fund investors reward funds with greater managerial ownership with more capital inflows. Overall, our evidence suggests that portfolio manager ownership serves as an incentive alignment mechanism and has important implications to fund investors.

Equity-Based Compensation: An Important Determinant for Chinese Cross Listed Firms

Taking advantage of a unique aspect of Chinese securities regulations regarding exchange listings, this paper investigates if the ability to offer equity-based compensation determines Chinese firms' cross-listing decision. We also assess the effects of equity-based compensation on performance and shareholders' wealth of Chinese cross listing firms. To the best of our knowledge, it is the first study to link equity-based compensation and firms' cross listing, thus offering an opportunity to assess the effectiveness of stock options as an incentive alignment mechanism. Up until 2006, Chinese securities regulations precluded listed firms to offer equity-based compensation to executives and directors. However, there were not such regulations for Chinese firms listing in Hong Kong or other markets. The study compares a sample of firms that cross-listed outside of China with firms listing their shares only in China. Results show that the ability to offer equity-based compensation is an important determinant for Chinese firms cross listing. As a result, equity-based compensation significantly increases shareholders' wealth. However, equity-based compensation does not seem to affect a firm's operational performance, which is proxied by return on assets (ROA). Our results have financial and governance implications and bring additional insights into the motivation underlying cross-listings in international settings and also for the effectiveness of equity-based compensation as an incentive mechanism.

Share reacquisitions, surplus cash, and agency problems

Share repurchases help alleviate agency costs of surplus cash by restricting management’s scope to waste corporate resources. But why do self-interested managers agree to disgorge surplus cash in the first place? This study examines the intervening effect of managerial monitoring and incentive alignment mechanisms on the decision to distribute excess cash through a share repurchase. Findings indicate that repurchases substitute for cash retention decisions that would otherwise prove costly for shareholders, and that better managerial incentive alignment and closer monitoring by external shareholders are important factors stimulating such payouts.

Incentives Management During Privatization: An Agency Perspective

abstract This paper explains, through a field study and from an agency perspective, how monitoring and incentive alignment mechanisms change to support the interests of a privatized firm's new ownership. In this case, privatization led to important changes in the board of directors and to more formal performance evaluation and compensation systems for top managers, as profitability and financial control gained relevancy with the firm ownership change. Our results show that differences in incentives management before and after privatization are due to different agency relations in the two periods. We also argue that in a privatization framework the relation between monitoring and incentive alignment mechanisms is complex, not simply substitutive as agency theory would predict, and this finding allows us to refine and extend agency theory for this specific context.

Contractual difficulties in environmental management: The case of wetland mitigation banking

This paper offers a principal–agent model of private contracting in mitigation banking aimed at protection of wetland acreage and habitat, bio-diversity and physical functions of US wetlands. While it is straightforward to design an incentive contract, such a contract may be incapable of achieving the federally mandated objective of no net loss of wetland functions through wetland mitigation; there may be failure of contract design or execution. Also considered are several institutional mechanisms that may promote the convergence of private contracting and attainment mandated wetland protection. These include greater oversight by the government, payment of subsidies, greater accuracy in the identification of actual wetland quality by the principal, and use of several other incentive alignment mechanisms.

A coordination framework for supply chain inventory alignment

PurposeA traditional supply chain, all too often, is a sequence of weakly connected activities both within and outside the organization and leads to many misalignments. Tackling this inherent lack of coordination is a major value creation opportunity for supply chain managers. This paper aims to present a coordination framework, called ASCEND, to align the inventory decisions in decentralized supply chains.Design/methodology/approachThe framework rests on three pillars – multi‐agent technology, coordination theory, and optimization technology. Inventory alignment is transformed into a decentralized constraint satisfaction optimization problem, which is then solved using a genetic algorithm‐based coordination process. The guiding principle of this framework is the establishment of a proper incentive alignment mechanism through cost‐sharing and service level contracts, taking into account the associated dependencies.FindingsThe results of the pilot study indicate that the coordination framework reduces the supply chain inventory‐holding cost, compared with the “as‐is” scenario. Interestingly, the results also indicate that not all the supply chain partners will experience lower inventory costs in the absence of a proper incentive alignment mechanism. Only through cost sharing and service level contracts can the value of coordination be realized by each partner in a supply chain network!Practical implicationsThe coordination approach is applied to a pilot supply chain. The results of the case study lead to 10.4 percent (average) reduction in supply chain inventory‐holding costs, validating the efficacy of the coordination framework.Originality/valueThis research has resulted in the development of a supply chain coordination framework, which requires the establishment of a proper incentive alignment mechanism, based on cost‐sharing and service level contracts, and taking into account the associated dependencies.

Incentive Alignment or Perverse Incentives? A Behavioral View of Stock Options

Agency theoretic models have been used in the past to justify the use of stock options as an effective incentive alignment mechanism to create a common fate between principals and agents. In this paper, we use behavioral theory to reach the opposite conclusion – namely, that the design characteristics of the typical stock option plan foster perverse incentives for loss‐averse agents, leading to decisions with detrimental consequences for principals. We also consider alternative stock option designs and other equity‐based executive compensation plans and argue that they may suffer from the same problems as traditional stock option plans – namely, that loss‐averse executives will try to protect the endowed value of that equity through self‐serving decisions that do not enhance shareholder wealth.

The Phenomenology of Earnings Management within the Confines of Agency Theory

Agents' selective and acceptable reporting of economic events by different accounting systems, compounded by alternative accounting methods and estimates, make financial statements an approximation of economic reality. The tendency to delay accounting recognition of some transactions suggests that financial statements lag behind reality. The difference between reality and imaginary is often referred to as the agency problem. An essential characteristic of this problem is risk attitudes of principals (shareholders) and agents (management). Shareholders are considered risk neutral in their preferences for individual firms. They are in a position to diversify their shareholdings across multiple firms. Agents on the other hand have security and income that are inextricably linked to one firm. It would not be surprising to find agents exhibiting risk aversion in decisions regarding the firm. Immediately one's attention is drawn to the opportunity costs that arise for the risk-neutral shareholders who prefer that agents maximize their returns. The risk differential between agents and principals creates a problem in principal-agent relationship. It is within this framework that supervisory and incentive alignment mechanisms that alter the risk orientation of agents are set up. Powerful incentives act upon agents as they exercise their judgment, particularly when the judgment can trigger a stock market response that will, in turn, affect the firm in numerous ways. The responsibility of agents is to manage earnings. From a principal's perspective not all of the methods used to achieve this goal are equally desirable. Agents can either increase productivity or they can strategically manipulate accounting choices to affect earnings. The latter method need not come with any associated changes in productivity. Consequently, there is misstatement of the financial results and position. The calculus of earnings management is considered within the confines of agents' treatment of risk. Using an Agency Theory framework, this study examines the techniques used by agents to manage and manipulate earnings. The study initially tests the hypothesis whether earnings are really managed. For this purpose two manipulation indices were developed and based upon these indices the phenomenology earnings management was considered.

Factors Associated with the Use of Long‐Term Earnings and Market‐Based Compensation Plans

Factors associated with the use of long‐term plans in management compensation contracts and the choice between earnings‐based performance plans and market‐based long‐term plans are examined. Results indicate the firms using long‐term plans are large, have diffuse ownership and more long‐term growth. Furthermore, performance plans are more likely to be used when stock‐return variability is high relative to earnings variability. Firms using performance plans are also larger and have more diffuse ownership than firms with market‐based plans alone. Overall, the evidence is consistent with long‐term plans serving as incentive alignment mechanisms.