by Dr Adelphe Ekponon and Dr Scott Guernsey, Research Associates, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
Motivated by preliminary empirical evidence showing that firms with more committed managers tend to suffer less during downturns, CERF Associates Adelphe Ekponon (now at the University of Liverpool) and Scott Guernsey (now at the University of Tennessee) propose a model to help understand the mechanisms under this phenomenon.
Economic crises bring about periods of prolonged turmoil. During such periods, shareholders have difficult decisions to make, in particular, regarding the retention or firing of the incumbent management team (assuming also that the change of CEO is likely to be followed by a reshuffle of the managing team). There exists a labour market for executives with two possible statuses. An executive team can be either the incumbent or an entrant. This framework assumes that the labour market for executives is not only competitive but is also highly restrictive, as managers do not have many outside options. Thus, there exists a lack of diversification in the labour market – i.e. they are “all-in” on the firm. This incites executives to be committed to the firm and exert more effort. In practice, the firm can grant managers part of their performance-related compensation in derivatives such as stock options or deep out of the money options.
In their model, shareholders optimally derive both the cost of replacing and the probability of retaining the incumbent, that maximise their value. Shareholders derive these optimal decisions such that they are indifferent between keeping the incumbent or hiring an entrant after considering all firing/hiring costs. They also ensure the participation of both incumbent and entrant. Participation is defined as the gap between the pay for performance and the disutility of effort. Hence, their model differs from the different strands of the literature such as corporate structural models (Leland, 1994), those with agency conflicts (Jensen, 1986), macroeconomic risk (Hackbarth et al., 2006), contract incentives (Laffont and Tirole, 1988) and, governance and business cycle (Philippon, 2006; Ekponon, 2020).
Managers’ level of effort depends on the cost replacement and the likelihood that their tenure will be extended for the subsequent period. The incumbent chooses the level of effort to exert and, under perfect information, selects a higher level of effort when the combination of the two (costs of replacement and probability of retention) is higher because the labour market for executives is restrictive and higher replacement costs indicate longer tenure. So, managers commit to the firm knowingly, but the firm does not necessarily have to commit to managers.
In bad times, earnings are hit by poor macroeconomic conditions. To limit the losses, if shareholders adopt a higher pay for performance strategy, the model predicts a lower probability of retention, proxied by a lower governance index or good governance, but they have to face higher replacement costs. When the latter effect dominates, executives choose to exert more effort (reducing the impact of low profitability) and shareholders are better off keeping the incumbent team.
Ekponon, A. (2020) “Agency conflicts, macroeconomic risk, and asset prices.” Social Science Research Network, No. 3440168
Hackbarth, D., Miao, J. and Morellec, E. (2006) “Capital structure, credit risk, and macroeconomic conditions.” Journal of Financial Economics, 82(3): 519-550
Jensen, M.C. (1986) “Agency costs of free cash flow, corporate finance, and takeovers.” American Economic Review, 76(2): 323–329
Laffont, J.-J. and Tirole J. (1988) “The dynamics of incentive contracts.” Econometrica, 56(5): 1153-1175
Leland, H.E. (1994) “Corporate debt value, bond covenants, and optimal capital structure.” Journal of Finance, 49(4): 1213-1252
Philippon, T. (2006) “Corporate governance over the business cycle.” Journal of Economic Dynamics and Control, 30(11): 2117-2141