Multimillion-dollar pay packages for corporate executives are often derided by the public, but companies say they are necessary for recruiting and retaining top managers whose goals include creating wealth for the company’s investors.
The question for management professor Anju Seth, of Virginia Tech’s Pamplin College of Business, is “how do the compensation packages achieve such results?”
Compensation for senior corporate executives typically includes shares of the company’s stock in addition to base salary, bonuses, and various benefits and perks.
A study by Seth and Todd M. Alessandri of Northeastern University, found that pay packages that are heavier on cash and lighter on stock appear to motivate top corporate managers to pursue risky but potentially very profitable international diversification strategies but have less influence in the pursuit of high-risk, high-return domestic diversification strategies.
“Our results show that managerial stock ownership has a large negative effect on the extent of U.S. firms’ international diversification and only a small positive effect on their domestic business diversification,” said Seth.
These findings, she said, have considerable significance for corporate boards of directors who are designing executive compensation packages in companies seeking high-risk, high-return ventures.
Shareholders — who can diversify their risks by holding portfolios of stocks — want corporate managers to take high-risk decisions that have the potential to yield high returns. “There is a point, however, at which managers paid in high quantities of their corporation’s stock see their personal wealth endangered, so they become averse to risky corporate ventures,” Seth says.
A larger equity stake, she said, represents greater exposure to risk for managers and may de-incentivize them to push these strategies.
Previous studies have explored how executive compensation packages can influence the kinds of business diversification decisions taken by top managers, Seth noted. “We sought to examine the benefits and costs of managerial stock ownership in the context of both international and domestic business diversification,” says Seth.
“Entering new businesses and markets are major strategic decisions with huge implications for shareholder value.” Foreign markets offer considerable growth potential for U.S. companies, she says. But they also present risks and uncertainty that managers often prefer to avoid.
The traditional “incentive alignment” perspective holds that increasing managerial stockholdings will align the interests of managers with those of stockholders, who want to see higher profits and market value for the corporation. This model does not include the impact of personal risk resulting from high levels of stock ownership by managers.
Based on their research, Seth and Alessandri developed the “efficient incentive contracting” perspective, which considers both the incentive alignment and risk-bearing effects of managerial share ownership.
“In the present global economy, we expect international diversification to represent high-risk, high-return decisions and that the risk-bearing effect would dominate at high levels of share ownership. So, incentive contracts with higher levels of managerial ownership may not be efficient for shareholder value creation.”
“In the domestic economy, a focus strategy – one that limits business diversification to focus on the company’s core competence – may be more likely to be the high-risk, high-return decision that is preferred by shareholders. Both these circumstances would suggest the need for more certainty to managers in their compensation packages.”
Seth and Alessandri chose to study managerial compensation packages and diversification among the Standard and Poor’s 1,500 firms during the period from 1998 to 2006. They selected the Standard and Poor sample because large corporations are more likely to have both international and business diversification.
Their study, Seth said, extends the business community’s understanding of how stock-based compensation can influence managers’ decisions to undertake international diversification.
“Given increasing use of equity-based incentives and the pressure on firms to increase globalization, our study’s results cast new light on the need for shareholders to be conscious of the level of risk that managers are forced to bear as part of the incentive contract.”
“The effects of managerial ownership on international and business diversification: Balancing incentives and risks,” by Todd M. Alessandri and Anju Seth, is published in the December 2014 issue of Strategic Management Journal.