Critics of short-term incentives argue that they lead the CEO to take myopic actions that boost the short-term stock price at the expense of long-run value. These critics however, rarely back this up with rigorous evidence. This is partly confirmation bias – willingness to accept ‘evidence’ that confirms one’s prior belief, no matter how flimsy. Since the current political environment is distrustful of businesses, people may be more willing to accept ‘evidence’ that CEOs act in ways that destroy value for personal gain. For example, a recent McKinsey study showed that firms that invested more have enjoyed superior long-run returns, and interprets this finding as “finally, evidence that managing for the long term pays off” (Barton et al. 2017).
…In our most recent work on the topic (Edmans et al. 2017b), we study the long-term consequences of short-term incentives by examining two corporate actions with similarities to investment cuts, but whose long-run consequences could be measured more accurately:
- Repurchases: These boost the short-term stock price (Ikenberry et al. 1995). CEOs with short-term concerns might have incentives to undertake them. Also like investment cuts, repurchases can either be myopic (if financed by scrapping valuable projects) or efficient (if financed by free cash that would otherwise have been wasted). The long-term stock return measures the return that the firm obtains from the repurchased stock. So, unlike investment cuts, the long-term stock return can be used to diagnose the value implications of the repurchase, even if the return was not caused by the repurchase.
- M&A: This has different advantages to repurchases. First, M&A has an announcement date, allowing us to cleanly calculate short- and long-term returns. Second, M&A is a much more significant event than an investment cut (or repurchase) – it is arguably the most transformative corporate decision that a firm can undertake – and so it is likely that at least a significant portion of long-run stock returns would be attributable to the M&A. Indeed, prior research (e.g. Agrawal et al. 1992) has used long-run stock returns to assess the long-term value implications of M&A.
Studying “the relationship between vesting equity and repurchases, and vesting and M&A announcements, between 2006 and 2015,” the researchers found that
a one-standard-deviation increase in vesting equity is associated with a 1.2% increase in a firm’s likelihood of conducting a share repurchase in a given quarter, compared to the unconditional repurchase probability of 37.5%. This translates into $6.16m annualised, compared to the finding in Edmans et al. (2017a) of an annualised fall in investment of $1.8m. While economically meaningful, this magnitude is also plausible: a too-large, myopic repurchase may have prompted the board to step in and block it. We find similar results for M&A. A one-standard deviation increase in vesting equity is associated with a 0.6% increase in a firm’s likelihood of announcing an M&A in a given quarter, compared with the unconditional probability of 15.8%.
…A one-standard-deviation increase in vesting equity is associated with an annualised 0.61% higher return over the two quarters surrounding a repurchase, but a 1.11% (0.75%) lower return during the first (second) year after the repurchase. For M&A, the negative association with long-run returns persists for longer. A one-standard-deviation increase in vesting equity is associated with an annualised 1.47% higher return over the two quarters surrounding an M&A announcement, but a 0.81%, 0.35% (insignificant), 0.72%, and 0.62% lower return in the first, second, and third, and fourth subsequent years.
The results are consistent with Graham et al. (2005), who used a survey to find that 78% of executives would sacrifice long-term value to meet earnings targets. We studied a CEO’s actual behaviour and found that short-term incentives indeed have negative long-term consequences. The current debate on CEO pay typically focuses on how big it is. As a consequence, in the UK and US, there will soon be disclosure of pay ratios. Our results suggest that the horizon of CEO incentives is a more important dimension to reform.