Courtesy of Truc (Peter) Thuc Do, Huai Zhang, and Luo Zuo
Relative Performance Evaluation (RPE) allows a firm to compensate its managers according to the firm’ performance relative to the performance of peer firms. A typical RPE contract has two distinct features. First, relative rather than absolute performance matters. Under an RPE contract, the CEO usually receives no award if her firm does not outperform a pre-determined percentage of peer firms. Once her firm reaches the performance benchmark, her award increases with the ranking of her firm relative to peer firms. Second, it is important to the CEO that her firm comes out on top of the competition. In our sample, achieving the top 10th percentile in the peer-firm group means an increase of $4.2 million worth of compensation, compared to finishing within the bottom 10th percentile. This is significant given that $4.2 million presents a big chunk of the median CEO total compensation in our sample of $7.3 million. Importantly, these two features mirror the definition of tournaments, a competition where relative performance determines the outcome, and a substantial spread in award exists between winners and losers. In our paper, we argue that an RPE contract introduces a tournament-like competition among the focal firm and peer firms, and that the focal firm CEO’s position as a tournament participant may influence the CEO’s decisions on firm riskiness.
The tournament perspective offers fresh and interesting predictions based on a firm’s interim performance. Specifically, the tournament-like compensation structure introduced by RPE contracts incentivizes managers to alter their risk-taking behavior according to the firm’s interim performance. Managers who are interim losers (i.e., whose firms’ interim performance is poor relative to peers) are incentivized to take substantially more risk in the remainder of the evaluation periods, in the hope of making up for prior deficits, while managers who are interim winners will be incentivized to preserve the status quo and refrain from taking on more risk. Therefore, our central testable hypothesis is that the interim losing firms will take on more risk than the interim winning firms in the remainder of the evaluation periods. This tournament-theory based prediction has been validated in the context of fund managers, financial analysts and professional athletes. For example, prior research analyzes NBA games and finds that interim losing teams (e.g., losing at the end of the third quarter) substantially increase their three-point attempts in the remainder of the games (e.g., the fourth quarter). To the extent that three-point shots are inherently risky, the evidence is consistent with the theoretical prediction that interim losers take on more risk in order to change the outcome.
We test our hypothesis using a sample of 1,454 RPE contracts for the period 1998–2017. We focus on RPE contracts which use stock returns as the performance metric, and which clearly identify peer firms. This research design assures that a firm’s management can observe its peer firms’ performance and determine the firm’s ranking relative to peer firms during the interim period. In addition, we require the evaluation period to be three years, since the majority of RPE contracts use a three-year evaluation period. Using the end of the first half of the evaluation period as the interim, our main empirical tests show that the increase in risk in the remainder of the RPE evaluation period is substantially higher for interim losing firms than for interim winning firms. Relative to the top interim performer, the bottom interim performer experiences an increase of 17.8 percentage points in the stock return volatility and 31.1 percentage points in ROA volatility in the remainder of the RPE contract period. Further analyses show that interim losing firms take on more risk by increasing their leverage, spending more on R&D, engaging in restructuring, and reducing the number of business segments.
Next, we draw on tournament theories and offer several cross-sectional tests. Tournament theory predicts that when the interim period is closer to the end of the tournament period, interim losers’ incentive to increase risk becomes stronger. In the basketball setting, it implies that the incentive to take risky three-point shots in the remainder of the game is higher when the team finds itself losing at the end of the third quarter than at the end of the second quarter. In our setting, we find that the increase in the interim losing firm’s riskiness is more pronounced when the interim period is closer to the end of the evaluation period. We form two interim periods, with the second interim ending closer to the finish line than the first interim. Our results indicate that for firms in the second interim, the increase in the bottom interim performer’s riskiness (measured by stock return volatility) relative to the top interim performing firm in the remainder of the evaluation period is 26.1 percentage points, which is significant at the 1% level. In contrast, the difference in riskiness for firms in the first interim is statistically insignificant.
Another prediction based on the tournament theory is that the interim loser’s incentive to increase risk is correlated with the importance of winning the tournament. Essentially, increasing risk is a way to “rock the boat” to win the tournament. If winning the tournament is not important, risk-taking motives are subdued. We empirically estimate the importance of winning the tournament by computing the ratio of target payout in the current year to the CEO’s total compensation in the previous year. If the target payout is a higher proportion of the CEO’s total compensation, winning the tournament is financially more important. We find that when the target payout is proportionally high, the impact of interim performance status on the increase in risk (measured by stock return volatility) in the remainder of the evaluation period is almost three times as high as when the target payout is low.
Finally, in a rational risk-return framework, an increase in risk shall be compensated by an increase in expected return. However, if the interim losing CEO increases risk simply to “rock the boat,” the increase in risk in the remainder of the tournament period likely represents a poor risk-return trade-off. We use the Sharpe ratio to measure the risk-return trade-off. We find that, relative to the top interim winner, the bottom interim loser experiences a drop of 2.8 percentage points in the Sharpe ratio in the remainder of the tournament periods—a lower rate of return relative to the amount of risk taken. This result suggests that the incentive of the interim losing CEO to win the tournament results in a non-ideal risk-return trade-off.
Our paper contributes to two lines of literature. The first line of literature explores the tournament incentives in corporate settings. This line of literature demonstrates that corporate promotions are similar to tournaments and investigates the effect of tournament incentives on firms’ risk-taking. We argue that RPE contracts are another means of introducing tournament incentives to the top management, and we demonstrate that a firm’s level of risk-taking behavior changes in response to the firm’s interim performance ranking relative to the peer firms. Our paper represents a step forward in understanding the competition-based incentive of top management and the consequences of such an incentive.
Our paper also contributes to the literature on the use of Relative Performance Evaluation. There is a growing empirical literature which investigates how RPE contracts influence managerial behavior. We add to this literature by identifying the tournament-based incentives introduced by RPE contracts. We show that when RPE contracts are used, the firm’s management takes on additional risk simply to outperform peer firms in the remainder of the evaluation period. Our further analyses, however, suggest that the additional risk does not necessarily benefit shareholders, as the Sharpe ratios of these firms deteriorate. Our findings therefore pinpoint the unintended consequence of RPE contracts.
