The Long‐Term Consequences of Short‐Term Incentives

• Published date: 01 June 2022
• Author: ALEX EDMANS,VIVIAN W. FANG,ALLEN H. HUANG
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/1475-679X.12410

DOI: 10.1111/1475-679X.12410

Journal of Accounting Research

Vol. 60 No. 3 June 2022

Printed in U.S.A.

The Long-Term Consequences of

Short-Term Incentives

ALEX EDMANS,∗VIVIAN W. FANG,†AND ALLEN H. HUANG‡

Received 7 September 2020; accepted 10 September 2021

ABSTRACT

This paper studies the long-term consequences of actions induced by vesting

equity, a measure of short-term incentives. Vesting equity is positively associ-

ated with the probability of a firm repurchasing shares, the amount of shares

repurchased, and the probability of the firm announcing a merger and ac-

quisition (M&A). However, it is also associated with more negative long-term

returns over two to three years following repurchases and four years following

∗London Business School, CEPR, and ECGI; †University of Minnesota, ECGI; ‡Hong Kong

University of Science and Technology

Accepted by Christian Leuz. Wethank the Editor, two anonymous referees, Heitor Almeida,

Jack Bao, TedChristensen, David De Angelis, Rudi Fahlenbrach, Chris Florackis, Julian Franks,

Mireia Giné, Moqi Groen-Xu, Mathias Kronlund, Tomislav Ladika, Beni Lauterbach, Lisa

Liu, Chul Park, Florian Peters, Shiva Rajgopal, Christoph Schneider, Henri Servaes, Laksh-

manan Shivakumar,Rui Silva, Alminas Zaldokas, and conference/seminar participants at AFA,

City University of Hong Kong International Finance Conference, dbAccess Global Quant

Conference, EFA, EFMA, FIRS, FMA, HKUST, IESE/ECGI Corporate Governance Confer-

ence, LBS Accounting Symposium, LSE, MIT Asia Conference in Accounting, PSU Account-

ing Conference, Rotterdam Executive Compensation Conference, Shanghai University of Fi-

nance and Economics, Shanghai Jiao Tong, Stanford Conference on Theory and Inference

in Capital Market Research, Toulouse Corporate Governance Conference, Tsinghua, UMass

Lowell, UNC/Duke Fall Camp, UT Arlington, UT Dallas, and Xiamen for comments, Jen-

nifer Estomba of Equilar for answering numerous questions about the data, and Ali Up-

pal, Xinyuan Shao, and Yifan Yan for excellent research assistance. Edmans gratefully ac-

knowledges financial support from European Research Council Starting Grant 638666 and

London Business School’s Deloitte Institute of Innovation and Entrepreneurship, and re-

search support from the LBS AQR Asset Management Institute. An online appendix to this

paper can be downloaded at http://research.chicagobooth.edu/arc/journal-of-accounting-

research/online-supplements.

1007

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

This is an open access article under the terms of the Creative Commons Attribution License, which

permits use, distribution and reproduction in any medium, provided the original work is properly cited.

1008 a.edmans,v.w.fang,anda.h.huang

M&A, as well as future M&A goodwill impairment. These results are inconsis-

tent with CEOs buying underpriced stock or companies to maximize long-run

shareholder value, but consistent with these actions being used to boost the

short-term stock price and thus equity sale proceeds. CEOs sell their own

stock shortly after using company money to buy the firm’s stock, also incon-

sistent with repurchases being motivated by undervaluation.

JEL codes: G12, G14, G32, G34, G35, M12, M52

Keywords: repurchases; M&A; short-termism; CEO incentives; managerial

myopia

1. Introduction

The short-termism induced by executive pay schemes is a major problem

alleged by academics, practitioners, and policy makers. A central concern

in Bebchuk and Fried’s [2004] influential critique of executive pay is that

CEOs are rewarded for short-term stock price increases, and so their main

reform proposal is to escrow the CEO’s equity until the long term. In 2018,

the revised U.K. Corporate Governance Code increased the minimum vest-

ing period of executive equity from three to five years. The following year,

the U.S. Council of Institutional Investors revised its executive pay policy

to recommend “extended, time-based vesting requirements—for example,

those that might begin to vest after five years and fully vest over 10 (includ-

ing beyond employment termination).”

The concern with short-term pay incentives is that they lead the CEO to

take myopic actions that boost the stock price at the expense of long-run

value. However, finding systematic evidence is challenging for two main

reasons. First, it is difficult to demonstrate a causal effect of short-term in-

centives because the CEO’s contract is endogenous. Second, even if one

found that CEO incentives cause particular actions, it is difficult to study

the long-term implications of such actions.

Edmans, Fang, and Lewellen [2017, EFL] address the first challenge by

introducing a new measure of short-term CEO incentives: the amount of

stock and options scheduled to vest in a given quarter. CEOs typically sell a

significant amount of vesting equity, and so they may boost the short-term

stock price to increase the proceeds from their equity sales. Separately, vest-

ing equity depends on the magnitude and vesting schedule of equity grants

made several years ago,1andsoisunlikelytobedrivenbyomittedvari-

ables such as current economic conditions. EFL find that vesting equity is

significantly correlated with reductions in investment growth. They study

investment because it is arguably a firm’s most important day-to-day deci-

sion. However, it is difficult to ascertain whether the scrapped investment

would have been value-creating or value-destroying, and thus whether stock

price concerns induce myopia or curb overinvestment. Although EFL con-

1The median vesting period for stock (options) is three (four) years.

the long-term consequences of short-term incentives 1009

duct cross-sectional tests that suggest myopia, they cannot use stock returns

to study the long-term consequences of investment cuts, for two reasons.

First, any association would be unlikely to be causal, because long-run stock

returns are affected by many decisions other than investment. Second, in-

vestment is reported at the quarterly level and thus does not have a clear

announcement date.

This paper studies two corporate actions whose long-term consequences

can be estimated, enabling us to assess the impact of short-term incen-

tives. The first is stock repurchases. Like investment cuts, repurchases boost

the short-term stock price (Ikenberry, Lakonishok, and Vermaelen [1995])

and so CEOs with short-term concerns might have incentives to undertake

them. Also like investment cuts, repurchases can either be myopic (if fi-

nanced by scrapping valuable projects and/or if they are of overvalued

stock) or efficient (if financed by free cash and/or if they are of under-

valued stock). Critically, unlike investment cuts, long-term stock returns

measure the value created for existing shareholders from the repurchase,

regardless of whether the returns were caused by the repurchase. If the firm

was undervalued (overvalued) and so future stock returns would have been

positive (negative) anyway, the repurchase creates (destroys) value.

The second corporate action is mergers and acquisitions (M&A), which

has different advantages to repurchases. First, M&A has an announcement

date, enabling us to cleanly calculate 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 the long-

run stock return is attributable to the M&A. Indeed, prior research (e.g.,

Agrawal, Jaffe, and Mandelker [1992], Asquith [1983], Franks, Harris, and

Titman [1991], Rau and Vermaelen [1998]) uses long-run stock returns to

assess the value implications of M&A.

Importantly, Agrawal, Jaffe, and Mandelker [1992] find a significantly

negative relation between short- and long-term M&A returns, suggesting

that certain acquisitions boost the short-term stock price at the expense of

long-run value. As an example of how vesting equity might induce such an

acquisition, Bazaarvoice acquired PowerReviews in June 2012, which led to

its stock price soaring above $20 and its officers and directors selling $90

million of stock. The U.S. Department of Justice (“DoJ”) launched an an-

titrust lawsuit in January 2013, which forced Bazaarvoice to divest PowerRe-

views and caused its stock price to drop below $7. In internal communica-

tions, Bazaarvoice executives stated that their motivation for the acquisition

was “[e]limination of our primary competitor” to leave them with “literally,

no other competitors.” However, even if they suspected that a DoJ lawsuit

would be likely, this would be of little concern because they could cash out

beforehand.2

2The market did not foresee any antitrust risk, hence the positive reaction to the acquisi-

tion. All of the analyst reports after the acquisition announcement were strongly positive, with