Trade‐off Between Risk and Incentives: Evidence from New‐ and Old‐Economy Firms

• Date: 01 January 2016
• Published date: 01 January 2016
• DOI: http://doi.org/10.1002/jcaf.22122
• Author: Imen Tebourbi

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© 2016 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22122

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Trade-off Between Risk and

Incentives: Evidence from

New- andOld-Economy Firms

Imen Tebourbi

INTRODUCTION

The trade-off

between the incen-

tives offered to an

agent and the level

of risk imposed on

him, is a central issue

of principal-agent

theory. Agency

models predict that

executive compensa-

tion in firms with

more volatile stock

prices should be less

sensitive to stock

market performance

than executive com-

pensation in less

risky firms. This

means that execu-

tive pay-performance

sensitivity is decreas-

ing in the variance

of the firm’s per-

formance (Jensen

& Meckling, 1976;

Lambert,1983).

On the other

hand, manage-

rial ownership

theory argues that in

uncertain environ-

ments, this relation

will not hold. In fact,

this theory suggests

that in risky settings,

it is more difficult

for the principal to

monitor the agent,

and this monitoring

difficulty would lead

the principal to us e

more performance-

based compensation

that would reward

the agent based on

the output (Dem-

stez & Lehn, 1985;

Prendergast, 2002).

In this case, the

relation between

pay- performance

sensitivity and risk

ispositive.

Empirical studies

failed to provide con-

vincing evidence on

the sensitivity of pay

to stock market per-

formance. While the

studies of Lambert

and Larcker (1987);

Aggarwal and

The sensitivity of managerial compensation to the

firm’s risk is a controversial issue. While some

articles find evidence supporting the agency theory

that predicts a negative relationship between pay‐

performance sensitivity and risk, others support

the managerial ownership that predicts a positive

relationship between these factors. This article

reconciles these theories and provides evidence

that these two theories are not conflicting, when

tested properly, using industries risk characteris-

tics. In this articled, we distinguish between new‐

and old‐economy industries, and demonstrate

that managerial ownership theory applies to new-

economy firms, which are high‐tech firms that

operate in more uncertain environments, whereas

the agency theory applies to old‐economy firms

that operate in more traditional industries. We fur-

ther control for the size effect and find a positive

relationship between pay‐performance sensitivity

and risk for medium and large size new-economy

firms. Furthermore, we find that high‐tech compa-

nies increased their CEOs noncash compensation

dramatically during the high‐tech market crash

between 2000 and 2002 to cushion the fall in their

CEOs wealth in the company. This caused CEOs

pay‐performance sensitivity to risk to become

negatively related to their firms’ risk during that

period. © 2016 Wiley Periodicals, Inc.

Editorial Review

54 The Journal of Corporate Accounting & Finance / January/February 2016

DOI 10.1002/jcaf © 2016 Wiley Periodicals, Inc.

Samwick (1999, 2002); and Jin

(2002) find evidence in favor

of trade-off theory, the studies

by Core and Guay (2001, 2002)

seem to support the managerial

ownership theory predictions.

The studies of Garen (1994);

Yermack (1995); Bushman,

Indejikian, and Smith (1996);

Ittner, Larcker, and Rajan

(1997); and Conyon and Mur-

phy (2000) test this relation but

fail to find statistically signifi-

cant results. On the other hand,

Jensen and Murphy (1990) find

results that are not economi-

cally significant.1 A study by

Dee, Lulseged, and Nowlin

(2005) finds mixed results.

Given these competing

arguments and opposing views,

our study’s goal is to shed light

on this debate by providing new

empirical evidence on the rela-

tion between pay-performance

sensitivity and risk. More spe-

cifically, we use a sample of

new- and old-economy firms

during the period of 1995 to

2007. Distinguishing between

these two types of industries

is important because they

have different risk attributes.

Moreover, our sample has two

advantages: (1) the long sample

period comprises a period

where the use of incentive

compensation became more

aggressive, at the point that

executive compensation became

heavily criticized; and (2) the

sample period is a period when

new-economy firms knew a

rapid growth. Ittner, Lambert,

and Larcker (2003) argue that

these firms strongly differ from

the old-economy firms as they

have smaller sizes in terms of

sales, assets, and number of

employees; invest more inten-

sively in research and develop-

ment; and have a more rapid

growth and lower marginal tax

ratesand accounting returns

than old-economy firms. More-

over, these firms rely more

heavily on stock-based com-

pensation (Anderson, Baker,

& Ravindran, 2000; Ittner et

al., 2003; Murphy, 2003); the

sample period includes a period

when the stock market crashed

(2000–2002) and it is interest-

ing to test whether this event

caused a change in executive

practices in a way that modifies

their pay-performance sensitiv-

ity to their firms’ performance.

This is, to the best of our

knowledge, the first attempt

that tests more properly mana-

gerial ownership and trade-off

theories. Prior research did not

distinguish between industries

based on their risk level. Our

findings suggest that conflicting

findings of exciting literature is

due to the heterogeneity in the

samples used. Industries partic-

ularities help explain the con-

tradiction between the trade-

off theory and the managerial

ownership theory. Our results

show a negative relationship

between pay-performance and

risk for old-economy firms,

which is consistent with the

trade-off theory and Aggarwal

and Samwick’s (1999, 2002)

findings. This relationship is

positive for the new-economy

firms, which is consistent with

managerial ownership theory

and Prendergast’s (2000, 2002)

arguments that the trade-off

theory does not hold in uncer-

tain environments, such as

high-tech firms. Moreover, our

results show the importance of

the size factor. First, we find

that small firms have higher

pay-performance sensitivi-

ties than large firms from the

same industries. Moreover,

we find that the positive pay-

performance sensitivity to risk

holds only for medium and

large new-economy firms. Our

results suggest that monitor-

ing problems that can occur in

uncertain environments does

affect small high-tech compa-

nies. We further test the robust-

ness of our results in different

market periods. We find strong

evidence suggesting that CEOs’

pay-performance sensitivity

becomes negative during the

market crash in 2000–2002 for

high-tech firms. This sensitiv-

ity is positive in the rest of

the sample period. Our results

illustrate that high-tech com-

panies increased the noncash

compensation of their CEOs

by 139% on average during the

market crash to cushion the

CEOs overall wealth loss in

their firms. Concurrently, all

return measures dropped

dramatically among these

high-tech firms.

The rest of this article is

organized as follows. The next

section reviews the studies

that examine the relationship

between pay-performance sen-

sitivity and risk and explains

the hypotheses to be tested.

The third section describes the

sample selection. The fourth

section specifies the meth-

odology and variables used.

The fifth section reports the

descriptive statistics and the

results of our empirical analy-

sis. The final section concludes

the article.

LITERATURE REVIEW

ANDHYPOTHESES

The formal agency model

of optimal contracting aims

at providing incentives to risk-

averse CEOs by tying their

compensation to shareholders’

wealth. Indeed, investment

opportunities and managerial

choice of actions are often not

observable to shareholders.

For these reasons the agency