Study: When CEOs’ Equity Is About to Vest, They Cut Investment to Boost the Stock Price

February 28, 2018 Alex Edmans

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Are today’s businesses plagued by short-termism? The narrative is compelling. Executives cut investment to hit short-term earnings targets and trigger bonus payouts, the argument goes. They are egged on by short-term shareholders, who care only about making a quick buck, rather than growing the company for the long term. Moreover, long-term investments — such as reducing carbon emissions, developing blockbuster drugs, or training workers — benefit more than just shareholders. So, the charge that businesses are deprioritizing them leads to concerns that business no longer serves society.

But despite how common the charge of short-termism has become, rigorous evidence of short-termism is surprisingly difficult to find. Eighty percent of CFOs say that they’d cut investment to meet earnings targets — but what they say isn’t necessarily what they do. A recent McKinsey study found that a “long-termism” index (including how much a firm invests) is correlated with future long-term stock returns, suggesting that long-termism pays off. But causality could easily run the other way. When a firm’s long-term outlook is worse, it should invest less. This is taught in any Finance 101 class, and is presumably what McKinsey advises its clients.

So does short-termism exist? And if it does, what’s the underlying cause?

This is what Vivian Fang, Katharina Lewellen, and I set out to study. We wanted to see whether CEO pay packets encouraged short-termism — whether CEOs cut investment to pump up their company’s short-term stock price and then cash out their shares.

But it’s extremely hard to document causation rather than simply correlation. Say we found that a CEO cuts investment and then sells their shares. One interpretation is that they cut investment to cash out. But another is that their firm’s long-term outlook is poor. This causes the CEO (correctly) to cut investment and also (rationally) to sell their shares. So, there’s correlation between investment and sales, but no causation.

We studied not how many shares the CEO sells, but how many shares are scheduled to vest. Here’s the idea: CEOs’ shares come with a vesting or lock-up period. Only once this period is over can they sell — and they typically do, to diversify their personal investments. So, when the lock-up expires, the CEO is concerned about the stock price. But a lock-up expiring today is driven by the board’s decision several years ago to grant the shares. It’s unlikely that at the time the board would have known the firm’s present outlook. So the decision to grant shares back then, and thus the fact that shares are vesting today, is unlikely to be driven by factors that also determine investment. By focusing on when shares vest rather than when CEOs sell shares, we’re able to show causation — not just correlation — from CEOs’ personal wealth concerns to cuts in investment.

We find that the more equity CEOs have vesting in a given quarter, the more they cut investment. This result holds for five different measures of investment and for both vesting stock and vesting options. In addition, vesting equity is positively correlated with the CEO just barely meeting analyst earnings forecasts — suggesting that it causes the CEO to focus on short-term earnings rather than long-term investment.

That result is consistent with short-term behavior, but we considered an alternative interpretation. Could the investment cuts actually be efficient? Perhaps stock price concerns are motivating, because they induce the CEO to make tough decisions, such as cutting wasteful investment. If so, we would expect the CEO to improve efficiency in other ways as well, such as increasing sales growth or cutting other expenses. And we find no evidence of that.

Moreover, in a new paper with Vivian and Allen Huang, we aim to more precisely document the long-term consequences of short-term incentives. To do so, we study share buybacks and M&A, since — unlike with investment cuts — we can measure the long-term returns to these actions as they have a clear announcement date. We find that the more vesting equity the CEO has in a given quarter, the higher the likelihood is of both buybacks and M&A. Like investment cuts, buybacks and M&A could be good rather than bad — but we find that vesting equity leads to the bad type. It is associated with higher short-term returns to both decisions, but significantly lower long-term returns. In short, vesting equity encourages CEOs to take actions with destructive long-term consequences.

What does this all mean for CEO pay? There is widespread belief that CEO pay needs to be reformed, but proposed reforms typically focus on the level of pay. Our research suggests that the horizon of pay is more important — it affects the CEO’s incentives to invest, with major implications for the company’s long-run success and contribution to society. Cutting pay in half will win more headlines than extending the vesting horizon from, say, three to five years, but the latter is likely to be much more important. Indeed, the UK government’s green paper on corporate governance has proposed this extension, and the Norwegian sovereign wealth fund’s remuneration principles advocates making the CEO a long-term shareholder.

Cutting the level of CEO pay aims to redistribute the CEO’s share of the pie to other stakeholders. But since the CEO’s slice is small to begin with — in large U.S. firms, it accounts for just 0.05% of firm value — the result would be negligible. Increasing the horizon of pay will encourage the CEO to invest for the firm’s long-term success, growing the pie to the benefit of both shareholders and society.


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