When the issue of backdating stock options was revealed in research by Lie in 2005, stockholders were reviled about the perverse incentives in backdating. The reaction of stockholders to new CEO compensation incentives such as restricted stock grants or options is not simply a ‘thumbs up’ as is often portrayed in the financial press. Though theoretically top management’s interests are aligned with shareholders’ interests by receiving equity-based compensation, it does not always benefit the shareholders. In the new paper “Stockholder and Bondholder Wealth Effects of CEO Incentive Grants,” Dave Mauer of SMU Cox and co-authors show that stockholders do care about what form the incentives take. Bondholder reactions to CEO compensation hasn’t been studied recently or with a large sample until now. This often-forgotten group’s reaction has a telling consequence: the potential for a higher cost of capital—important for future investments and company performance.

“It has always been assumed that it is good to load up CEOs with stock to align their interests with shareholders, who after all own the company,” Mauer says. However, shareholders come and go and have limited liability. “But salary compensation solely tends to make them more risk-averse as their livelihood is tied up with the company. They may not make investments that carry risk or have long-term payoffs. Thus came equity compensation, giving CEOs a stake in the company’s performance.”


Volatility vs. Wealth incentives

Rightly so, stockholders react according to the type of compensation a CEO is offered.  The devil is really in the details of the offer. Stockholders react positively when compensation is tied to the volatility of the stock price (vega incentives). In other words, when the compensation is bound to the ups and downs of the company’s stock price or performance. They are more sanguine when the CEO is offered compensation that is tied to changes in stock price (delta incentives or pay-performance), whereby his/her choice can determine their amount of compensation or wealth in relation to how the stock price changes per dollar amount. Compensation of this type encourages more managerial conservatism or an aversion to making investments that could potentially drive down the stock price and thus their wealth.

In the paper, shareholders are verified as reacting negatively to the delta piece of new equity compensation. Mauer comments, “The problem is you have two potential incentives that can go wrong. If stock options have high vega (volatility), CEOs may take more risks than shareholders prefer, ie., they go for broke.” He continues, “Alternatively, you can bias things on the opposite end. If you are giving a large stock or options piece that is well ‘in-the-money,’ it turns out (counterintuitively) CEOs can be risk-averse.” For example, if a restricted stock grant is given, but it vests over a schedule from five to seven years, the stock can only be received in pieces as the schedule plays out. CEOs tend to get more risk averse, and don’t want to damage the stock price. They may not want to take risky yet potentially very valuable investments because they are worried about the stock price going down. “This is why pay-performance compensation may not be as valuable to equityholders,” Mauer says. “That’s being picked up in delta.”

An important and novel contribution the research makes is the reaction of equityholders to new CEO grants, and their differing reactions given the delta and vega incentives of grants. Equityholder reactions are increasing in vega, and decreasing in delta. While the sample shows an excess stock return of 2.56% when stock options or grants are filed, the details of vega and delta reveal more complexity in the thought processes of stakeholders. This information has never been unpacked before.


Bondholders’ Stakes

A second, and perhaps more important contribution, is the bondholders’ reaction to compensation events. In some cases the polar opposite, bondholders have interests that are different than stockholders. They want to be paid and dislike volatility in earnings that would impact getting their principal and interest back. Consistent with intuition, bondholders react negatively to volatility (vega) and positively to pay-performance (delta). They want to get repaid. They don’t want the corporation to stop making investments and become less profitable. Mauer comments, “But when bondholders lend money, they like what they see and how the existing operation works. It is probably not in their interest for a CEO to take risky investments that may have a higher payoff later (using their capital), long after their bonds are re-paid. Their interests lie in neither excessive risk-taking nor ultra conservatism, but somewhere in between.”

The psychology of volatility relates to stockholders, but bondholders are about cold, hard cash. They are resource-driven; there are pieces of compensation that are more favored by bondholders. They don’t like investments that may have future positive profitability but increase volatility. It could be possible that an investment pays off in 15 years because it was a good investment, but if it causes present stock price volatility, making the payback of bonds uncertain, bondholders cringe.

The authors find a transfer of wealth from bondholders to equityholders. The higher is the vega of new compensation, the greater is the transfer of wealth to equityholders. “When a board of directors decides to load up a CEO with equity-based compensation, they may be forgetting that they are potentially increasing the cost of the company’s debt capital,” Mauer relays. “This can increase the overall weighted average cost of capital, which can then lower the value of future investments.”


Conclusion

The way in which CEO compensation is structured has implications for investment decisions, and therefore company performance. Too much volatility in the package makes stockholders, and especially bondholders, uneasy. Stockholders also dislike compensation that makes CEOs overly conservative, preserving their wealth at the expense of shareholder wealth. Overly volatile compensation takes away from bondholders, and ultimately shareholders, through a higher cost of capital. The incentives behind CEO compensation matter.


The paper “Stockholder and Bondholder Wealth Effects of CEO Incentive Grants” was written by David Mauer of SMU Cox, Matthew Billett of University of Iowa, and Yilei Zhang of University of North Dakota.


Written by Jennifer Warren.