Managerial Ability and Executive Compensation

We study the role of latent managerial ability in determining executive compensation. We decompose the variation of executive compensation into time variant and invariant firm and manager components and find that the time invariant manager fixed effect, a proxy for latent (i.e. unobservable) managerial human capital, explains a majority of the variation in executive pay. In addition, we show that including manager fixed effects alters coefficients and interpretations of other variables. We also find that firm performance improves after CEOs with larger compensation fixed effects are hired, which is consistent with the fixed effect being associated with innate managerial ability or social capital, which in turn leads to better performance. We further derive managers ’ excess compensation by purging time variant effects and firm, manager, and year fixed effects, and show that firms with over-paid managers use less debt, consistent with theoretical predictions