Theoretical development and empirical evidence on misalignment between investor investment horizon and executive pay duration

This dissertation focuses on the issue of misalignment between executive pay duration and investor investment horizon. In Chapter 1, this dissertation works within the agency paradigm with two alternations: First, unlike the traditional agency model, where the shareholders are assumed to be of one kind and prefer long-term value creation, we assume heterogenous time preferences of the investors (short-term investors pursuing short-term trading gains and long-term investors who pursue long-term value creation). We develop a simple three-period model (original period, period 1 and period 2), where there are two types of principals liquidate their holdings at different periods. Second, unlike the standard agency models, in which the management can affect the stock price only through the choice of effort (Spence and Zeckhauser, 1971; Ross, 1973; Holmstrom, 1979), our model assumes the manager can engage in unobservable earnings manipulation, like in Goldman and Slezak (2006), that upwardly biases disclosed information but hurts the long-term cash flows of the firm. The manager chooses a myopic action at the original period that can increase the period 1(short-term) earnings at the expense of the period 2 (long-term) value. Therefore, the unobservable earnings manipulation transfers long-term value of the firm to the current. We first work out the manager's hidden choice that maximizes the manager's payoff based on the contract that has been offered prior to the choice of the action and ownership structure. Then we take a step further to examine the optimal contract scheme by making the contract endogenously set by the current shareholders and argue that the optimal contract should “mirror” the ownership structure of the firm. In Chapter 2, we use empirical method to test the prediction from our model in Chapter 1, that short-termism is a result of optimal compensation contracting, by showing a positive relationship between investors investment horizon, as measured by the reverse of the weighted churn rate of firms’ institutional investors, and CEO’s pay duration, as measured by the weighted average of different components of CEO’s compensation grants, after controlling other factors may affect pay duration industry fixed effect and year effect. Then, we take a further step to develop a measure to quantify the sub-optimality of the compensation contract by measuring the misalignment between investor horizon and executive pay duration. We take the absolute value of the difference between standardized investor investment horizon and standardized CEO pay duration and identify that the misaligned horizons will lead to higher stock volatility and more harmful real earnings management (negative effect on future operating performance). The negative result of misalignment is more pronounced if the pay duration is shorter than the investor horizon. That is to say, the abnormal behavior (overproduction, sales discount, extraordinary expense cut) captured by Roychowdhury's model is more out of opportunistic choice rather than efficient contract when their pay duration is misaligned with investors' investment horizon, especially with the misalignment direction of shorter pay duration relative to investor horizon. Therefore, we argue that what really matters to existing shareholders’ interest is not whether the compensation scheme of the management is long-term or short-term per se, but rather the relative stand of executive pay duration comparing with their own investment horizon.Ph.D.Includes bibliographical referencesby Lingyi Zhen