Title: CEO Contract Horizon and Investment (PDF)
Author: Moqi Xu (INSEAD)
Publisher: INSEAD Working Paper
Date Published: June 2011
The common wisdom has it that as time winds down on a CEO’s contract, boards should be worried about a couple of possibilities. Concern number one: To earn a higher end-of-term bonus and/or a new contract, the CEO might underinvest in long-term R&D and capital expenditures in an effort to make short-term earnings look stronger. Concern number two: The CEO might overinvest in risky projects to show that he or she is “indispensable” to a just-launched initiative.
The reality of the dangers posed by these so-called myopic CEOs is actually somewhat worse than that conventional wisdom, says this paper, which examines how the length and type of a CEO contract affects investment behavior. Using 20 years of data about the performance of more than 3,700 CEOs, the author finds that overall investment activity declines as the contract deadline nears. But if short-term CEOs are cutting back on investments to bolster earnings or throwing money at them to prove their indispensability, they don’t seem to be succeeding: Their firms are no more profitable than others, according to the researcher.
The study is the first to find that a chief executive’s investment strategies depend on the length of time remaining on his or her contract; the author calls this the contract horizon effect. CEOs invest much more at the beginning of their term, the researcher says, suggesting that chief executives who are tied to long contracts feel stable and secure enough to make long-term investments.
To keep CEOs focused on the right kind of investments, and not have their decisions distorted by end-of-term worries, the paper implies, boards should consider renegotiating CEO contracts before they enter their final phase. The paper’s findings also have implications for how boards should view the performance of CEOs who don’t have a fixed-term contract. Compared with chief executives who have fixed terms, these CEOs, working under a so-called at-will arrangement, invest much less throughout their tenure and produce lower earnings as their time comes to a close, the author says.
The author analyzed 3,717 employment contracts or summaries of employment terms, culled from U.S. Securities and Exchange Commission filings and from the Corporate Library, an independent corporate governance research firm. Spanning the period from 1989 through 2008, the contracts covered 2,371 U.S. firms with an average book value of US$1.18 billion. The data set allowed the author to track changes in CEOs’ investment behavior during the course of their tenure and to measure the impact of their contract type and length on executive and firm performance.
First, the author had to differentiate between fixed and at-will arrangements. Under at-will employment, the company or the employee can sever ties at any time, so that a CEO is effectively working with the constant possibility of losing the job. Under fixed-term contracts, early termination leads to severance pay or costly litigation.
The industry with the highest number of at-will contracts in the sample was software, which is in line with the argument that firms with high operating risks prefer to protect themselves with more flexible CEO arrangements. The highest number of fixed contracts was in banking. (Not all CEOs sign explicit employment documents, so the author treated those without formal contracts as at-will employees, which had no effect on the resulting analysis.)
Although having a fixed contract doesn’t necessarily mean that a CEO will stay for the entire stipulated period, it does generally result in a longer tenure than an at-will arrangement. On average, the author found that CEOs with fixed-term deals stayed two years more than at-will CEOs.
To isolate the effects of contracts on investment, the author ran several models that controlled for a variety of factors, including CEO age and career path and such industry variables as the quality of corporate governance, volatility of sales, firm survival rates, investment opportunity, company size, and risk measures. The author performed several regression analyses across different contract lengths, looking for correlations with capital expenditure and R&D spending.
The author found that investments decreased over the course of a fixed-term contract; CEOs spent 20 percent more on capital projects, for example, in the first year of a five-year deal than in the last year. The horizon effect in the last two years of the contract is stark in the other direction: Investment is lower by 8 percent in the penultimate year compared with the year before that and falls another 9 percent in the final year.
At-will CEOs also showed a decline in investment activity over time; overall, however, the analysis showed they invested much less than their peers, implying that to some degree they always feel like short-timers. By contrast, CEOs with a longer expected horizon invested more than their peers, a finding that held true when the comparison was made both with at-will CEOs and with CEOs whose fixed-term contracts were almost up. The author ran several models to gauge the impact of these investment approaches on profitability. Although the models revealed no earnings improvement under the stewardship of CEOs in the waning days of a fixed-term contract, they showed that profitability for CEOs with at-will deals was lower as their time neared an end, which was presumably a reflection of the increasing tenuousness of their employment situation.
If boards want to keep their investment programs on track as periods of possible transition approach, they should carefully consider how they structure their CEO’s contract, the author concludes.
The type and duration of CEO contracts have a big effect on decisions involving investments in research and development and capital projects. Overall, CEOs with long fixed-term contracts invest the most, and mostly at the beginning of their tenures. To keep investment programs on a more stable basis, boards should consider renegotiating contracts before they enter their final phase.