Author: Huasheng Gao (Nanyang Technological University), Michael Lemmon (University of Utah), and Kai Li (University of British Columbia)
Publisher: Social Science Research Network Working Paper Series
Date Published: April 2012
Having created a new database to examine the compensation packages of CEOs at publicly owned U.S. companies and of those at private firms, the authors of this paper dispel the conventional wisdom — echoed loudly during the Great Recession — that the CEOs of big public firms are paid too much by comparison.
As a group, public CEOs are indeed paid more than their private counterparts, almost twice as much, on average — US$2.97 million a year versus $1.57 million in total compensation, according to the new database. But when the authors compared CEO compensation at public and private companies of approximately the same size and industry share, the gap shrank dramatically. Much of the advantage for the public CEOs turns on industry, firm, and demographic differences — namely, they tend to have more experience and run larger, older companies. Their compensation also entails significantly more risk, in terms of restricted stock and options tied to firm performance.
When these and other differences are factored in, the public CEOs make just shy of 20 percent more, on average, than their private counterparts. Only a quarter of this much-reduced differential, or 5 percent, is attributable to cash, and the rest is tied to restricted stock and option grants. Even this premium is overstated, the authors say, because of “differences in liquidity, dividends, and employment risk between public and private firms.” When all is said and done, they conclude, public CEOs “are not overpaid.”
The researchers analyzed all U.S. private and public firms with compensation data available in the S&P Capital IQ database from 1999 to 2008, then retrieved stock option information from the ExecuComp database and SEC filings. In all, the researchers examined 1,938 private firms, with average assets of $273 million, and 5,333 public firms, with average assets of $467 million.
The analysis also revealed that the compensation of public CEOs was based much more than that of private CEOs on how well their firm performed. On average, equity-based pay (or restricted stock and options grants) was 24 percent of overall compensation at public firms, compared with 11 percent at private companies. And although private firms tended to be smaller, younger companies with weaker returns, higher cash flow volatility, slower growth, and fewer segments than public firms, their CEOs had been rewarded with a much larger ownership stake — about 13 percent, on average — than the CEOs’ public colleagues (6 percent).
The authors also examined succession searches that involved outside candidates and found that public CEOs faced a tougher labor market. Matching up 123 successions at private firms with the same number at public companies in the same industries and with similar sales levels, the authors found that 81 percent of outside hires at private firms came from other private firms, but that just 68 percent of CEOs appointed at public companies came from the public sector. And only 7 percent of new CEOS at private firms were hired from public companies.
To further demonstrate that the two types of firms structure their compensation packages in different ways, the authors tracked the 574 private companies in the sample that had changed their status through an initial public offering (IPO). They measured CEO compensation for a period of three years before and three years after the transition. Each company was matched to a control firm from the same industry that remained private and that posted similar sales the year before the IPO.
The total pay for CEOs at the new public companies shot up substantially at the time of the IPO and stayed higher, the authors found. These CEOs saw an increase of 245 percent from the year prior to the IPO to the year after, compared with an increase of 32 percent for CEOs in the control group. The gap between the average compensation levels of the two CEO groups should narrow considerably over time if the IPO company remains at about the same size as the control company — but will stay in place if the IPO company grows.
Noteworthy now, however, is how the increases are paid. The CEOs at IPO companies received less than one-third in cash, on average, compared with more than half in cash for the control group. And the proportion of total pay from restricted stock and options increased significantly for the newly public CEOs, soaring from an average of 8 percent before the IPO to about 40 percent in the three succeeding years.
“Overall, the results indicate a significant permanent shift in the level and structure of CEO pay as firms transition from private to public,” the authors write. “The change in pay is largely driven by CEOs being given additional equity incentives to maximize shareholder value.”
The researchers conclude that “[t]he observed public firm pay premium might actually be the result of good governance and stronger links between CEO pay and firm performance.”
Contrary to popular conception, the CEOs of U.S. public firms are not overpaid in comparison with the CEOs of privately held companies. Employing a unique dataset, the authors find that public CEOs earn just under 20 percent more, on average, in total compensation, but only one-fourth of that differential is in cash. The rest is in risk-heavy stock options, effectively leveling the playing field between public and private CEOs.