By Tomislav Ladika, University of Amsterdam, and Zacharias Sautner, Frankfurt School of Finance & Management and ECGI
The managerial myopia debate
Institutional investors and policymakers frequently express concern about managerial short-termism. Business leaders like Jamie Dimon and Warren Buffet recently joined the fray, arguing that “companies frequently hold back on technology spending, hiring, and research and development to meet quarterly earnings forecasts.” (Short-Termism Is Harming the Economy, Wall Street Journal, 6 June 2018.) Yet little clean evidence exists on the prevalence of managerial short-termism.
Our paper, Managerial Short-Termism and Investment: Evidence from Accelerated Option Vesting, recently published in the Review of Finance[i], helps to fill this gap. It provides new evidence that CEOs with more short-term incentives spend less on long-term investment.
We start from the insight that CEOs’ incentive horizons are determined largely by the length of the vesting periods on their equity pay grants. Short vesting periods make it more likely that CEOs pump up the stock price and then quickly sell their shares at a profit.
As investment cuts are a plausible target for myopic CEOs, because investors may only realise the long-term consequences years down the road, we examine whether CEOs reduce investment when vesting periods become shorter.
Acceleration of option vesting periods
To examine this question, we exploit a unique event that led 723 firms to eliminate vesting periods on CEO stock options. FAS 123-R was adopted in the US in 2004 and required firms to expense option compensation costs in their income statements.
It created retroactive expenses for options granted years earlier that had not yet vested. Firms could avoid charges by accelerating options to fully vest before the FAS 123-R compliance date. Option acceleration led to a 78% decline in CEO incentives from unvested equity, the single-biggest reduction in incentive horizon observed at these firms over a 10-year period.
FAS 123-R took effect for each firm in the fiscal year starting after 15 June 2005. Firms with late fiscal year-ends (June through December) complied before firms with early fiscal year-ends (January through May).
Because of this staggered compliance schedule, late fiscal year-end firms were much more likely to accelerate options in 2005, while early fiscal year-end firms were more likely to accelerate in 2006, even though the two sets of firms were otherwise highly similar. Our tests examine whether each set of firms was also more likely to cut investment in the year of acceleration.
Effects on corporate investment
We find that option acceleration led CEOs to cut both capital expenditures and R&D, leading to a US$14m decline in total investment at the median accelerating firm. CEOs whose incentive horizons decreased more engaged in bigger cuts.
Shortly afterwards, accelerating firms reported higher earnings, beat analysts’ forecasts at a higher rate, and experienced short-term stock price increases. Over the next year, their CEOs increased option exercises by 65%, and sold most of the resulting shares. Thus, CEOs personally benefitted from stock price increases following investment cuts.
Our evidence on the importance of vesting periods complements our prior work[ii], which shows that vesting periods also serve as a key tool for retaining executives.
Using the same empirical setting, this paper finds that an increase in accelerated options led to a significant rise in voluntary CEO turnover. Turnover rose more among CEOs who would have waited longer for options to vest in the absence of acceleration and whose options were more in the money.
Our analysis suggests that most CEOs used the windfall to transition their careers – the typical departing CEO was in their mid-50s, and many continued to serve on corporate boards or pursued alternative opportunities like working in private equity.
Implications for institutional investors
Our findings show that executives’ incentives depend not only on the amount of pay that is granted in equity, but also the length of time until incentives can be unwound. Our findings support initiatives by institutional investors that engage firms to increase executives’ incentive horizons in order to reduce problems with managerial myopia.
Based on our evidence, longer vesting periods in equity compensation plans lead to more long-term investments and higher value creation.
Read the full paper here.
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[i] Ladika, Tomislav, and Zacharias Sautner, 2020, Managerial Short-Termism and Investment: Evidence from Accelerated Option Vesting, Review of Finance, Volume 24, Issue 2, March 2020, Pages 305–344
[ii] Torsten Jochem, Tomislav Ladika, Zacharias Sautner, 2018, The Retention Effects of Unvested Equity: Evidence from Accelerated Option Vesting, Review of Financial Studies, Volume 31, Issue 11, November 2018, Pages 4142–4186.