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CEO Contract Design: How Do Strong Principals Do It?

Author

Listed:
  • Henrik CRONQVIST

    (Claremont McKenna College)

  • Rüdiger FAHLENBRACH

    (Ecole Polytechnique Fédérale de Lausanne and Swiss Finance Institute)

Abstract

We study changes in the design of CEO contracts when firms transition from being public with dispersed shareholders to having strong principals in the form of private equity sponsors. These principals redesign some, but far from all, contract characteristics. There is no evidence that they reduce excessive salary, bonus, and perquisites, but they redesign contracts away from earnings-based and non-financial bonus criteria. They do not change CEO severance cash pay, but they redesign contracts so unvested equity is forfeited by terminated CEOs, and they restrict the resale market for equity. CEO contracts are also redesigned so that a significant fraction of equity grants performance-vests: if the agent does not produce prespecified multiples or IRRs, the equity is forfeited. We find that even these sophisticated principals rely on subjective performance evaluation, use some time-vesting equity, do not use premium options, and do not condition vesting on relative industry performance. We compare the real-world contracts in our sample to contracting theories, and we relate our findings to recent discussions of executive compensation reform.

Suggested Citation

  • Henrik CRONQVIST & Rüdiger FAHLENBRACH, 2011. "CEO Contract Design: How Do Strong Principals Do It?," Swiss Finance Institute Research Paper Series 11-14, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1114
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    Cited by:

    1. Colonnello, Stefano, 2020. "Executive compensation, macroeconomic conditions, and cash flow cyclicality," Finance Research Letters, Elsevier, vol. 37(C).
    2. N. Gregory Mankiw, 2013. "Defending the One Percent," Journal of Economic Perspectives, American Economic Association, vol. 27(3), pages 21-34, Summer.
    3. Sharjil M. Haque, 2023. "Does Private Equity Over-Lever Portfolio Companies?," Finance and Economics Discussion Series 2023-009, Board of Governors of the Federal Reserve System (U.S.).
    4. Steven N. Kaplan, 2012. "Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges," NBER Working Papers 18395, National Bureau of Economic Research, Inc.
    5. Gao, Huasheng & Li, Kai, 2015. "A comparison of CEO pay–performance sensitivity in privately-held and public firms," Journal of Corporate Finance, Elsevier, vol. 35(C), pages 370-388.
    6. Victor Esteban Jarosiewicz, 2019. "CEO Compensation after Harvester Director Departure," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 9(01), pages 1-21, March.
    7. Alex Edmans & Xavier Gabaix, 2016. "Executive Compensation: A Modern Primer," Journal of Economic Literature, American Economic Association, vol. 54(4), pages 1232-1287, December.
    8. Gulen, Huseyin & O'Brien, William J., 2017. "Option repricing, corporate governance, and the effect of shareholder empowerment," Journal of Financial Economics, Elsevier, vol. 125(2), pages 389-415.
    9. Sharjil M. Haque & Simon Mayer & Teng Wang, 2024. "How Private Equity Fuels Non-Bank Lending," Finance and Economics Discussion Series 2024-015, Board of Governors of the Federal Reserve System (U.S.).
    10. Chua, Ansley & Nasser, Tareque, 2016. "Insider sales in IPOs: Consequences of liquidity needs," Journal of Corporate Finance, Elsevier, vol. 39(C), pages 1-17.
    11. Jochen Bigus & Aline Grahn & Mustafa Karakaya, 2024. "Determinants of executive pay in small private firms–initial evidence from Germany," Journal of Business Economics, Springer, vol. 94(1), pages 41-73, January.
    12. Ernst Maug & Bernd Albrecht, 2011. "Struktur und Höhe der Vorstandsvergütung: Fakten und Mythen," Schmalenbach Journal of Business Research, Springer, vol. 63(8), pages 858-881, December.
    13. Lu, Erin P. & Lai, Gene C. & Ma, Qingzhong, 2017. "Organizational structure, risk-based capital requirements, and the sales of downgraded bonds," Journal of Banking & Finance, Elsevier, vol. 74(C), pages 51-68.
    14. Li‐Ying Huang & Gene C. Lai & Erin Lu & Michael McNamara, 2020. "Auditor quality, audit fees, organizational structure, and risk taking in the US life insurance industry," Risk Management and Insurance Review, American Risk and Insurance Association, vol. 23(2), pages 151-182, June.
    15. Lindbeck, Assar & Weibull, Jörgen, 2015. "Pay Schemes, Bargaining, and Competition for Talent," Working Paper Series 1100, Research Institute of Industrial Economics.
    16. Sharjil M. Haque & Anya V. Kleymenova, 2023. "Private Equity and Debt Contract Enforcement: Evidence from Covenant Violations," Finance and Economics Discussion Series 2023-018, Board of Governors of the Federal Reserve System (U.S.).
    17. Phalippou, Ludovic & Rauch, Christian & Umber, Marc, 2018. "Private equity portfolio company fees," Journal of Financial Economics, Elsevier, vol. 129(3), pages 559-585.
    18. Yaowen Shan & Terry Walter, 2016. "Towards a Set of Design Principles for Executive Compensation Contracts," Abacus, Accounting Foundation, University of Sydney, vol. 52(4), pages 619-684, December.
    19. Sara Fernández‐López & David Rodeiro‐Pazos & Lucía Rey‐Ares, 2020. "Effects of working capital management on firms' profitability: evidence from cheese‐producing companies," Agribusiness, John Wiley & Sons, Ltd., vol. 36(4), pages 770-791, October.
    20. Miaowei Peng & Xue Tan, 2023. "Does controlling persons’ foreign residency rights influence executive compensation?," Review of Managerial Science, Springer, vol. 17(7), pages 2375-2416, October.

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    Keywords

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    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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