Data from the Corporate Governance Research Initiative at Stanford Graduate School of Business track the steep, relentless climb of average CEO annual compensation in the top 100 US companies. In the 80s, it was $1.8M, mostly in keeping with the trend for the past 45 years. In the 90s, however, it shot up to $4.1M, and at the turn of the millennium, to $9.2M, scaling new heights at $13.7M in 2014. The sky is indeed the limit for chief executive pay. Perhaps no one can claim greater responsibility for this phenomenon than Harvard Business School finance professor Michael Jensen. In line with Milton Friedman’s financial theory of the firm (its purpose is “to maximize shareholder value”) and his own agency theory (managers are “agents” of stockholders, who are “principals”), Jensen (and co-author Murphy) advocated tying CEO compensation to stock price performance through stock options and other equity-based pay. Thus CEO incentives align with those of stockholders, and agency problems such as shirking are avoided. Moreover, this way corporate management careers would attract “the best and the brightest”, for no doubt they prefer greater monetary rewards, not less, and they’d rather be paid for their performance, not independently of it. Further, performance-related pay could stop the flight of top talent to investment banking or consulting, encouraging them to seek jobs in the “real economy” instead.
In a recent article for Institutional Investor, Dan Rasmussen and Haonan Li tested Jensen’s almost intuitive claims relating MBA CEO pay to stock price performance and found no supportive empirical evidence. Stock options did not discourage MBAs from elite schools from working in investment banking and consulting. Even more worrying, elite MBA diplomas for CEOs were not correlated with market-beating stock price performance, nor was CEO performance measured in stock price consistent through a period of six years. In other words, the impact of CEOs on their companies’ stock prices was no greater than that of randomness. If Rasmussen and Li are right, then aren’t CEOs being grossly overpaid on the basis of a mistaken attribution?
Let’s have a look at their methods. Rasmussen and Li created a database of around 8500 CEOs, their tenure and education, with information on company stock returns. First they tested the predictive power of CEO characteristics on stock price performance. They found that CEOs with MBAs did not outperform those without them. It didn’t matter from which school they graduated. Neither did CEOs from banks and consultancies do better than the market average. “MBA programs simply do not produce CEOs who are better at running companies, if performance is measured by stock price return,” they reported. CEOs with MBAs from top schools are of course well-represented in corporate boards. But this only indicates that executive search firms have a clear preference for recruiting them, despite the lack of evidence for superior performance. It would be just another case of confirmation bias, when people tend to see a clustering of MBA CEOs in successful companies although there is no due cause.
Next, Rasmussen and Li examined whether CEO performance was persistent through a six-year period, either in the same company or in successive companies. Again, surprisingly, they discovered it was not. At least, outcomes were no different from what we could expect to occur by mere chance. Companies, then, seem to be rewarding (or punishing) CEOs based on exogenous factors rather than their own performance or trajectory, measured in stock price behavior during their tenure. Similarly, this may be an example of the “hot-hand” fallacy, when we project a pattern from past results to the future without justification.
Absence of evidence is not evidence of absence. And we cannot really prove or demonstrate that CEO MBAs do not increase stock prices (all things being equal), because that is a null hypothesis. But the lack of correlation between CEO credentials and superior stock performance is certainly puzzling, were the contrary true.
What the research seems to imply, however, is that we cannot attribute company success in terms of stock price to the CEO, either exclusively or mainly. Management has always been a team effort. A just compensation policy has to take this principle more into account. Also, it may not be wise to focus on a single metric as stock price to gauge company performance, because this is far more complex. Doing so only creates an enormous temptation for CEOs and other members of the management team to be working for the wrong motives. And lastly, perhaps we should reconsider the usefulness of MBA programs to society at large, apart from boosting school and alumni incomes through networking. Originally, business schools were meant to help transform business into a profession, like law, medicine, or religion; now they are considered pricey leadership bootcamps. Do they really provide the right education for the kind of corporate and civic leaders we need?