Incentives, Short-termism and Investment Decisions

Introduction

           In recent years, there have been a growing number of academic research studies on the topic of CEO’s role in shaping investment decision for a business. As stated by Carpenter et al. (2010) that CEO is a key decision maker in investment related decisions and charged with the liability of formulating corporate strategy and is frequently involved in promoting the short-term as well as long-term success of the business. In the contemporary competitive business environment, incentive mechanism is a significant component of management control system and motivational factor of compensation contracts. Lin et al. (2011) stated that the well-designed incentive scheme is likely to influence decision making of CEO towards the improvement of firms’ performance and competitiveness.

Most of the companies use different measures in order to reward their Chief Executive Officers and employees, including compensation pay schemes, incentives, or pay contracts. It asserts that there is a positive relationship between incentive schemes and investment decisions as incentives and compensation pay schemes are likely to influence CEO to make effective decisions regarding investment. Preferably, CEOs are required to take risky investment decisions, but in reality they are not engaged in excessively and imprudent risky investment decisions. As regard to this, the aim of the following essay is to analyse how the incentive system or compensation pay scheme should be designed in order to incentivise CEO in order to undertake investment decisions except excessively risky decisions for the business.

Analysis of Principal- Agent Problem and General Solution

            The principal agent problem in business firm occurs when an entity or person is able to take actions or make decisions on the behalf of the firm of impact on another entity or person. In other words, Gailmard (2012) stated that principal-agent problem usually occurs when a principal creates a situation in which incentives of an agent do not line up with those of the principal. It is the liability of principal to offer incentives to the agent in order to encourage agent to work as the principal wants. The assumptions of agency theory underlying the causes of principal-agent problem and asserted that the main cause of arising principal -agent problem is the nonalignment of incentive to the goals and desires of manager or CEO as an agent or agents are only incentivise in order to act for their own best interests as opposed to the interest of their principal.  

      The assumptions underlying the principal-agent is based on the agency theory which asserted that organisational system is comprised on the association between principal and an agent in which agent represents the interest of principal with regard to his personal interest. However, due to poor incentive system, agents are influenced to work for their own interest rather than for the benefit of the principal. This issue has become a serious concern for most of the organisations as interest of the agents are not aligned with those of the principal. Moreover, Forbes-Pitt (2011) stated that another assumption of agency theory underlying the principal-agent problem is that agents rationally seek to increase the material or financial returns to themselves. This is one of the major driving motivations of agent’s action for their self-interest.

Another assumption that underlines the cause of principal -agent problem is that agent is gravitating towards equilibrium and has more information than principal. Similarly, principal is concerned of being exploited by the agent and not to enter in the transaction that would be equally beneficial for both of them. As regards to this, agents become deviated from the interest of agent and cause agency costs for the principal. As state by Heineman and Davis (2011), principal-agent problem usually exists between shareholders as principal and managers or CEO as an agent and this problem contributing significantly to the short-termism. Short-termism hypothesis is also a major cause of principal-agent problem as managers are focused on the attainment of short-term goals and objectives at the expense of long-term profit. In this regard, Dallas (2011) stated that managers are directed towards short-term stock prices for the reason that firms’ performance is evaluated on the basis of short-term stock price and cause short-termism in the firm.

Moreover, Antia, Pantzalis, and Park (2010) stated that short-termism has negative significant relationship with investment decision as agents like CEO are likely to act towards the short-term goals and eventually reduces the firm’s performance as well as current stock prices. CEOs are most likely to concern with the short-term stock price of the firm which make them unable to invest in major or risky projects that will provide profit in the long run. This CEO’s alignment with short-termism results in excessive risky investment decisions.

Another major assumption underlying principal-agent problem is that managers are highly risk-averse and may not take those projects that are highly risky and may yield high profits. This is another case of conflict of interest between shareholders and CEO as shareholders prefer high risky projects, while CEO prefers low risky and low profitable projects.  Most of the companies such as banks, financial institutions, car companies, and other business firms are now facing principal-agent problem and determines to address this issue significantly. In general, there is only a way to resolve the principal-agent problem between shareholders and agent is to create an effective contract design between the principal and the agent in order to address the problem of information asymmetry and stimulate the incentives and compensation of agent in order to act in the best interest of the principal and regulate monitoring procedures.

Analysis of Challenges in Compensation Pay Schemes and Investment Behaviour

            In the recent literature, there is controversial hypothesis that compensation pay of managers or CEO is likely to influence investment behaviour in the business firm. Chrisman and Patel (2012) stated that most of the firms are now implemented compensation pay schemes within the organisation in order to address principal-agent problem within the organisation with the general formula of nominal exchange rate which is S(e)=K+a*Pi(e) and tells firm that how much amount is required to compensate managers in order to work for the interest of the principal.  Modern firms are using different compensation pay schemes in order to deal with principal-agent. These compensations schemes are based on pay level and structures. Structure of pay is a hierarchical group of jobs and pay levels within the organisation, while pay level is a basic unit in the compensation structure of an organisation.

Pay level is used to denote difference in compensation or pay structure due to smallest variations in job specification. Muehlemann, Ryan, and Wolter (2013) stated that pay structure is remain fixed for a particular job, while pay level is determined by the position, level of job, responsibility, accountability, and experience within the organisation. In this regard, Larkin, Pierce, and Gino (2012) stated that firms are designing pay structure on the basis of using pay level mechanism. Pay structure is a fixed payment set for a particular job, while pay level is a variable component that depends significantly on the performance of the firm. For example, CEO’s stock option is an example of pay level which is designed to motivate individual to work beyond his expertise and perform productively. It asserts that level of pay can influence the investment behaviour adversely. It is further stated that equity based pay levels in the compensation schemes such as through granting stock and stock options make CEO to be involved in imprudent risk and take excessive risky decisions for the firms.

Renneboog and Zhao (2011) support this statement and stated that incentivising CEO through stock options is becoming challenging for the firm as designing pay level on the basis of stock options is beneficial for the executives as well as firm when the stock price increases but no beneficial for the firm if the stock prices declines. Executives become diverted to take excessive risky actions for the firm as they would not see their profit damage in case of declining of stock prices. In addition, Ladika and Sautner (2013) stated that CEO determined to take only short-term improvements and plans in share value in order to take advantage from their stock options. It asserts that level of pay is likely to affect investment behaviour of executives and encouraged them to take excessive risky investment decisions.

On the other hand, DeYoung, Peng, and Yan (2013) stated that structure of pay is also likely to influence investment decisions of executives, including vesting period. In the recent literature, the researchers have found that vesting period of CEO’s stock options can influence CEO to take shorter vesting period and take options for vesting equity in the short-terms. This may cause short-termism through refocusing on the short-term stock price by making excessive risky investment decisions. A study conducted by Edmans et al (2014) analyses the compensation pay contracts of U.S CEOs in order to examine the increases in equity sales acquired from scheduled vesting of the existing options holdings and stocks of CEO. The scheduled vesting is predictable by the CEO and he could be able to change investment decisions in the anticipation on order to increase the stock price in short term and benefited from the price increase. This is one of the major shortcomings of vesting period of stocks options designed to incentivise CEO to perform with the interest of shareholders and associated with an average decline of $2.2 million in the firm’s growth.

Solutions

            It has been identified in the literature above that compensation schemes such as stock options, stock, vesting induced-equity sales are encouraging CEO or other agents to be involved in imprudent or excessive risky investment decisions that is less beneficial for the firm. In this regard, it is become challenging for firm to offer a solution for addressing principal-agent problem. Inside debt would be best option for dealing with the principal-agent problem significantly. With respect to this, Arnold (2012) stated that deferred compensation scheme or pension which is also termed as inside debt can be used to prevent imprudent risk taking by the executives as it delay the receipt of certain amount of current year pay and bonus of CEO, leaving it in the investment of the firm at a fixed amount of return until the process of retirement. This compensation pay scheme encourage executives to take less risky investment decision for the firm as it may also reduce their incentive during any financial setback or distress. In addition to this, Gibbs (2012) stated that cap on pay is also likely to minimise the principal-agent problem within the organisation as it limits the pay level of CEO to certain level and should be penalised if they are making high risky decisions for the firm.

Conclusion

            On the conclusive remarks, it has been identified that it is become challenging for firm to offer a solution for addressing principal-agent problem as compensation schemes such as stock options, stock, vesting induced-equity sales are encouraging CEO or other agents to be involved in imprudent or excessive risky investment decisions that is less beneficial for the firm. These compensation schemes also contributing to short-termism and eventually results in excessive risky investment decisions. It has been identified that incentivising CEO through stock options is becoming challenging for the firm as designing pay level on the basis of stock options is beneficial for the executives as well as firm when the stock price increases but no beneficial for the firm if the stock prices declines. Executives become diverted to take excessive risky actions for the firm as they would not see their profit damage in case of declining of stock prices. For this purpose, inside is the best option to deal with the principal-agent problem as it as it delay the receipt of certain amount of current year pay and bonus of CEO, leaving it in the investment of the firm at a fixed amount of return until the process of retirement and encourage executives to take less risky investment decisions for the firm. However, this option is also risk for the firm as they have to repay the amount that they delay to be paid in future even if the stock price decreases. It asserts that inside debt also has some shortcomings that also need to be considered while designing compensation pay schemes.

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