Can the Design of Equity-based Compensation Limit Investment-related Agency Problems?

Abstract

We investigate the association between managerial investment behaviour and CEO incentives derived from compensation contracts. Based on a sample of the largest two hundred Australian firms over the period 2010 to 2014, we find that investment inefficiency, proxied by investment-cash flow sensitivity, is reduced through the strategic design of CEO equity compensation. The positive sensitivity of investment to cash flow decreases as the use of equity grants increases, indicating greater interest alignment between management and shareholders. The decreased investment-cash flow sensitivity also occurs when using a longer vesting duration and a graded vesting pattern (benefits gradually vest throughout the vesting period), suggesting that enhanced horizon incentives align managers’ interest with long-term firm value. We also find that the investment-cash flow sensitivity is reduced when attaching performance hurdles to equity grants, especially the long-term hurdles, implying substantial financial incentives provide incremental interest alignment and correspondingly reduces investment-related agency problems. We note that CEO power has a moderating effect on our regression results. When CEOs have relatively higher power, the utility of equity compensation becomes inadequate to reduce investment-cash flow sensitivity. Overall, the results are consistent with the agency cost explanation that firms can strategically design equity-based compensation to reduce investment-related agency problems.