Using the data on a panel of quoted UK firms over the period 1995–2002, this paper studies the effects of financial leverage on managerial compensation. The change in the investors’ expectations that caused the recent collapse of the stock market tech bubble has been used as a source of plausibly exogenous variation in the firm’s debt. We find that pay-for-performance sensitivity is increasing in financial leverage, with the exception of the 10% most levered firms
This paper empirically studies the effects of financial leverage on managerial compensation. Since Jensen and Meckling (1976) the firm has been recognized as a nexus for a multitude of contracting relationships and the literature that followed their seminal paper recognized that managerial compensation depends on the conflict of interests between different contracting parties that are asymmetrically informed.
On the one hand, executive compensation is designed to align managerial incentives with the interests of shareholders who are uninformed about the level of effort exerted by their managers and who therefore link part of the remuneration to the firm’s performance.1 This is done to minimize the agency cost coming from the separation between ownership and control. Since the firm’s debt is recognized to reduce shareholder–manager conflicts, several theoretical works predict a negative association between pay-for-performance sensitivity and financial leverage. There are different reasons that explain this negative relationship. First, debt could decrease the firm’s free-cash flow, which should reduce the manager’s ability to use corporate resources for empire-building purposes (Jensen, 1986). Second, higher debt could increase the threat of bankruptcy (Grossman and Hart, 1982), which could imply that managers act in the interest of shareholders even in the presence of low-powered explicit incentive schemes. Third, an increase in the firm’s debt could increase monitoring by lenders, which could substitute for the provision of monetary incentives by shareholders.
On the other hand, higher financial leverage could increase the stockholder–bondholder conflicts. Indeed, a compensation that is designed to align managerial incentives with shareholder interests could induce risk-shifting incentives for managers. In a context of asymmetric information concerning risk choices taken by managers in their investment decisions, bondholders would anticipate that managers have risk shifting incentives by simply observing the management compensation structure. This would affect their decision about the price of the bond. Low pay-for-performance sensitivity can thus be seen as a precommitment device to minimize the agency costs of debt related to the risk-shifting problem (John and John, 1993).
Either by reducing shareholder–manager conflicts or by nourishing stockholder–bondholder ones, the mentioned theoretical works predict that an increase in financial leverage lowers pay-for-performance sensitivity. There has been little empirical work to test these theoretical predictions. Studying management compensation policies in 77 publicly traded firms that filed for bankruptcy or privately restructured their debt from 1981 to 1987, Gilson and Vetsuypens (1993) find that during periods of financial distress pay-for-performance sensitivity is extremely low (even insignificantly different from zero), while it increases after firms restructure their debt. Using a sample of 1652 CEOs in the largest publicly traded US companies for the period 1993–1999, Ortiz-Molina (2007) find that the elasticity of managerial remuneration to total shareholder returns is decreasing in total financial leverage, except for firms with convertible debt (the latter finding is in line with John and John, 1993 and with Green, 1984).
In contrast to the findings of the mentioned theoretical and empirical literature, in our paper we show how pay-for-performance sensitivity may be increasing in financial leverage, with the exception of the most levered firms. We estimate a panel of quoted firms from the UK, ranging from 1995 to 2002. In the United Kingdom, remuneration is set by an independent committee. There is also nearly full disclosure and intense scrutiny of remuneration practices by institutional investors. It is probably fair to say that it is unlikely that managers set their own pay. We employ robust regression techniques to deal with the presence of outliers and firm dummy variables to take account of unobserved heterogeneity.
A methodological contribution of this paper is that we exploit the tech bubble burst as a source of variation in firm’s debt. The collapse of the tech bubble after the year 2000 implied different changes in financial leverage for sectors with different technological levels. The sharp change in investor’s expectations was very likely to be exogenous to the incentive schemes of the firms. In contrast to results in previous empirical works, we find evidence of an increasing relationship between financial leverage and pay-for-performance sensitivity for almost all the firms in our sample. This relationship turns into negative for the 10% most levered firms. Our estimates indicate that, on average, the negative effect of financial leverage concerned UK companies with long term debt larger than 34% of total assets. Moreover, our estimates show an increasing relationship between financial leverage and total short-term compensation (basic salary plus bonus) as well, with the exception of firms with a level of financial leverage that is larger than the 99th percentile of the financial leverage distribution.
In auxiliary regressions, we also show that for our sample both total shareholder returns and their variance are positively associated with financial leverage. These additional findings are helpful to shed some light on possible mechanisms driving the relationship of interest. We discuss these potential channels in the context of the standard agency theory with moral hazard. For firms with high levels of financial leverage, it was less easy to align managerial and shareholder interests through an incentive scheme because total shareholder returns may have become a noisier signal for managerial effort. For all other firms, the estimates show a positive effect of financial leverage on incentives. In this case, financial leverage may have raised the marginal value of the agent’s effort for the principal. Additionally, it may have implied a positive effect on pay-for-performance sensitivity through its effect on risk. This mechanism may be along the lines of a recent literature showing a positive relationship between risk and incentives through effects on delegation of responsibilities, endogenous market structure and/or endogenous matching between managers and firms (see Prendergast, 2002, Raith, 2003, Wright, 2004 and Serfes, 2005).
The rest of the paper proceeds as follows. In Section 2, we present an empirical analysis of the relationship between financial leverage and pay-for-performance sensitivity. Section 3 proposes some possible explanations for our estimation results. We conclude in Section 4.
In this paper, we have studied the effects of financial leverage on managerial pay. We have estimated a panel of quoted firms from the UK, ranging from 1995 to 2002. The change in investor’s expectations that caused the collapse of the stock market tech bubble after the year 2000 has been used to capture a plausibly exogenous variation in firm’s debt. Our estimates show that pay-for-performance sensitivity is increasing in financial leverage, with the exception of the most levered firms. A similar relationship has been found between financial leverage and total short-term compensation.
Our results indicate that in firms with high levels of financial leverage it is less easy to create an incentive scheme that aligns managerial and shareholder interests. In the presence of high levels of firm’s debt, total shareholder returns may become a noisier signal for managerial effort. Our estimates show that on average this negative effect of firm’s financial leverage concerned UK companies with long term debt larger than 34% of total assets (the 10% most levered firms in our sample).
Our work also sheds some light on possible reasons why during periods of crisis financial leverage tends to grow together with variable pay.14 During the 2008 financial crisis, the fact that banks which had to be bailed out with tax payer’s money continued to pay high bonuses to their managers was at the center of a harsh debate. In periods of stock market bust, the financial leverage/total assets ratio tends to increase. Since this may raise the volatility of the payoff from the manager’s effort, shareholders have to increase the variable part of the managerial remuneration to provide enough incentives to their manager whose utility is decreased because of the higher volatility.
Finally, a caveat of this study is our restricted focus on the effects of financial leverage on short-term compensation (basic salary plus bonus). Due to data availability, our paper has followed most of the other empirical work on managerial remuneration in the UK that use cash compensation alone as dependent variable. Recent corporate reforms in the UK are generating more complete and detailed information on stock options, pension arrangements and long-term incentive plans, which represent a small percentage of total remuneration for the British CEOs, especially if compared to the long-term compensation of the American CEOs (Conyon and Murphy, 2000). The availability of these data will allow future research to examine the relationship between firm’s debt and long term compensation in the UK
