The Optimal Size of Hedge Funds: Conflict between Investors and Fund Managers

This study examines whether the standard compensation contract in the hedge fund industry aligns managers’ incentives with investors’ interests. I show empirically that managers’ compensation increases when fund assets grow, even when diseconomies of scale in fund performance exist. Thus, managers’ compensation is maximized at a much larger fund size than is optimal for fund performance. However, to avoid capital outflows, managers are also motivated to restrict fund growth to maintain style‐average performance. Similarly, fund management firms have incentives to collect more capital for all funds under management, including their flagship funds, even at the expense of fund performance.     

Auditors’ Economic Incentives and the Sensitivity of Managerial Pay to Accounting Performance

The use of managerial incentives to manage earnings in order to enhance accounting performance‐based compensation is greater when auditors have economic incentives to compromise their independence. Hence, compensation committees face more difficulties in determining cash compensation when earnings quality declines. This study investigates whether boards of directors can mitigate the agency problems between managers and shareholders by being aware of the opportunistic earnings management encouraged by auditors’ economic incentives and actively adjusting performance‐based compensation for the reduced earnings quality. To this end, it examines how auditors’ economic incentives affect the sensitivity of managerial pay to accounting performance. The findings show a negative association between the client's economic importance to the auditor and the sensitivity of managerial pay to accounting performance, with this association more pronounced for firms that opportunistically inflate earnings, suggesting that boards mitigate agency problems by actively intervening to modify performance‐based compensation schemes for the reduced earnings quality. Additional analyses show that board effectiveness in determining compensation depends on its characteristics. These results suggest the urgent need to oblige companies to establish compensation committees, particularly in countries that lack such a mandatory requirement or where few companies have such committees.     

Nonfinancial Performance Measures and Promotion-Based Incentives

In this paper, I examine the sensitivity of promotion and demotion decisions for lower‐level managers to financial and nonfinancial measures of their performance and investigate the extent to which the behavior of lower‐level managers reflects promotion‐based incentives. Additionally, I test for learning versus effort‐allocation effects of promotion‐based incentives. I find that promotion and demotion decisions for store managers of a major U.S.‐based fast‐food retailer (QSR) are sensitive to nonfinancial performance measures of service quality and employee retention after controlling for financial performance. The likelihood of demotion in this organization is also sensitive to nonfinancial performance on the dimension of service quality, while the probability of exit is primarily sensitive to financial performance measures rather than nonfinancial performance measures. I also find evidence that the behavior of lower‐level managers is consistent with the incentives created by the weighting of nonfinancial performance measures in promotion decisions. Managers in locations where there is a higher ex ante probability of promotion and a higher potential reward upon promotion demonstrate significantly higher levels and rates of performance improvement in service quality. Finally, consistent with promotion‐based incentives inducing both effort‐allocation and learning effects, I find that performance‐improvement rates for service quality: (1) are higher in prepromotion periods in markets where promotions occur, (2) decrease immediately after the occurrence of a promotion in the same market area, and (3) remain higher than in markets where promotions do not occur. These findings provide some of the first empirical evidence on an alternative to the explicit weighting of nonfinancial metrics in compensation contracts as a mechanism for generating improvements in nonfinancial dimensions of performance.     

Rank and file equity compensation and earnings management: Evidence from stock options

The widespread use of rank and file equity‐based compensation suggests that executives believe that rank and file employees can affect firm outcomes, and some research supports this view. If equity‐based incentives influence rank and file employees’ productive efforts, they might also influence their earnings management decisions. We find that increases in rank and file employees’ option‐based compensation—our proxy for equity‐based compensation—are associated with increases in earnings management and that this relation is attributable to real activities (as opposed to accrual) earnings management. Cross‐sectional tests indicate that the relation is stronger when rank and file option compensation is likely to generate greater performance incentives and attenuated in the presence of more intense monitoring. Finally, we explore the role of cash constraints and overvaluation as potential alternative explanations for this relation and find that neither accounts for our results.     

Equity‐based incentives and shareholder say‐on‐pay

We study the relationship between CEO pay‐performance sensitivity, pay‐risk sensitivity, and shareholder voting outcomes as part of the “say‐on‐pay” provision of the 2010 US Dodd‐Frank Act. Consistent with our hypothesis, we provide evidence that shareholders tend to approve of compensation packages that are more sensitive to changes in stock price (pay‐performance sensitivity). Our findings are consistent with theoretical predictions that outside owners approve of equity incentives as a means of aligning managers' interests with those of shareholders. We also document that future changes to equity‐based incentives are related to voting outcomes and that shareholders incorporate CFO incentives into their votes. Collectively, these results provide evidence of the importance of equity‐based incentives from the perspective of those most concerned with firm value and of the effectiveness of say‐on‐pay as a governance mechanism.     

Sensitivity of executive pay to accounting performance measures in all-equity firms

We investigate the relation between chief executive officer compensation and accounting performance measures as a function of the firm's capital structure. We specifically analyse pay–performance relationships for all‐equity firms relative to high‐levered firms. We find a significant positive association between return on equity and the level of compensation for all‐equity firms. Consistent with optimal contracting theory, we cannot discern any such relationship for high‐levered firms. Because of agency costs of debt, managerial compensation in high‐levered firms plays the role of a precommitment mechanism in addition to its conventional role of aligning management incentives with shareholder interest.     

Incentives and Endogenous Risk Taking: A Structural View on Hedge Fund Alphas

Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and prime broker contracts allowing for forced deleverage (put). The interaction of these option‐like incentives affects optimal leverage ex ante, depending on the distance of fund‐value from the high‐water mark. We study how these endogenous effects influence performance measures used in the literature. We show that reduced‐form measures that do not account for these features are subject to economically significant false discovery biases. The result is stronger for low‐quality funds. We propose an alternative structural methodology for conducting performance attribution in hedge funds.     

Outsourcing Mutual Fund Management: Firm Boundaries,Incentives, and Performance

We investigate the effects of managerial outsourcing on the performance and incentives of mutual funds. Fund families outsource the management of a large fraction of their funds to advisory firms. These funds underperform those run internally by about 52 basis points per year. After instrumenting for a fund's outsourcing status, the estimated underperformance is three times larger. We hypothesize that contractual externalities due to firm boundaries make it difficult to extract performance from an outsourced relationship. Consistent with this view, outsourced funds face higher powered incentives; they are more likely to be closed after poor performance and excessive risk‐taking.     

Letting Go of Norm: How Executive Compensation Can Do Better Than "Best Practices"

With executive pay under the media spotlight, the corporate search for “best practices” is in reality a drive toward common practices as cautious boards gravitate toward a safe norm. But are current trends in compensation structure as good for shareholders as they are for the consultants who implement them? This article explores some of these trends and derives some conclusions about their role in shareholder value creation based on detailed data on executive plans and stock price performance for the S&P 500. One key finding is that rewarding managers for profit growth produces higher stock price returns than rewards based on multiple measures or balanced scorecards. Also, the popular practice of adding long‐term incentive plans to the compensation mix does not appear to improve long‐term performance. Finally, the granting of equity based on the past year's performance rather than in annual fixed‐value amounts appears to be good for shareholders because of additional incentives created by performance‐based grants as well as the elimination of the perverse incentive of rewarding poor stock price performance with more shares.     

Incentivizing Calculated Risk‐Taking: Evidence from an Experiment with Commercial Bank Loan Officers

We conduct an experiment with commercial bank loan officers to test how performance compensation affects risk assessment and lending. High‐powered incentives lead to greater screening effort and more profitable lending decisions. This effect is muted, however, by deferred compensation and limited liability, two standard features of loan officer compensation contracts. We find that career concerns and personality traits affect loan officer behavior, but show that the response to incentives does not vary with traits such as risk‐aversion, optimism, or overconfidence. Finally, we present evidence that incentives distort the assessment of credit risk, even among professionals with many years of experience.     

公司社会声望与高管薪酬:公共服务抑或职业声誉

本文基于“隐性—显性”契约激励研究范式,探讨公司社会声望对高管薪酬的影响以及作用机制。本文选取2009—2017年间的非金融A股上市公司为样本,研究发现,拥有较高社会声望的公司,其高管显性薪酬较低。具体而言,公共地位较高的国有企业、具有较高市场声誉的民营上市公司,其高管薪酬平均而言分别比其他上市公司低4.97%和6.30%。进一步地,我们发现公司声望对我国高管显性薪酬契约存在两种作用机制:一方面,公共地位较高的国有企业,可以为高管带来较高的社会声誉和社会认可,满足了“公共服务”类高管的社会声望偏好,从而降低了显性薪酬的支付水平;另一方面,市场声誉较高的民营企业,可以为高管带来较高的职业声誉和未来职业利益,符合“以商为荣”类高管的社会声望偏好,使高管愿意接受较低的显性薪酬。本文的结论为公司声望作为一种有价值的资源,可以对高管显性薪酬形成议价能力提供了重要证据,揭示了公司声望对高管显性契约激励的影响路径;同时,为国有企业高管薪酬契约设计以及激励机制提供了一定启示。     

Incentives, Discretion, and Asset Valuation in Closed–End Mutual Funds

This paper studies earnings management using 363 closed–end mutual fund firm–years of data. Closed–end fund assets consist of unrestricted and restricted securities, and realized and unrealized income. While unrestricted securities are not subject to earnings management, restricted security values are largely discretionary. Managerial valuation of restricted securities is modeled as contingent on unrestricted returns relative to a performance benchmark. Four unrestricted performance regions are identified. Known multi–period compensation incentives become the basis for hypothesizing earnings management behaviors in the regions in the form of restricted security valuation. Across several benchmarks, the results are consistent with multi–period maximization rather than simpler single–period compensation maximization or income smoothing. Funds with extreme unrestricted performance show relatively larger income–decreasing earnings management, and funds with slightly–below benchmark returns show relatively larger income–increasing earnings management than those slightly above. These results clarify the relationship between complex earnings management behavior and managerial incentives.     

Indirect Incentives of Hedge Fund Managers

Indirect incentives exist in the money management industry when good current performance increases future inflows of capital, leading to higher future fees. For the average hedge fund, indirect incentives are at least 1.4 times as large as direct incentives from incentive fees and managers’ personal stakes in the fund. Combining direct and indirect incentives, manager wealth increases by at least $0.39 for a $1 increase in investor wealth. Younger and more scalable hedge funds have stronger flow‐performance relations, leading to stronger indirect incentives. These results have a number of implications for our understanding of incentives in the asset management industry.     

Taking the Long Way Home: U.S. Tax Evasion and Offshore Investments in U.S. Equity and Debt Markets

We empirically investigate one form of illegal investor‐level tax evasion and its effect on foreign portfolio investment. In particular, we examine a form of round‐tripping tax evasion in which U.S. individuals hide funds in entities located in offshore tax havens and then invest those funds in U.S. securities markets. Employing Becker's ( 1968 ) economic theory of crime, we identify the tax evasion component by examining how foreign portfolio investment varies with changes in the incentives to evade and the risks of detection. To our knowledge, this is the first empirical evidence of investor‐level tax evasion affecting cross‐border equity and debt investment.     

Manager fee contracts and managerial incentives

Under the principal-agent framework, we study and compare different compensation schemes commonly adopted by hedge fund and mutual fund managers. We find that the option-like performance fee structure prevalent among hedge funds is suboptimal to the symmetric performance fee structure. However, the use of high water mark (HWM) mitigates the suboptimality, though to a very limited extent. Both our theoretical models and simulation results show that HWM will induce more managerial efforts only when a fund is slightly under the water but it will unfavorably dampen incentives when a fund is too deep under the water and when the manager’s skill is poor. Allowing managers to invest personal wealth in their own funds, however, helps align interests and provides positive managerial incentives.     

公司社会声望与高管薪酬:公共服务抑或职业声誉

本文基于“隐性—显性”契约激励研究范式,探讨公司社会声望对高管薪酬的影响以及作用机制。本文选取2009—2017年间的非金融A股上市公司为样本,研究发现,拥有较高社会声望的公司,其高管显性薪酬较低。具体而言,公共地位较高的国有企业、具有较高市场声誉的民营上市公司,其高管薪酬平均而言分别比其他上市公司低4.97%和6.30%。进一步地,我们发现公司声望对我国高管显性薪酬契约存在两种作用机制:一方面,公共地位较高的国有企业,可以为高管带来较高的社会声誉和社会认可,满足了“公共服务”类高管的社会声望偏好,从而降低了显性薪酬的支付水平;另一方面,市场声誉较高的民营企业,可以为高管带来较高的职业声誉和未来职业利益,符合“以商为荣”类高管的社会声望偏好,使高管愿意接受较低的显性薪酬。本文的结论为公司声望作为一种有价值的资源,可以对高管显性薪酬形成议价能力提供了重要证据,揭示了公司声望对高管显性契约激励的影响路径;同时,为国有企业高管薪酬契约设计以及激励机制提供了一定启示。     

Why Do Mutual Fund Advisory Contracts Change? Performance,Growth, and Spillover Effects

We examine changes in equity mutual funds' investment advisory contracts. We find substantial advisory compensation rate changes in both directions, with typical percentage fee shifts exceeding one‐fourth. Rate increases are associated with superior past market‐adjusted performance, whereas rate decreases reflect economies of scale associated with growth, and are not associated with extreme poor performance. There are within‐family spillover effects. Superior (e.g., star) performance for individual funds is associated with rate increases for a family's other funds. Rate reductions post‐2004 by family funds involved in market timing scandals do not have large industry spillover effects.     

Clawbacks,Holdbacks, and CEO Contracting

“Clawbacks” are much discussed in the context of senior executive compensation, yet the discussion has largely ignored the presence of holdbacks that are already in place in many firms. Holdbacks are deferred compensation that is potentially foregone in the event that the CEO leaves the firm without good reason or they are dismissed for wrong‐doing. They are explicit or written features of a CEOs employment contract. Holdbacks are already in use at 70% of S&P 500 firms and average $18.4 million each. Firms with higher CEO replacement costs, greater information asymmetry, a recent bad experience (fraud, lawsuit, or restatement), or in more certain environments are more likely to have a holdback. In contrast, clawback adoptions are mainly driven by firms' bad experiences and external pressure from shareholders. Holdbacks and incentive‐based compensation are substitutes, as termination incentives can reduce the need for incentive compensation. As managers reasonably demand a premium for accepting risky compensation, a measure of abnormal compensation is positively associated with holdbacks, but there is no significant association between clawbacks and holdbacks. These findings suggest that the holdbacks many firms already have in place could help an “ex‐post settling up” in the event of financial misconduct, or even simply misstated financials. As companies have more control over the amounts held back ex‐ante, holdbacks are potentially more efficient.     

Empirical Evidence on the Implicit Determinants of Compensation in Big 4 Audit Partnerships

This study investigates the implicit financial incentives of individual Big 4 audit partners by examining the association between a partner's compensation and characteristics of the audit firm, audit partner, and individual partner clientele for Big 4 firms in Sweden. Using tax and financial data for individual audit partners and clients, our empirical findings indicate that there is significant variation in the implicit determinants that are associated with compensation across the Big 4. We find that audit partners’ compensation is positively associated with the size of their clientele or the number of publicly traded clients, both of which represent revenue‐generating opportunities. Similarly, compensation and developing an industry specialization are positively related. In three firms, gaining clients is clearly related to an increase in compensation, while losing a client is associated with a reduction in partner income in only one firm. We find that audit partner income is more sensitive to performance‐related incentives, such as attracting new clients, as partners progress in their career. Finally, we find evidence that audit failures, proxied by reporting errors related to issuing a going concern opinion, are associated with lower compensation. These results should be of interest to the auditing profession, audit firms, and regulators when they consider the effects of implicit incentives of partner compensation on audit quality.     

Rewarding risk-taking or skill? The case of private equity fund managers

We examine whether typical private equity fund compensation contracts reward excessive risk-taking rather than managerial skill. Our analysis is based on a novel model of investment value, cash flows, and fee dynamics of private equity funds. Given the embedded option-like fee components, our results demonstrate that fund managers indeed have an incentive for excessive risk-taking when only fee income from the current fund is considered. However, when managers also consider potential compensation from follow-on funds, their risk-taking incentives depend on their individual skill levels, and skilled managers will have an incentive to reduce fund risk. We also show that managers must generate substantial abnormal returns in order to compensate investors for the given fee components.