The Long-Run Performance of Firms Adopting Compensation Plans Based on Economic Profits

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1 The Long-Run Performance of Firms Adopting Compensation Plans Based on Economic Profits Chris Hogan Edwin L. Cox School of Business Southern Methodist University P.O. Box Dallas, Texas Craig Lewis Owen Graduate School of Management Vanderbilt University Nashville, Tennessee July 2001 The authors thank seminar participants at the 2000 Summer Symposium at the Hong Kong University of Science and Technology, University of Arizona, Goethe University, Ohio State University, Southern Methodist University, Texas A&M University, and Vanderbilt University; especially Bill Christie, Gerald Garvey, Tim Loughran, Ron Masulis, and Ralph Walkling. The authors also would like to thank Flora Chen, Oliver Chen, Ping Dong, and Stephan Schulze for capable research assistance.

2 The Long-Run Performance of Firms Adopting Compensation Plans Based on Economic Profits Abstract: Proponents of compensation plans based on economic profits, defined as net operating profits after tax less the cost of all capital used to generate those profits, argue that these plans control for deficiencies in stock-based or earnings-based bonus plans and thereby better align managers and shareholders interests. We examine whether compensation plans based on economic profits do in fact produce better investment decisions. We use a sample of 65 firms adopting economic profit plans between 1983 and 1995 to examine compensation, ownership, and governance structures, and long-run operating and stock price performance. While we document significant improvements in operating performance subsequent to adoption of the compensation plans, a sample of nonadopting matched firms shows similar significant improvements. There is no significant difference in the stock price performance of the two groups in the four-year period following an adoption. We conclude that economic profit plans are no better than traditional plans that provide a blend of earnings-based bonuses and stock-based compensation in terms of their ability to create shareholder wealth. 2

3 The Long-Run Performance of Firms Adopting Compensation Plans Based on Economic Profits 1. Introduction Most executive compensation plans include features designed to provide managers with incentives to make efficient investment decisions. These include earnings-based bonuses and stock ownership (including employee stock ownership plans, restricted stock, phantom stock, and stock options). One of the more recent innovations is plans that reward managers for generating economic profits in excess of a charge for the amount of invested capital. Plans that compensate managers on the basis of economic profits have become increasingly popular, with adoption by blue-chip companies that include Boise Cascade Corp., the Coca-Cola Company, Eli Lilly & Co., and Monsanto. The management consulting firm of Stern Stewart and Co. is the leading advocate of the economic profit approach, which it markets under the name of Economic Value Added (EVA TM ). Other consulting firms such as the Boston Consulting Group, KPMG, and LEK/Alcar Consulting Group offer similar plans. The potential importance of the economic profits approach is best seen in the context of traditional compensation plans that typically include a base salary, a bonus tied to accounting performance, and some form of equity-based compensation. Stock ownership plans have the advantage that they motivate managers to improve share prices. Unfortunately, stock price changes reflect changing market conditions and only partially the efforts of managers. This can make performance attribution problematic, particularly in diversified firms. For example, if managers in one division create significant value yet see stock prices drop due to poor performance in another division, their superior performance goes unrewarded. 1

4 Including earnings-based compensation is one way to compensate for the lack of performance attribution inherent in equity-based compensation. Bonus plans have the advantage that they are based directly on accounting numbers. Since performance can be evaluated at the divisional level, attribution is unambiguous. The disadvantages of earningsbased bonus plans is that they tend to induce a short-term orientation; accounting numbers are subject to manipulation; and they fail to adjust for operating risk. Proponents of Economic Profit Plans (EPPs) argue that their plans control for deficiencies in other types of incentive plans because they focus on net operating profits rather than accounting earnings, yet appropriately adjust for capital costs. Moreover, valuations using discounted economic profits are equivalent to those using discounted free cash flows. 1 This implies that an appropriately designed EPP should provide incentives for improving investment performance because it links executive compensation to performance measures that have value relevance. Of course, the actual design of a compensation plan dictates whether managers have improved long-term incentives. Since plan design is an endogenous choice made by managers and approved by the Board of Directors, the decision to switch to an EPP would be optimal only if it results in improved incentive alignment. A drawback with bonus plans based on either earnings or economic profits is that the performance metrics only reflect the current year s operating performance. One factor that motivates a switch to an EPP is that these plans typically include long-run incentives not used in traditional bonus plans. For example, Stern, Stewart and Company uses an approach that includes a bonus-banking system whereby a portion of a manager s bonus each year is banked and only paid if economic profits continue to rise. Another approach uses the discounted sum of future economic profits as a measure of long-run value creation. Both 2

5 approaches overcome the problems of long-term performance attribution because economic profits can be estimated at the business unit level. The main hypothesis we consider is simple. If EPPs provide managers with incentives to make better investment decisions, firms that adopt such plans should experience improved long-run operating performance. 2,3 To date, academic studies of EPP adopters only consider short-term performance. Wallace (1997) provides evidence that managers make operating and investment decisions, such as decreasing new investment, increasing asset dispositions, and increasing share repurchases, that produce higher levels of economic profits in the year following the adoption of an EPP. Biddle, Bowen, and Wallace (1997) suggest that stock prices respond more to traditional earnings than economic profits. Lehn and Makhija (1997) show that CEO turnover is lower in firms that have higher levels of economic profits. Our study examines long-run operating performance. Following the methodology in Loughran and Ritter (1997), we examine the long-run operating performance of firms adopting EPPs in four-year periods prior to and following plan adoption. This approach extends Wallace (1997) by evaluating whether short-run reductions in investment and increases in asset dispositions impact long-run operating performance. We find that the operating performance of companies adopting EPPs, as measured by numerous accounting measures, significantly improves in the four-year period following plan adoption. 1 See Copeland, Koller, and Murrin [1999]. 2 Murphy (1998) argues that incentives are an important driver of managerial actions and corporate performance and that fully analyzing and documenting the effect of executive incentives on subsequent performance is a fruitful, if not critical, direction for future research in executive compensation. 3 For example, practitioners claim that that there are three ways for EPP firms to increase value. Increase the returns from the assets already in the business by running the income statement more efficiently without investing new capital; invest additional capital and aggressively build the business so long as expected returns on new investments exceed the cost of capital; and release capital from existing operations, both by selling assets that are worth more to others and by increasing the efficiency of capital by such things as turning working capital faster and speeding up cycle times. Information obtained from the Stern and Stewart website on September 24, See 3

6 One of the characteristics of adopting firms is that they are relatively poor performers prior to the adoption of these plans. This finding is consistent with the observation that innovative incentive plans are often introduced as a last resort by troubled companies (Murphy 1998, Gilson and Vetsuypens 1993). To better understand the decision to switch to an EPP and its effect on future operating performance, we analyze changes in the compensation, ownership, and governance structures of adopting firms from the year prior to adoption to the year of adoption Not surprisingly, given that EPPs are bonus-based systems, we find that adopting firms respond to poor recent performance by strengthening the link between bonus payments and performance. We also show that EPP adopters have relatively high percentages of shares in the hands of large block shareholders and independent boards. This suggests that EPP adopters have ownership and governance structures that provide strong external oversight. Taken together, the operating performance and incentive structure results indicate that EPPs work. Before concluding that these improvements are attributable to the economic profits approach, we examine the operating performance of a sample of nonadopting firms in similar industries that are comparable in size and profitability. We find that the operating performance of the control firms is very similar to the adopting firms, which suggests that these improvements are not plan specific but likely to have been triggered by poor recent performance. Both adopters and control firms appear to respond to performance drop offs by making changes in their compensation structures. Prior to adoption, adopters tend to pay CEOs smaller bonuses and grant more equity-linked compensation than control firms. Following periods of sustained poor operating performance, adopting firms increase their relative use of bonus compensation, while control firms increase their relative use of equity 4

7 compensation. The net effect of these changes is to bring the cash and equity-based compensation levels of adopter and control firm CEOs together. Since these redesigned compensation structures produce similar improvements in operating performance, we conclude that traditional earnings-based and economic profit approaches are equally effective. The next issue we consider is whether there are firm-specific factors that influence the decision to adopt an EPP. Our univariate evidence indicates that there are a number of differences in the ownership and governance structures. The most important is that EPP firms have better external monitoring, suggesting that adopters may be more concerned about potential problems of managerial discretion. We provide multivariate evidence that reinforces this point. A logistic regression model of adoption choice is estimated using a sample of firms that operate in the same industry as the adopter. We find that smaller firms with recent increases in growth opportunities, but with less financial slack, are more likely to adopt an EPP plan. This suggests that shareholders and Boards of Directors may view an EPP plan as a way to control potential managerial discretion problems that are possibly created by the development of new growth opportunities. The paper is organized as follows. We describe our data sources and sample selection procedure in section 2. In section 3, we evaluate both pre-adoption and post-adoption operating performance of firms that adopt EPPs, and provide comparison operating performance measures for a matched sample of comparison firms. In section 4, we examine the compensation, ownership, and governance structures of our sample of firms. Discussion in section 5 examines the determinants of the EPP choice. We consider whether past operating performance, compensation, ownership, and governance structures can be used to predict which firms switch to EPP plans. Section 6 examines stock price performance for 5

8 adopting and comparison firms and finds no evidence of significant differences. In section 7, we summarize and conclude. 2. Sample Description and Data Sources The sample consists of all adoptions of economic profit plans during the period. The initial sample of EPP adopters was obtained based on a keyword search of proxy statements on the LEXIS/NEXIS database. The keywords used to perform this search are: Economic Value Added, EVA, Residual Income, Economic Value Management, Economic Profit, Value Based Management, and Market Value Added. We then read proxy statements for each company identified by the search to ensure that the firms did in fact adopt an EPP. We verified the adoption year by reading prior year proxy statements to ensure that the adoption year was the first year the firm mentioned economic profits in its proxy statements. In addition, we compared our adoption years with those listed in the Wallace (1997) study for any of the sample firms appearing in both studies. Regulated utilities (SIC = 481 and ) and financial institutions and their holding companies (SIC = ) are excluded from the final sample. Since our study uses accounting-based measures of operating performance, we also require that the adopting company appear on the Compustat Annual Research Tapes in the year of the EPP adoption. These industry and data restrictions result in a final sample of 65 firms. The Appendix lists the adopting companies and the comparison firms. Summary information on the number of EPP adopters by year and industry affiliation is provided in Table 1. The number of adoptions has increased every year since 1990, which reflects the increasing popularity of this type of compensation plan. Panel B of Table 1 provides two-digit SIC codes for our sample. EPP firms represent a broad cross- 6

9 section of industries, suggesting that EPPs are considered a useful tool for motivating managers in a variety of business activities. We report operating performance results for EPP firms and control firms that are selected based on industry affiliation, firm size, and operating performance. This approach allows us to detect meaningful changes in operating performance that are unrelated to simple mean reversion. We follow the procedure recommended by Barber and Lyon (1996) and implemented by Loughran and Ritter (1997) in a study of the operating performance of firms that issue seasoned equity. Specifically, we match each EPP firm in the year of adoption with a comparison firm that has not previously adopted an EPP according to an algorithm as follows: (1) If there is at least one nonadopter in the same two-digit industry with end-of-year assets within 25% to 200% of the EPP firm, the nonadopter with the closest Operating Income Before Depreciation/Total Assets (OIBD/Assets) ratio to that of the adopter is chosen as the matching firm. (2) If no nonadopter meets this criterion, then all nonadopters with adoption year assets of 90% to 110% of the adopter are ranked, and the firm with the closest, but higher, OIBD/Assets ratio is selected as the matching firm. This procedure is designed to select a comparison firm on the basis of industry affiliation, asset size, and normalized operating income similarities. We also control for operating income because Barber and Lyon (1996) find that test statistics are misspecified when comparison firms are not matched on operating performance. Comparison firms must also appear on Compustat, and can be listed on the NYSE, the AMEX, or Nasdaq. Finally, we require that EPP firms and their comparison firms have proxy statements for the year prior to and the year of adoption. 7

10 There are times when a control firm is delisted during the period under study. When this occurs, we splice in the operating performance of alternate control firm at the point of the delisting event. This provides a continuous record of operating performance results for the control firms. The alternate control firms represent the next best match based on the above algorithm in the year of adoption Operating Performance Changes Surrounding the Adoption of Economic Profit Plans Table 2 provides comparative operating performance measures for the two groups of firms: EPP adopters and industry-matched nonadopters (comparison) firms. We report median values for four cash flow variables and two investment-related variables. We report median values rather than mean values due to skewness of the data. Results are reported for years -4 through +4, where year 0 is the fiscal year of the EPP adoption Operating performance measures include the operating income to assets ratio, profit margin, return on assets, and operating income relative to sales. The cash flow operating performance measures provide evidence on accounting rates of profitability and the efficient use of assets-in-place. The investment-related operating performance measures include capital expenditures plus R&D expenses relative to total assets and the market-to-book ratio. These measures reflect the rate of incremental long-term investment and the profitability of future growth opportunities. Distinguishing between assets-in-place and growth opportunities is a useful way to differentiate short-run and long-run operating performance changes. Panel A presents median operating performance measures for adopting firms. The evidence in Panel A suggests that the operating performance of EPP firms generally 4 If the alternate control firm delists, we splice in the firm that represented the third best match in the adoption year. These replacement procedures never required more than two alternate matches. This method of splicing replacement firms is consistent with that used in other operating performance studies (Core and Larcker (2000), Loughran and Ritter (1997)). 8

11 improves after adopting the plan. For the median adopter, operating income before depreciation relative to assets increases from 15.8% in the year preceding adoption to 16.6% two years after adoption, although it then falls to 14.8% four years following adoption. Median adopter profit margins increase from 2.8% in the year preceding adoption to 4.5% four years after adoption. This increase in profit margin appears to be attributable at least partially to a parallel increase in the adopter s return on assets; return on assets increases from 3.7% in the year before adoption to 5.6% four years later. Operating income per dollar of sales, a measure that is not affected by a change in the adopting firm s assets-in-place and/or interest expense, shows a similar pattern to OIBD to assets, rising from 11.8% in the year before adoption to a maximum of 13.0% in the year following adoption before dropping slightly to 12.7% four years subsequent to the adoption. Investment-related operating performance measures also improve during the postadoption period. The median adopter s market-to-book ratio is 1.90 in the year preceding adoption and increases to 2.28 four years after adoption. This suggests that the marginal profitability of the adopter s investment opportunities increases substantially after the adoption of an EPP. Despite the apparent improvement in the investment opportunity set, reinvestment rates do not change significantly in the post-adoption period. Capital expenditures and R&D expenses increase slightly from 6.9 cents per dollar of assets in the year prior to adoption to 7.2 cents per dollar in the fourth year following the adoption. Wallace (1997) argues that firms adopting EPPs may have an incentive to decrease their new investment because of the implicit capital charge and provides evidence that supports this hypothesis. Since the relative levels of capital expenditures do not change, it suggests that firms must be reducing the amount spent on new investment in proportion to the assets sold. 9

12 While these measures indicate that operating performance improves following the adoption of EPPs, an accurate assessment of whether adopters are performing exceptionally well depends on their performance relative to comparable firms. Median operating performance results for comparison firms appear in Panel B of Table 2. The adoption year OIBD/Assets ratios are similar for adopters and non-adopters (16.2% v. 16.6%) because the matching procedure is designed to select comparison firms on the basis of this operating performance measure. Comparison firms OIBD/assets, profit margin, return on assets, and OIBD/sales all increase during the four years subsequent to the adoption year, much like the results reported in Panel A for the adopter firms. The investment measures are likewise similar for the comparison firms. Investment expenditures per dollar of assets and the market-to-book ratio exhibit similar behavior to EPP adopters in the four years after the adoption. Figure 1 plots the adopter and nonadopter median values as reported in Panels A and B of Table 2, for operating income before depreciation, amortization, and taxes, plus interest income/sales, profit margin, and market-to-book. The darker bars are the EPP adopters, and the lighter bars the nonadopters. Operating performance as measured by profit margin deteriorates prior to plan adoption for both adopters and nonadopters. The market-to-book ratio shows steady improvement through the adoption year for the adopters. Panel C of Table 2 reports the results of formal statistical tests of the performance differences between the two groups. We compute z-statistics using a Wilcoxon matched-pair signed-rank test to examine the hypothesis that the annual distribution of adopter and nonadopter operating performance measures is identical. A positive (negative) z-statistic indicates that the operating performance measure for the adopter is greater than (less than) the same measure in the same year for the comparison firm. In years -4 through -1, Panel C suggests that annual operating performance is similar for adopters and comparison firms 10

13 with very few exceptions. The similarity in cash flow and investment-related operating performance continues in the post-adoption period. Table 3 provides further evidence comparing pre-adoption and post-adoption operating performance of EPP firms. It reports z-statistics of a Wilcoxon matched-pair signed-rank test examining the hypothesis that the distributions in the performance ratios between pre-adoption and post-adoption periods for EPP firms are equal. Operating performance measures show statistically significant improvement mainly in the first two or three years following adoption (panel A), while investment activity in the post-adoption period, as measured by the ratio of capital expenditures and research and development to assets, is similar to pre-adoption levels (panel B). Incremental investment opportunities, reflected in the market-to-book ratio, are significantly improved in the post-adoption period. 3.1 Survivorship bias induced by splicing procedure for control firms As stated earlier, if a control firm delists, we replace that firm with an alternate control firm (also matched as of the adoption year) going forward. If an EPP adopter delists, both the adopter and the control firm are dropped from the analysis going forward. This procedure would introduce a bias if the control firms are delisted due to poor financial performance and are replaced by a firm that is performing better. We analyze delisting codes from CRSP for both the adopters and nonadopters up through December 31, 1999 and find that 17 (13) EPP adopters (nonadopters) delisted as a result of a merger, whereas 4 (1) adopters (nonadopter) delisted for poor performance. In fact, the one nonadopter that was delisted for poor performance was not delisted until after the four-year period examined in Table 2. We conclude that our replacement of control firms on a going-forward basis does not result in an upwards bias of the operating performance for the nonadopters. Further, the analysis suggests that EPP adopters are more likely to delist due to poor performance than the control firms. 11

14 3.2 Sensitivity of results to the control sample selection procedures We also compare operating performance using several other matching procedures to evaluate whether our results are simply due to the control firms selected. The idea is to have narrower definitions of industry classifications and to control for compensation structure rather than operating perfomance. The alternate matching procedures we use are: (1) 3-digit SIC codes, size and closest OIBD/Assets in the year of adoption; (2) 3-digit SIC codes, above or below median share ownership (sum of shares and unexercised stock options held by the CEO scaled by total shares outstanding), and closest OIBD/Assets in the year of adoption; (3) 3-digit SIC codes, above or below median OIBD/Assets and closest share ownership level in the year of adoption; (4) 2-digit SIC codes, above or below median share ownership, and closest OIBD/Assets in the year of adoption; (5) 2-digit SIC codes, above or below median OIBD/Assets, and closest share ownership level in the year of adoption, and finally (6) 2-digit SIC codes, size and closest OIBD/Assets in the year prior to adoption. All of these alternate matching procedures produce results qualitatively similar to those presented in Tables 2 and 3, suggesting that the conclusion of similar performance is robust to alternate control firm selections. For the first four alternative sampling approaches described above, Figure 2 shows operating income before depreciation, amortization, and taxes plus interest/sales, profit margins and market-to-book levels. 4. Compensation, Ownership and Governance Structures The results reported in Panels A, B, and C together indicate that measures of operating performance increase both for EPP firms and comparison firms during the fouryear post-adoption measurement period. This similarity in performance across adopters and nonadopters suggests that the post-adoption operating performance of EPP firms may be attributable to (1) an industry effect, or (2) reversion to industry performance levels since the comparison firms are matched on operating characteristics (i.e. an EPP firm that has 12

15 underperformed the industry will be matched with a comparison firm that also has underperformed), or (3) the nonadopters have also made changes in their compensation, ownership or governance structures that have resulted in improved incentive alignment. In this Section, we analyze data collected from proxy statements and the Execucomp database on the compensation, ownership and governance structures of both the adopter and nonadopter control firms for the year prior to adoption and the year of adoption. We consider whether EPP plans have different incentives than traditional plans. 4.1 Compensation structure Table 4 provides compensation data for both EPP and comparison firms. Each firm has a complete record for the selected data items. Following Mehran (1995), we collect compensation items including: (1) salary, (2) bonus, (3) other compensation, (4) performance shares and units, (5) restricted stock, (6) phantom stock, (7) dividend units, (8) number of options granted and held, (9) savings plans, (10) properties and insurance, and (11) number of shares held by executives. The numbers we report are the compensation amounts for the chief executive officer (CEO). We calculate four measures of compensation: (1) percentage of total compensation in salary, (2) percentage of total compensation in bonus and long-term incentive payments, (3) percentage of total compensation in new option grants, and (4) percentage of total compensation in all equity-based compensation. Total compensation is the sum of the dollar values of salary, bonus, other compensation, savings plans, properties and insurance, long-term incentive payments, restricted stocks, and stock options. 5 Long-term incentice payments include the sum of the 5 Stock options are valued using the Black-Scholes model. When available, we used the data item BLK_VALUE from theexecucomp database. Otherwise, we need the current stock price, the annualized standard deviation of the instantaneous rate of return for the underlying stock, the risk free rate, the exercise price, and the time to maturity. The current stock price is the closing price on the fiscal year-end date. The standard deviation is estimated using daily, continuously compounded returns in the year preceding the option 13

16 dollar values of grants of performance shares, performance units, phantom stock, and dividend units. The percentage of total compensation that is equity-based is the ratio of the sum of the value of grants of stock options and restricted stock to total compensation. Panel A shows that the average level of cash compensation overall increases in the year of the plan adoption and that CEOs of EPP adopters receive more cash compensation than CEOs of comparison firms. EPP CEOs see their bonuses increase from $234,732 to $310,460, which is an increase of 32.4%. Since EPP firms have adopted new bonus plans, this large increase is not particularly surprising. By contrast, CEOs in the comparison firms have much smaller increases in bonus-based compensation - the average bonus increases from 301,522 to $328,572, or 9.0%. Interestingly, the net effect of these changes brings the cash compensation levels of adopters more in line with the compensation levels of control firm CEOs. Prior to adoption, the average salary plus the average bonus paid to adopter CEOs was $95,849 less than that paid to CEOs at control firms. Although the total average of salary and bonus for adopter CEOs is still less following the adoption, the gap is only $14,622 in the adoption year. Panel C indicates that there is little difference between adopters and nonadopters in the percentage of total compensation in salaries, bonuses and long-term incentive payments, and option grants following EPP adoptions. This result foreshadows our primary finding that there are few substantive differences in the compensation structures of adopters and nonadopters. In fact, t-tests and median tests (Wilcoxon z-scores) indicate that none of these compensation measures are statistically different. Panel B indicates that adopting firms have more equity-based compensation than control firms both prior to and following adoption. Long-term incentive payments increase grant. Following Parrino, Borokhovich, and Brunarski (1997), we assume that new grants have five-year maturities. We also assume that new grants are issued at-the-money (the exercise price equals the current stock price). The risk free rate is the annualized yield to maturity for one-month U.S. Treasury bills. 14

17 by 37.0% to $114,260 for adopters. Although control firms have a larger increase (48.7%) that brings the level of long-term incentive payments to $57,481, it is still below the amounts paid to EPP adopters. This result is not particularly surprising because several adopters include payments based on economic profits in this category. The value of the option grants also increases. Prior to adoption, the value of stock option grants for adopter firms was 86.5% higher than control firms ($943,173 compared to $505,698). Following adoption, CEOs at adopters and control firms receive stock option grants of $1,463,796 and $1,377,651, respectively. Similar to our findings for cash compensation, these equity-based compensation levels are more comparable following adoption. Although it is not reported here, the median levels for all stock-based compensation variables except stock option grants are zero, which indicates that only stock option plans are regularly used to motivate top executives. Panel D shows that the CEOs of EPP firms are younger on average (53.6 years) than the CEOs of comparison firms (56.6 years). Also in panel D are the percentages of total shares outstanding in option grants, unexercised options, and current shares held. Total shares outstanding is computed as the sum of total shares outstanding and options held by CEOs. The percentage of shares held by CEOs via stock options is similar for adopters and control firms. By contrast, CEOs in control firms directly hold larger percentages of shares outstanding. This suggests that, despite the similarities in compensation, control firm managers may not need as much equity-based compensation to align their interests with outside shareholders. 4.2 Ownership structure Table 5 presents summary measures of outside ownership structure. We collect the number of outside blockholders and the percentage of shares they own from proxy 15

18 statements. Outside blockholders are defined to be shareholders who have equity positions that exceed 5% of the outstanding equity and are required to file a Schedule 13-d with the SEC. Panel A indicates that, compared to the control firms, EPP adopters have slightly more outside blockholders, and that these blockholders control larger positions. 4.3 Governance structure Table 5 also presents corporate governance measures. We collect proxy information regarding the number and affiliations of board members. Panel B shows that EPP adopters have larger boards and a significantly higher percentage of independent directors. Adopters have 9.6 members in the year of adoption, and 71.3% are independent. Comparison firms have 8.8 members, and only 64.3% are independent. Given the relatively small levels of managerial share ownership by EPP adopters noted in Panel D of Table 4, appointment of a more independent board may be a response to potentially higher costs of managerial discretion. The majority of outside directors are employed by manufacturing firms. Board members are also from the ranks of bank-like institutions, investment banks, venture capital institutions, and insurance companies. The remaining outside directors are academicians, former government and military employees, consultants, clergy, and employees of not-forprofit organizations. The analyses of compensation structures and operating performance show that EPP adopters have similar compensation structures following adoption, and similar operating performance for the nine-year period surrounding adoption. These results suggest that EPP plans provide similar incentives to traditional compensation plans. Both adopters and nonadopters succeed in providing incentives to managers to improve operating performance; however, they use different methods. The adopters chose to compensate 16

19 based upon economic profits, while the nonadopters continue to use, or perhaps modify, their more traditional compensation plans. 5. Choosing an EPP Plan We estimate several logistic regression models that predict the likelihood that a firm adopts an EPP. The idea is to compare a firm that adopts an EPP to non-adopters in the same industry and at the same point in time in an effort to identify characteristics of firms that adopt such plans. The dependent variable in the logistic model is equal to zero if the firm does not have an EPP and equal to one if the firm adopts an EPP during the current fiscal year. To increase the ability of the model to distinguish between adopters and nonadopters, we increase the sample of nonadopters by including all firms in the Execucomp database with the same 2-digit SIC codes as our sample of adopters. Including nonadopters other that our sample of control frms also allows us to determine whether size and profitiablity are determinants of adoption. Thus, the possible sample for the logistic regression includes adopters (65 firms), the control firms used in the operating performance analysis (65 firms), and all other firms included in Execucomp with the same 2-digit SIC codes as the adopters and control firms (an additional 1,766 firms). Data requirements reduce the actual number of observations used in the logistic analysis. The EPP adoption model investigates whether explanatory variables that are observable prior to adoption influence the firm s choice of a compensation plan. The model includes predictive variables that evaluate operating performance, financial structure, compensation and ownership levels, and stock performance, prior to adoption. We briefly summarize the selection and measurement of the independent variables that are potential determinants of plan adoption. 17

20 5.1 Discussion of explanatory variables Long-run operating performance: Firms with poor operating performance relative to their industry counterparts may be more likely to adopt EPP plans in an effort to motivate managers. We use the percentage change in profit margin to measure accounting profitability, and report the results of the logistic regression when we include the percentage change in profit margin from four years to one year prior to adoption. The results are also qualitatively similar if we use return on assets, a measure of the efficient utilization of assetsin-place, as opposed to profit margin. The investment-related operating performance measures include the percentage change, from year 4 to year 1, in capital expenditures plus R&D expenses relative to total assets and the percentage change in the market-to-book ratio. These measures reflect changes in the rate of incremental long-term investment and the profitability of future growth opportunities. 6 Financial Structure. Shareholders and/or Boards of firms with high agency costs may pressure top management to adopt EPP plans if they believe that the plans more effectively align the interests of managers and shareholders. We examine proxies for agency costs such as financial slack, leverage and firm size. Cash and liquid assets to total assets is a proxy for financial slack. Long-term debt to total assets measures the amount of financial leverage. This controls for financial risk and the potential agency costs of debt. Finally, the size variable is measured as the natural logarithm of sales, which reflects the scale of a firm s operations rather than the intensity of capital investment. Compensation Structure: We include the percentage of total compensation that is equitybased to control for the existing structure of the compensation plan. Similar to the argument 6 The results are qualitatively similar if we use levels of the changes, or levels in year 1 as opposed to changes for profit margins, capital expenditures plus R&D expenses relative to total assets, and the percentage change in the market-to-book ratio. 18

21 for agency costs, shareholders and/or Boards of firms with managers having lower equitybased compensation may pressure top management to adopt EPP plans if they believe that the plans more effectively align the interests of managers and shareholders. Following Mehran (1995), total compensation is the sum of the dollar values of salary, bonus, dividend units, savings plans, properties, insurance, and the value of awards from grants of new stock options, phantom stocks, restricted stocks, performance shares, and performance units. Ownership structure: The percentage of total shares held by the CEO is used to control for the existing ownership structure. If managements interests are already aligned with shareholders as a result of their existing share ownership, the firm may be less likely to adopt an EPP plan. The total shares held by key executives is measured as the sum of shares held by key executives and the shares granted through stock options. Stock return performance: Firms that are performing poorly relative to their industry counterparts, or relative to the market as a whole, may be more likely to adopt EPP plans in an effort to improve stock performance. Market-adjusted stock returns are the difference between the stock return and the 12-month return on the S&P 500 index over the same period. Returns for the comparison firms are calculated in the same manner using the same fiscal year-ends as the EPP firms. 5.2 EPP adoption model results Table 6 provides the logit model results for the EPP adoption decision. Column (1) presents the results of estimating the model including only the operating performance and financial structure variables. The results in column (2) also include the compensation and ownership variables, and the column (3) results include the measure of excess market returns. Since the dependent variable is equal to one for adopters, positive regression 19

22 coefficients indicate that the explanatory variable increases the likelihood of adopting an EPP plan. Column (1) in Table 6 indicates that EPP adoptions are less likely when the firm has high financial slack, and less likely for larger firms. The measures of financial leverage (longterm debt to total assets), percentage changes in profit margin, and percentage change in investment in new projects (capital expenditures plus R&D scaled by total assets) are insignificant determinants of EPP adoption in this model specification. Percentage changes in growth opportunities (market-to-book) are significantly, positively associated with adoption, implying that firms with recent increases in growth opportunities are more likely to adopt an EPP. Alignment of shareholder and manager interests in growth firms is particularly important because shareholder wealth of growth firms depends especially upon the successful exploitation of investment opportunities, rather than upon the management of existing asset-in-place (Bryan, Hwang, and Lilien 2000). The model correctly classifies 66% of the observations and has a psuedo-r 2 of 7.0%. The results in column (2) suggest that the likelihood of adopting an EPP plan is not significantly associated with share ownership by executives or the level of equity compensation relative to total compensation. Similarly, the results in column (3) show that there is not a significant relation between excess stock returns and the decision to adopt an EPP. All other inferences from column (1) remain unchanged. Overall, the EPP adoption models perform reasonably well in the sense that they correctly classify a substantial proportion of observed EPP adoptions. The pseudo R 2 values for each model indicate that the model specifications explain a significant portion of the variation in adoption decisions. The negative coefficient on firm size and the positive coefficient on the percentage change in the market-to-book ratio suggests that firms with increases in growth opportunities are more likely to adopt an EPP, possibly in an effort to 20

23 control the growth of the firm. The negative and significant coefficient on financial slack combined with the strong external oversight that characterizes adopters suggests that these firms have dealt with managerial discretion costs by previously limiting access to funds. We do not find support for the arguments that EPP plans are adopted as a means to align the incentives of managers and shareholders when operating performance is relatively low, or when management ownership or incentive compensation are relatively low. 6. Operating Performance Changes and Stock Returns This section examines the long-run stock performance of EPP firms using the same procedures as Loughran and Ritter (1995). If the market correctly prices the future benefits of the EPP plan at the time of adoption, then we would not expect long-run abnormal returns related to adoption. However, market inefficiencies or the lack of information on the details of the structure of the compensation plan could possibly result in long-run abnormal returns. We examine returns both in the year of adoption and for the four years following adoption. We find that stock performance results are similar to the operating performance results. EPP firms have better return performance following adoption, but performance is not significantly different from the returns to the market or the comparison firms. Average annual returns are calculated as an equally weighted average of event (fiscal) year returns for each firm. If a firm is delisted during the measurement time interval, the annual return for that year is computed by splicing in the CRSP value-weighted index returns for the remainder of the year. 7 Table 7 compares the average year-by-year returns for EPP firms to the CRSP valueweighted index (panel A) and to the matched firms (panel B) for the year of, and the four 7 We also re-estimate table 7 by including only those firms that were listed for the entire year and the results are qualitatively similar. 21

24 years following, adoption. 8 Even in the year of adoption, the EPP adopters do not significantly outperform the market or the control firms. Average returns for adopters increase subsequent to adoption (adopters have an average return of 17.5% in the year prior to adoption); however, the evidence indicates that EPP firms and the broad market have similar performance in each of the first three years following the adoption date. The EPP firms and the comparison firms also have similar performance in each of the three years following adoption. The results suggest that EPP firms significantly underperform both the market and the comparison firms in year 4; however, there are fewer observations in year 4 due to delistings and data availability issues, and the results are skewed. Fama (1998) cautions that long-run return inferences are sensitive to the way longrun returns are measured. In particular, skewness and possible correlations of returns across events may significantly bias statistical results for long-run buy-and-hold returns. To investigate the sensitivity of our results to these statistical problems, we follow Fama (1998) and measure stock performance of EPP firms using the average monthly returns procedure. For each calendar month, we calculate the abnormal return for each EPP firm as the difference between the return of the adopting firm and the return of a matched comparison firm. Following Jaffe (1974) and Mandelker (1974), we allow for changes in the risk of each abnormal return portfolio and heteroscedasticity of returns due to changes in portfolio composition. We divide the abnormal portfolio return each month by an estimate of its standard deviation to produce a time series of monthly standardized portfolio abnormal returns. The overall abnormal return is then estimated by averaging the standardized monthly abnormal returns. The overall standardized value-weighted portfolio abnormal return of per month is not significantly different from zero (t = 0.46). Similarly, the 8 Since there is significant skewness in the stock returns, we repeat the analysis using medians, with largely similar results. 22

25 standardized equal-weighted portfolio abnormal return of per month is not significantly different from zero (t = 0.17). Overall, our long-run return results do not appear to be altered when consideration is given to the statistical problems noted by Fama (1998). These long-run return findings indicate that EPPs do not generate excess returns over either matched firms or a market index as a result of improved operating performance Conclusion We have analyzed the long-run operating and stock price performance of firms adopting economic profit plans. In a sample of 65 firms that adopted EPPs between 1986 and 1995, we document significant improvements in operating performance in the years following adoption. While these results appear to support the hypothesis that EPPs motivate managers to make efficient investment decisions, a matched sample of nonadopters realizes similar changes in operating and stock performance during the same period. There are at least two possible explanations for the similarity in operating performance improvements. First, these improvements may be a result of making changes in compensation plans that produce better incentive alignment. Second, the improvements may reflect a return to historical performance levels that have little to do with managers actions. That is, managers may opportunistically time EPP adoptions to coincide with predictable changes in operating performance. 9 Our conclusions regarding the long-run stock price performance by EPP firms are robust across methods used to calculate excess returns. First, we calculate excess returns using size and market-to-book reference portfolios. Excess returns are computed for one-, two-, three-, and four-year rebalanced and buy-and-hold returns following the approach described in Barber, Lyon, and Tsai (1999). The mean monthly rebalanced excess return is 0.55%, 0.32%, -0.07%, and 0.57% for one-, two-, three-, and four-year holding periods, respectively. The corresponding t-statistics are 1.26, 0.89, -0.17, and The mean monthly buy-and-hold excess return is 0.54%, 0.23%, -0.18%, and 0.41% for one-, two-, three-, and four-year holding periods, respectively. The corresponding t-statistics are 1.22, 0.67, -0.52, and Next, we perform an intercept test based on the Fama and French (1993) three-factor model, and we find no evidence of significant excess performance. The overall abnormal return is 62 (11) basis points per month with equally weighted (valueweighted) portfolio excess returns using ordinary least squares. Detailed results of these analyses are available from the authors upon request. 23

26 Distinguishing between these explanations requires inferring whether performance improvements are the result of better incentives or simply good timing. The opportunistic timing explanation is similar to Yermack (1997), who documents that CEO stock option awards are timed to immediately precede announcements of favorable corporate news. While this may be a concern when managers have short-lived, private information, it is a less compelling explanation in a long-run performance study where incentive realignment may take years before the effects are fully observable. The problem with the opportunistic timing story is that it relies on the notion that managers can identify when firm performance is going to improve for exogenous reasons that are unrelated to effort. Two frequently cited examples of exogenous factors are that managers can exploit industry trends and that they are able to capture performance improvements that are simply attributable to mean reversion. The problem with the first explanation is that industry trends reflect the collective efforts of all firms in an industry including those of managers in the poorly performing firms. Similarly, mean reversion is likely attributable to renewed efforts by managers rather than good fortune. To see this, note that poorly performing firms must raise their performance to the level of their competitors or they will not survive. In a similar manner, industry leaders find that their advantages are competed away as weaker firms imitate them. Thus, competition and renewed efforts explain mean reversion in the long run, but the underlying explanation is one of increased effort rather than exploiting exogenous knowledge about future performance. Since it is hard to motivate an opportunistic timing story that is unrelated to effort, we conclude that the incentive alignment hypothesis is a better explanation, particularly given our analysis of incentive compensation changes. Our evidence suggests that managers in both firms make changes to realign incentives but elect different methods. To do this, adopters increase their bonus payments, while control firms increase equity compensation. 24