Teaming Up and Quiet Intervention: The Impact of Institutional Investors on Executive Compensation Policies

In a modern corporation, a single large investor no longer monopolizes active monitoring. A typical investor base in the U.S. public firm constitutes several blockholders which arguably maximize the very same objective function. These investors communicate with one another via private channels e.g., word-of-mouth and interpersonal connections, in order to coordinate their monitoring activities and exert influence on corporations to adopt governance attributes that better protect their interests.

The article examines whether institutional investors intervene in corporations with the aim of improving their incentive systems. To investigate this question, we construct metrics based on the geographic location of institutions. We conjecture that institutional investors get involved in informal interactions and that the intensity of these interactions as well as their effectiveness is commensurate with the geographic distance between them. Investors which are close to each other in physical space, are more likely to exchange ideas through casual conversation in person or over the phone in the same word-of-mouth channel. Consequently, they are more likely to share similar views, act alike, and cooperate.

Our research shows that when institutional investors are located geographically closer to one another, companies are more likely to have incentive systems that better align the interests of managers with those of outside equity-holders. In particular, we find that due to the geographic proximity effect senior executives receive a significantly higher proportion of their annual compensation in the form of stock options and other instruments of the equity-based pay. This result is consistent across all categories of senior executives in the top management team. Interestingly, we also find that geographic proximity between institutional investors has virtually no impact on the level of total compensation.

We next consider other important dimensions of executive compensation, namely managerial incentives to expand effort in searching for new profitable investment opportunities, as well as managerial incentives to take risks. It is well established that incentives to expand effort are measured by executive stock option delta, whereas incentives to make managers more willing to take risks are captured by executive stock option vega. In line with prior literature, we find evidence of a significant positive relation between geographic proximity of institutional investors and managerial incentives as provided by delta and vega. Our results highlight the importance of strategic interactions among institutional investors and their impact on the system of effort and risk-taking incentives that, in turn, influence firm financial and investment decisions, and shape corporate policies.

In a subsequent analysis, we study executive pay differentials between CEO and lower-level executives. Specifically, we consider the difference in the level of total compensation, equity-based component of the executive pay package, as well as differences in delta and vega. We relate these measures to our proxies for investor coordination, constructed based on the mutual geographic positioning of the institutions. We find a significantly positive relation between executive pay disparity and the effect of geography. Our analysis suggests that when institutional investors are located farther away from one another and thus interact less, firms exhibit significantly larger compensation gaps. This association remains true for the level of total compensation, as well as for various equity-based instruments of the executive compensation contract. The results are suggestive of rank-order promotion tournaments with the winner’s prize (i.e., CEO compensation) being larger when institutional investors are geographically dispersed and when their joint monitoring activities are weaker.

Throughout the empirical analysis, we use the dynamic panel general methods of moments (GMM) methodology. We argue that investment decisions on the part of institutional investors and thus their geographic location with respect to one another can be determined endogenously. In general, an endogeneity problem may lead to a spurious relation between observable characteristics in the empirical model, and thus to spurious inference. The GMM estimator mitigates these endogeneity concerns by controlling for unobservable heterogeneity, reversed causality, simultaneity, and the dynamic relation between the current values of regressors and past values of the regressand. The model also accounts for time invariant (fixed) effects. In addition, in all test specifications, we control for the instrument proliferation problem.

We perform an array of tests to verify that our main results are robust to deviations from the baseline empirical model. We control for time-varying industry effects, time-invariant regional factors, various proxies for the business cycle fluctuations, metropolitan statistical area (MSA), location of the major U.S. cities, geographic distance to the nearest major airport hub, and well as the distance between institutional investors and the firm in which they stay invested. We rerun our base-case regressions using these additional controls and our main results remain qualitatively unchanged.

Taken together our results indicate that when institutional shareholders are in geographic proximity and thus coordinate more, firms adopt executive compensation contracts with better incentives to maximize shareholder wealth. Specifically, we show that these contracts include more value-enhancing mechanisms, greater incentives to encourage managers to work harder, and greater incentives that lead to increased risk-taking. Notably, the average level of executive pay is not affected by the effect of geography.

The full article is available for download here.