CEOs are often evaluated and paid based on how well their companies perform compared with peers. Benchmarking a company’s performance in this way—using relative performance evaluation, or RPE—has been extensively studied and determined to provide a precise signal of a CEO’s effectiveness.
But University of Michigan’s Ryan T. Ball, Chicago Booth’s Jonathan Bonham, and Rice University’s Thomas Hemmer make the case that conventional RPE has been limited by its focus on competitive peers, companies that pursue similar strategies or businesses. They argue that companies actually evaluate CEO performance against aspirational peers, ones that engage in a wider range of value-maximizing strategies.
To test this hypothesis, the researchers modified the conventional approach to RPE, which required identifying the set of peer businesses that could be considered aspirational. The executive-compensation consultancy Equilar identified a portfolio of peers for each company studied based on ones the companies themselves identified as peers in their proxy statements.
The Equation: Rewarding CEOs who emulate superstars
Click below for a visual translation of an equation that explains relative performance compensation.
These portfolios, however, didn’t differentiate between competitive and aspirational peers, so the researchers noted which companies named each other as peers and which named as a peer another company that did not reciprocate. One-way relationships indicate aspirational peers, they claim, and these peers may be bigger and in a different line of business than the selecting company.
Ball, Bonham, and Hemmer tracked the correlation in peer companies’ equity value over time, arguing that doing so can indicate whether management is pursuing strategies mimicking those of aspirational peers. Making 7,039 such market observations between 2007 and 2014, the researchers find that a given CEO’s compensation did not rise or fall based on the correlation of performance with that of aspirational peers. The research provides a more complete picture of how businesses evaluate and compensate executives. “Many people compete with their neighbors to keep up with the Joneses, but also aspire to keep up with the Kardashians,” Ball, Bonham, and Hemmer point out—and they say the same goes for companies.