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Journal Article•DOI•

Executive compensation, corporate governance and corporate performance: A simultaneous equation approach

Collins G. Ntim1, Sarah Lindop2, Kofi A. Osei3, Dennis Thomas2•
University of Southampton1, Aberystwyth University2, University of Ghana3
01 Mar 2015-Managerial and Decision Economics (Wiley)-Vol. 36, Iss: 2, pp 67-96
TL;DR: In this article, the authors investigated the association between executive compensation and performance using a three-stage least squares (3SLS) simultaneous equation framework and found that the executive pay and performance sensitivity is relatively weak.
Abstract: This paper investigates the association between executive compensation and performance. It uniquely utilises a comprehensive set of corporate governance mechanisms within a three-stage least squares (3SLS) simultaneous equation framework. Results based on estimating a conventional single equation model indicate that the executive pay and performance sensitivity is relatively weak, whereas those based on estimating a 3SLS model generally suggest improved executive pay and performance sensitivity. Our findings highlight the need for future research to control for possible simultaneous interdependencies when estimating the executive pay and performance link. The findings are generally robust across a raft of econometric models that control for different types of endogeneities, executive pay and performance proxies. Copyright © 2013 John Wiley & Sons, Ltd.

Summary (3 min read)

Jump to: [1. INTRODUCTION] – [2. CORPORATE GOVERNANCE, EXECUTIVE PAY AND THE SOUTH AFRICAN INSTITUTIONAL FRAMEWORK] – [3. PRIOR LITERATURE ON EXECUTIVE COMPENSATION AND CORPORATE PERFORMANCE] – [4.1. Data Considerations] – [4.2. Model Specification: Executive Pay-Corporate Performance Sensitivity] – [4.3. Three-Stage Least Squares, Executive Pay, Alternative Corporate Governance Mechanisms and Possible Interdependencies] – [5.1. Descriptive Statistics] – [5.2. Executive Pay and Corporate Performance Sensitivity] and [7. SUMMARY AND CONCLUSION]

1. INTRODUCTION

  • A number of reasons may explain the weak findings of past studies.
  • This development provides the opportunity to collect data on total pay of the Chief Executive Officer (CEO), as well as on the total pay of all executives and on CG in order to investigate the association between executive compensation and performance for a sample of SA listed companies, enabling us to make a number of contributions to the extant literature.
  • The next section discusses CG and executive pay practices within the SA institutional framework.

2. CORPORATE GOVERNANCE, EXECUTIVE PAY AND THE SOUTH AFRICAN INSTITUTIONAL FRAMEWORK

  • Attempts at improving CG practices in SA companies began with the publication of the first King Report in 1994 (King I) (Armstrong et al., 2006).
  • These domestic problems in combination with increased international attention on CG (Rossouw et al., 2002; Mangena and Chamisa, 2008), resulted in a review of King I and the subsequent publication of a second King Report (King II) in 2002.
  • An important aspect of King II is that it expects shareholders, especially institutional ones, to play an active part in setting executive pay, including the requirement that executive remuneration be approved 5 by shareholders at an annual general meeting, in which the chairperson of the RCOM should be available to answer questions.
  • Additional to the pursuance of recent CG reforms is the feature that, unlike the UK and US but similar to most Asian and some European countries, ownership of firms is highly concentrated (Firth et al., 2006, 2007; Ntim et al., 2012a, b).

3. PRIOR LITERATURE ON EXECUTIVE COMPENSATION AND CORPORATE PERFORMANCE

  • The executive compensation and performance literature has in the main developed from two major contrasting theoretical views 2 : optimal contracting and managerial power (Murphy, 1999; Bebchuk and Fried, 2003, 2004; Cheng and Firth, 2006; Van Essen et al., 2012).
  • The optimal contracting view considers 6 executive compensation packages as a result of arm‟s length dealing between independent corporate boards and executives that leads to the creation of efficient managerial contracts and incentives for minimising agency problems by aligning the interests of managers and shareholders (Jensen and Murphy, 1990; John et al., 2010; Tang, 2012; Lin et al., 2012).
  • These studies generally report a positive, but a weak, link between executive pay and performance; although US studies document a relatively stronger pay and performance sensitivity than their UK counterparts (Conyon and Murphy, 2000; Sapp, 2008).
  • Further, and of direct relevance, the results of a limited number of studies conducted in a number of developing countries are largely consistent with the non UK and US evidence.
  • Using a sample of 601 Chinese firms from 2000 to 2003, Buck et al. (2008) report a positive and higher sensitivity between CEO pay and total shareholder return than those reported for UK and US companies.

4.1. Data Considerations

  • The authors sample is drawn from all 291 non-financial firms 4 listed on the Johannesburg Securities Exchange (JSE) Ltd as at 31/12/2007.
  • Firms included in their final sample met two criteria: availability of a firm‟s executive pay data for all years from 2003 to 2007 and the accessibility to a company‟s financial and CG data from 2002 to 2006.
  • These criteria were set for a number of reasons.
  • Finally, the sample begins in 2002 because there is limited data coverage in the Perfect Information Database/Datastream on SA companies prior to that year, and crucially because King II came into effect in 2002.
  • As presented in Panel B of Table 1, the sample consists of a total of 169 firms out of the initial 291 firms 7 over five firmyears from eight industries that met the data criteria for their analysis.

4.2. Model Specification: Executive Pay-Corporate Performance Sensitivity

  • The widely used total shareholder return (TSR) is their main corporate performance proxy, but as a robustness check, the authors also employ return on assets (ROA) and Tobin‟s Q (Q) as alternative accounting and market-based corporate performance measures, respectively.
  • Table 2 contains full definitions of all the variables used.

4.3. Three-Stage Least Squares, Executive Pay, Alternative Corporate Governance Mechanisms and Possible Interdependencies

  • Firms with greater investment opportunities tend to grow faster and are more likely to receive higher market valuation (Barnhart and Rosenstein, 1998; Ghosh, 2007), and hence the authors expect sales growth (SGR) and capital expenditure (CAPX) to be positively related to TSR.
  • As larger firms are subjected to greater media and public scrutiny (Conyon, 1997; Ntim et al., 2012a), the authors hypothesise that BSIZE will be positively associated with the presence of an independent remuneration committee (RCOM) and a CG committee (see Table 2), but negatively related to CEO role duality (DUAL) and director ownership (DOWN).
  • Labelling all 12 exogenous variables together as EXOGENOUS, the second equation to be estimated in the system is specified as: ii j jii iiiii EXOGENOUSTPAYINSOWN BLKOWNLEVNEDsTSRBSIZE.
  • The authors also expect NEDs to vary across different industries and over-time (YD).

5.1. Descriptive Statistics

  • Table 3 contains descriptive statistics of the two main components of total executive pay for all firm-years, as well as for each of the five firm-years.
  • Panels A and B report statistics relating to total and average pay of all executives (TPAY), respectively, while Panel C presents similar figures for the CEO .
  • This appears to support the widely held view, especially within the SA financial press (Okeahalam, 2004; Sarra, 2004; Ntim et al., 2012a) that corporate executives continue to receive substantial pay increases that are well above the 16 average national growth rate in pay.
  • The mean institutional ownership of 74% is consistent with the 63% reported by Zheng (2010) for a sample of US firms, whereas the average block ownership 17 of 62% is considerably higher than the 20% reported by Ozkan (2011) for a sample of UK firms.
  • This supports previous evidence that CEOs, on average, tend to be matured and experienced individuals (Ozkan, 2011; Elsila et al., 2013).

5.2. Executive Pay and Corporate Performance Sensitivity

  • 2.1. Results based on estimating firm fixed-effects.
  • A major implication of this finding is that the structure rather than the levels of pay appears to be more effective in linking executive/CEO pay to corporate performance.
  • A number of minor sensitivities can be observed with regard to the magnitude of some of the coefficients, the results in both tables are essentially similar to those reported in Table 5 for TSR, suggesting that their results are fairly robust.
  • Statistically significant and positive effect of the TSR on the CEOPAY in Model 3 of Table 10 is easily discernible.

7. SUMMARY AND CONCLUSION

  • This paper investigates the association between executive pay and corporate performance, as measured by total shareholder return using a sample of South African (SA) listed firms, by uniquely taking into account a comprehensive set of corporate governance (CG) mechanisms within a three-stage least squares (3SLS) simultaneous equation framework.
  • The authors examine the link between cash and non-cash or equity-based compensation, as well as the association between both total CEO pay and corporate performance and between the total pay of all executives and corporate performance.
  • As financials and utilities are subject to different regulations and also differ in capital structure (Mangena and Chamisa, 2008; Ntim et al., 2012a), and following past studies (Blackwell et al., 2007; Dong et al., 2010), the authors exclude 111 financials and utilities, leaving us with 291 companies to be sampled.
  • As will be further explained, the authors also carried out Hausman system specification and Sargan exogeneity tests, but both tests rejected system misspecification and variable endogeneity for all seven equations.
  • The order-condition for identifying a system indicates that the number of exogenous variables excluded from any equation must be greater than or equal to the number of endogenous variables included minus one (Wooldridge, 2002; Gujarati, 2003; Beiner et al., 2004, 2006).

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University of Huddersfield Repository
Ntim, Collins G., Lindop, Sarah, Osei, Kofi A. and Thomas, Dennis A.
Executive Compensation, Corporate Governance and Corporate Performance: A Simultaneous
Equation Approach
Original Citation
Ntim, Collins G., Lindop, Sarah, Osei, Kofi A. and Thomas, Dennis A. (2015) Executive
Compensation, Corporate Governance and Corporate Performance: A Simultaneous Equation
Approach. Managerial and Decision Economics, 36 (2). pp. 67-96. ISSN 01436570
This version is available at http://eprints.hud.ac.uk/id/eprint/19536/
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http://eprints.hud.ac.uk/
Executive Compensation, Corporate Governance and Corporate Performance: A
Simultaneous Equation Approach
Collins G. Ntim
a
, Sarah Lindop
b
, Kofi A. Osei
c
, and Dennis A. Thomas
b
a
School of Management
University of Southampton
Southampton, UK
b
School of Management and Business
Aberystwyth University
Aberystwyth, UK
c
Department of Finance
University of Ghana Business School
University of Ghana
Accra, Ghana
Corresponding author. Address for correspondence: Centre for Research in Accounting, Accountability and
Governance, School of Management, University of Southampton, Southampton, SO17 1BJ, UK. Tel: +44 (0) 238
059 8612. Fax: +44 (0) 238 059 3844. E-mail: c.g.ntim@soton.ac.uk.
Executive Compensation, Corporate Governance and Corporate Performance: A Simultaneous
Equation Approach
Abstract
This paper investigates the association between executive compensation and performance. It uniquely
utilises a comprehensive set of corporate governance mechanisms within a three-stage least squares
(3SLS) simultaneous equation framework. Results based on estimating a conventional single equation
model indicate that the executive pay and performance sensitivity is relatively weak, whereas those
based on estimating a 3SLS model generally suggest improved executive pay and performance
sensitivity. Our findings highlight the need for future research to control for possible simultaneous
interdependencies when estimating the executive pay and performance link. The findings are generally
robust across a raft of econometric models that control for different types of endogeneities, executive
pay and performance proxies.
JEL Classification: G32; G34; G38
Keywords: Executive compensation; Corporate performance; Corporate governance; Simultaneous
equation; Generalised method of moments (GMM); Endogeneity
1
1. INTRODUCTION
Jensen and Murphy (1990) suggest that through optimal contracting, executive pay, especially that
involving equity/performance-linked compensation, can limit agency problems by aligning the interests of
managers and shareholders. However, the recent global financial crisis precipitated by increased risk-taking
and pay motives of top executives of major banks (Tung, 2010; Aebi et al., 2011; Lin et al., 2012;
Paligorova, 2011; Tang, 2012; Polat and Nisar, 2013; Wesep and Wang, 2013) has reignited the debate
regarding the effectiveness of executive compensation packages in mitigating agency conflicts in modern
corporations (Goering, 1996; Murphy, 1997; Grundy and Li, 2010; Van Essen et al., 2012; Berger et al.,
2013; Cook and Burress, 2013). Whilst a number of papers have examined the link between executive pay
and corporate performance, the general conclusion is that the link is weak (Murphy, 1999; Canarella and
Nourayi, 2008; Dong et al., 2010; Elsila et al., 2013; Kabir et al., 2013; Tiani, 2013).
A number of reasons may explain the weak findings of past studies. First, since executive pay is just
one of the possible corporate governance (CG) mechanisms that companies can employ to minimise agency
conflicts (Mehran, 1995; Borisova et al., 2012; Huang et al., 2012), its effectiveness may depend on the
simultaneous use of other CG mechanisms (Agrawal and Knoeber, 1996; Chung and Pruitt, 1996; Beiner et
al., 2004, 2006; Livne et al., 2013; O‟Connor et al., 2013). A major implication of this is that estimating the
executive pay and corporate performance sensitivity through the use of single equation modelling
techniques can result in endogenous associations (Core et al., 1999; Larcker and Rusticus, 2010; Connelly
et al., 2012; Gil-Alana et al., 2012; Bai and Elyasiani, 2013). Existing studies, however, have mainly used
single equation modelling, and thereby crucially ignored endogeneity problems that may be posed by the
possible simultaneous use of alternative CG mechanisms in estimating the executive pay and corporate
performance sensitivity (Guest, 2009; Wintoki et al., 2012; Zhao, 2013).
Second, the extant literature has focused mostly on cash-based rather than equity-based executive
compensation (Conyon, 1997; Benito and Conyon, 1999; Kato and Long, 2006; Buck et al., 2008; Shen and
Zhang, 2013). In contrast, corporate performance is more sensitive to equity-based than cash-based
executive compensation (Jensen and Murphy, 1990; Main et al., 1996; Cosh and Hughes, 1997; Ozkan,
2
2011), and this may also explain the weak findings of past studies. Third, Main (1991), Lewellen et al.
(1992), Conyon and Murphy (2000) and Firth et al. (2006, 2007) show that executive pay differs
substantially across countries due to variations in legal, institutional, cultural and CG practices.
However, past studies are concentrated in the UK and US, presenting comparatively similar
institutional contexts (Ang et al., 2002; Anderson and Bizjak, 2003; Chen et al., 2006; Cunat and
Guadalupe, 2009; Sun et al., 2009). In developing countries with different institutional settings, with
particular regard to CG reforms, ownership structures and executive director compensation incentives, the
link between executive pay and corporate performance can be expected to differ from what has been found
in industrialised countries. As such, studying the association between executive pay and corporate
performance in developing countries, where empirical evidence has been limited, contributes to a more
complete understanding of the relationship between executive compensation and corporate performance. A
major reason for the paucity of empirical evidence in developing countries, especially African countries, is
the difficulty in obtaining data of sufficient frequency and duration for analysis (Okeahalam, 2004;
Mangena and Chamisa, 2008; Mangena et al.,2012; Ntim et al., 2012a; Fosu, 2013).
Recent CG reforms in South Africa (SA), however, provide a unique and potentially rewarding context
for such a contribution. The recent South African CG reforms incorporate the expectation that executive
pay will be strongly linked to corporate performance, and also require listed firms to fully disclose
executive compensation details in their annual reports, making available information that hitherto has been
publicly inaccessible. This development provides the opportunity to collect data on total pay of the Chief
Executive Officer (CEO), as well as on the total pay of all executives and on CG in order to investigate the
association between executive compensation and performance for a sample of SA listed companies,
enabling us to make a number of contributions to the extant literature.
The paper documents for the first time evidence on the levels of executive pay, as well as the
association between executive compensation and corporate performance in SA. Distinct from most past
studies, we provide evidence on how corporate performance is associated with both the total pay of the
CEO and that of all other executives, as well as on the link between cash (i.e., salary, performance bonus,
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Frequently Asked Questions (8)
Q1. What are the contributions in this paper?

This paper investigates the association between executive compensation and performance. Results based on estimating a conventional single equation model indicate that the executive pay and performance sensitivity is relatively weak, whereas those based on estimating a 3SLS model generally suggest improved executive pay and performance sensitivity. 

Their results appear to justify their research design, as well as highlighting the need for future research to take into account a comprehensive set of CG mechanisms within a simultaneous 30 equation framework, which permits each mechanism to affect executive pay, but also allows executive pay to affect each mechanism when estimating the executive pay and corporate performance sensitivity. As data coverage improves, future studies may need to consider other CG mechanisms, such as data on the market for corporate control, 31 in estimating the executive pay and corporate performance sensitivity. Therefore, future research may improve their findings by investigating how different types of institutional owners influence the pay-for-performance elasticity. Incorporating such changes in CEO wealth in the total CEO pay package by future researchers may enhance their findings. 

The theory that larger firms are more complex to manage, implies the need for higher quality managers capable of making frequent and significant decisions, but such talented managers are both scarce and highly mobile who can largely be attracted with competitive pay packages (Murphy, 1999; Sapp, 2008). 

Apart from regulatory enforcement, their results further indicate that greater activism by institutional shareholders may help strengthen the executive pay and corporate performance link. 

Evidence of a stronger link between corporate performance and equity-based compensation provides support to the recommendations of King II that non-cash pay should form a substantial portion of total executive compensation in order to align executive interests with those of shareholders. 

It is also consistent with tournament theory (Sapp, 2008; Lee et al., 2008; Zhao, 2013), which suggests that CEOs are paid more to stimulate healthy competition among lower placed executives for the position of the CEO, ultimately resulting in the exertion of greater effort and improved corporate performance. 

During the late 1990s, the country experienced a number of high profile corporate failures, such asthe collapse of the Macmed, Leisurenet and Nedbank companies, which were attributed mainly to poor CG practices, including increased executive compensation (Okeahalam, 2004; Sarra, 2004). 

As data coverage improves, future studies may need to consider other CG mechanisms, such as data on the market for corporate control,31in estimating the executive pay and corporate performance sensitivity.