Comparing managers’ performance against the performance of their peers at other companies has become a popular way to evaluate them. Since 2006, there has been a sharp increase from about 20% to 65% of companies using such relative performance comparisons for their top management, and the pay these managers can earn from outperforming their peers is substantial (see bit.ly/3TXRZeZ and bit.ly/3TNCztt). For example, the average CEO can earn up to 75% of his or her previous year’s total compensation by outperforming peers when specified in the compensation contract, which translates to roughly $7 million on average.
This prevalence motivated us to examine the consequences for managers’ decisions. Because relative performance evaluation contracts state that managers are only paid if they perform better than their peers do, we focused on the aggressiveness of their decisions toward peer managers (“Relative Performance Evaluation and Competitive Aggressiveness,” Journal of Accounting Research, 2022).
With relative performance evaluations, managers aren’t held accountable for factors that are general to the industry or product market and thus beyond their control. For example, because the performance of all airlines decreased substantially during the COVID-19 crisis, in absolute terms, evaluating performance against peers allowed for a correction of this general decrease and thus for providing insights into how well airlines performed given the situation.
As a result, relative performance evaluation provides a better understanding of a manager’s true performance. Poor performance, in absolute terms, doesn’t necessarily imply that a manager performed poorly during an industry-wide crisis. Conversely, when a company grows by 7%, this might still be indicative of poor performance when peers grew by 15%.
Yet comparing a company relative to its peers also puts managers in direct competition with their peers, which has consequences for how aggressive managers act. Managers might directly challenge their peers and increase their own relative position by attacking them. For example, they could take increasingly competitive actions such as price reductions, developing new products, engaging in lawsuits toward competitors, engaging in merger and acquisition activities, and so forth. This means companies become more competitively aggressive when managers are evaluated relative to managers of peer companies.
OUR STUDY
Using data from the largest U.S. companies between 2006 and 2017, we examined the relationship between relative performance evaluation and competitive aggressiveness. One feature of these relative performance contracts is that when one company uses another company as part of its peer group, the other company doesn’t need to use relative performance evaluation itself or, if it does, doesn’t have to include the focal company as a peer in the manager’s contract. But if the other company selects the focal company as a peer, then there’s a peer group overlap.
Our prediction is that the greater a company’s peer group overlap, the greater the incentive to adjust its competitive aggressiveness. To measure managers’ competitive actions, we examined newspaper headlines identified in about 19,000 traditional media sources (e.g., Dow Jones Newswire and The Wall Street Journal) and social media sites. These headlines showed whether companies took competitive actions such as price reductions, strategic alliances, new product offerings, etc. On average, companies take about 33 competitive actions per year, and there’s substantial variation in the type of actions they take.
FINDINGS AND IMPLICATIONS
Results from our analyses show that peer group overlap in these relative performance evaluation contracts is associated with greater levels of competitive aggressiveness. Compared to companies using relative performance evaluation with no peer group overlap, those with the highest levels of peer group overlap take about 36% more competitive actions per year, and the variation of these actions across the different action types is 19% greater, which implies that companies significantly expand their competitive repertoire across more action types.
We also found that managers tend to spend more on advertising and that their operating margins are lower. Jointly, these patterns suggest that peer group overlap leads to more competitive aggressiveness in product markets. Our results also indicate that this increase in competitive aggressiveness is even greater when the company and its peers have more similarities (e.g., in terms of size, performance measures, and/or industry).
Collectively, our study provides several new insights that might be important for boards of directors, investors, regulators, and other practitioners. For example, when companies choose to evaluate managers on their relative performance to filter common uncontrollable factors, they need to consider that it also affects the way managers will compete with peers.
While being competitively aggressive can improve a company’s relative position, it might also have harmful side effects. For example, peer companies can decide to counteract these actions by also becoming more aggressive, which can lead to an upward spiral in competitive investments and a downward spiral in margins. Furthermore, managers might also take other actions that increase their relative performance but not necessarily their absolute value.
By being aware of such potential side effects, compensation committees as well as investors can better judge the costs and benefits of relative performance evaluation, establish whether these contracts expose companies to material risks, and prevent value-destroying actions by increasing the intensity with which they monitor managers and the company.
Knowing that relative performance evaluation is associated with increased aggressiveness is also important for managers themselves. Once they see that a peer company uses relative performance evaluation and includes them as a peer, it could warn them that the peer will likely increase its competitiveness. This allows managers of the focal company to set some counteractions beforehand.
From this perspective, our results also have implications for regulators. For example, while the U.S. Securities & Exchange Commission has increased its compensation disclosure requirement toward capital market participants, this increased transparency can also shape the way companies compete in the product market. Regulators should thus be aware of such market externalities when setting standards.
Finally, showing that aggressiveness increases with peer group overlap also has implications for other types of relative performance contracts in practice. For example, many companies use relative performance evaluation for lower-level employees (e.g., sales competition, forced ratings). In these settings, all employees typically compete against each other, and thus there’s a 100% peer group overlap. As a result, relative performance evaluation contracts within companies might also lead to aggressive actions among employees, which is often reflected by a lack of cooperative behavior. This informs companies about potential costs and benefits of these incentive plans.
December 2022
