Differences in CEO compensation under large and small institutional ownership

• Author: Onur Kemal Tosun
• DOI: http://doi.org/10.1111/eufm.12252
• Published date: 01 September 2020
• Date: 01 September 2020

Eur Financ Manag. 2020;26:1031–1058. wileyonlinelibrary.com/journal/eufm © 2019 John Wiley & Sons Ltd.

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DOI: 10.1111/eufm.12252

ORIGINAL ARTICLE

Differences in CEO compensation under large

and small institutional ownership

Onur Kemal Tosun

Cardiff Business School, Cardiff

University, Cardiff, UK

Correspondence

Onur Kemal Tosun, Assistant Professor,

Cardiff Business School, Cardiff

University, Cardiff CF103EU, UK.

Email: TosunO@cardiff.ac.uk

Abstract

I examine the influence of large and small institutional

investors on different components of chief executive officer

(CEO) compensation, using US data for 2006–2015. An

increase in large institutional ownership reduces total pay

and current incentive compensation (i.e., options, stocks,

bonus pay), whereas small institutional investors lower

long‐term incentive pay (i.e., pension, deferred pay, stock

incentive pay). These findings are consistent with manage-

rial agency theory and the substitution of incentive pay

by institutional monitoring. The effects are stronger for

higher ownership levels and firms with weak governance,

less financial distress, long‐tenured CEOs, multiple

segments, and more free cash flow.

KEYWORDS

CEO compensation, large institutional ownership, long‐term incentive

pay, short‐term incentive pay, small institutional ownership

JEL CLASSIFICATION

C33, C36, G32, J33, M12

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INTRODUCTION

Over the last 20 years, there has been an increasing trend among institutional investors to

accumulate a large amount of stock. Several studies have examined the potential impact of

increased institutional ownership on various firm policies (e.g., Becker, Cronqvist, & Fahlenbrach,

2011; Chichernea, Petkevich, & Zykaj, 2013; Holderness, 2003; Knyazeva, Knyazeva, & Kostovetsky,

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I would like to thank John Doukas (the editor) and two anonymous reviewers for their constructive and insightful

suggestions and comments on this paper. All remaining errors are my own.

2018; Ward, Yin, & Zeng, 2019; Yan & Zhang, 2009). Some papers have analyzed the possible effects

on chief executive officer (CEO) compensation in general (e.g., Clifford & Lindsey, 2016; Cronqvist

& Fahlenbrach, 2009). However, the literature has not reached an agreement yet on whether

institutional investors influence CEO pay (e.g., Zheng, 2010) and, if so, how. It is important to

analyze the relation between managerial remuneration and the ownership by big investors.

Considering their high level of ownership and influence in firms, large institutional shareholders

can shape a CEO's pay structure, which eventually affects the CEO's decisions on firm policies and

various vital operations.

My main research questions expand the literature and focus on the components of CEO

compensation that are associated with large and small institutional ownership and whether

increased ownership by large institutional shareholders influences the CEO pay structure

differently from small institutional shareholders. The literature has overlooked the strong

influence of large institutional shareholders with at least 10% ownership. Therefore, further

research questions in this paper concentrate on whether the results in the literature are driven

by earlier regulatory reforms, as well as by smaller institutional investors.

I focus on firms and investors based in the United States and examine separately how large

and small institutional ownership is associated with different CEO pay components in the

period 2006–2015. I find that option pay, stock pay, equity pay,

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bonus pay, cash pay, and total

pay decrease after large institutional shareholders increase their stakes in these companies.

When small institutional investors own more of these firms’shares, pension, deferred pay, stock

incentive pay, and total long‐term incentive compensation drop, although the CEO's salary

remains unaffected. The results indicate that monitoring by large shareholders substitutes for

the current proportion of incentive compensation and CEO total pay, while the long‐term

incentive components of pay are affected by small investors. These findings are consistent with

managerial agency theory and the substitution of incentive pay by institutional monitoring.

Jensen and Meckling (1976) note that managerial agency issues can be alleviated by tying the

managers’interests to those of shareholders through incentive compensation. This agency

problem can also be mitigated by strict monitoring. Shleifer and Vishny (1986) suggest that

large institutional shareholders effectively monitor management. Monitoring by institutional

investors can then substitute for the control mechanism through incentive pay.

This paper's extended analyses show that the magnitude of change in CEO pay components

is greater for higher levels of large and small institutional investor ownership. The negative

impact of large and small institutional ownership is more profound in cases in which greater

CEO monitoring is necessary, such as in firms with weak corporate governance, strong financial

security, long‐tenured CEOs, multiple business segments, and high levels of free cash flow.

In further analyses, I use the total number of large and small institutional shareholders with

stakes in the firm in question as the main explanatory variables. I examine how significantly

the ‘active monitoring’classification can explain changes in CEO pay components compared to

large institutional shareholder taxonomy. I also focus in particular on excess pay and test the

robustness of the findings further in a cross‐sectional model setup. I acknowledge the difficulty

of finding the ‘perfect instrument’in considering institutional investors (Edmans & Holderness,

2017). Hence, without making any strong claims, I address potential endogeneity issues through

an instrumental variable (IV) regression approach with various instruments that should provide

suggestive evidence only.

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The majority of the vesting period for equity compensation is less than 3 years in my sample. Hence, in my analyses, option pay, stock pay, and equity pay can

be categorized as a CEO's current incentive pay.

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TOSUN