Positive externalities of CEO delta

• Author: Hongrui Feng,Yuecheng Jia
• Published date: 01 June 2019
• DOI: http://doi.org/10.1111/eufm.12182
• Date: 01 June 2019

591Eur Financ Manag. 2019;25:591–621. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

DOI: 10.1111/eufm.12182

ORIGINAL ARTICLE

Positive externalities of CEO delta

Hongrui Feng1Yuecheng Jia2

1Black School of Business, Pennsylvania

State University--Behrend,4701 College

Dr, Erie, PA 16563, USA

Email: hxf51@psu.edu

2Chinese Academy of Finance and

Development, Central University of

Finance and Economics, Beijing, China

Email: jiayuecheng@cufe.edu.cn

Abstract

Increases in delta incentives are dramatic for a small group

of firms (leader firms) but negligible for the majority. We

show that leader firms have larger market capitalization and

higher irreversibility, and are in industries with negative

shocks. When leader firms experience substantial growth

in delta incentives, industry peers experience positive ab-

normal returns and abnormal improvement in fundamentals

despite no significant change in delta. Further, we provide

evidence that abnormal returns are induced by peer CEOs’

extra efforts in response to the increasing competitive pres-

sure caused by leader firms. To mitigate their competitive

pressure and turnover threat, peer CEOs allocate their extra

efforts to firms’ operating efficiency and product differenti-

ation.

KEYWORDS

CEO delta incentive, incentive spillover,positive externality

JEL CLASSIFICATIONS

G14, G34

1INTRODUCTION

Recent literature documents that increases in delta compensation stimulate chief executive officers

(CEOs) to exert extra efforts in the firms’ operation and enhance corporate stock market performance

(e.g. Cooper, Gulen, & Rau, 2014; Kale, Reis, & Venkateswaran, 2009; Lilienfeld-Toal & Ruenzi,

2014). However, changes in delta (Δ𝐷𝑒𝑙𝑡𝑎) have much richer dynamics. In reality, Δ𝐷𝑒𝑙𝑡𝑎 is not

evenly distributed among firms. In contrast, it varies substantially across firms, as dramatically evi-

denced by its large magnitudes for a small group of firms (leader firms) but negligible magnitudes for

the majority. For instance, Expedia Inc.’s CEO Dara Khosrowshahi’s incentive pay grew 10-fold in

2015 (Wall Street Journal, May 1, 2016; as of late August, Mr. Khosrowshahi became the acting CEO

We would like to thank the editor, John Doukas; an anonymous referee; Brian Boscaljon; Xiangjun Hong; Ramesh Rao; Kuo

Zhang (discussant); and seminar participants at European Financial Management 2017 Xiamen Symposium for helpful com-

ments and suggestions. All errors are our own.

2FENG AND JIA

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of Uber). However, the delta incentive of Priceline, Expedia’s primary competitor, merely decreased

by 2% in the same period.

In this study, we first examine potential determinants for a substantial increase in the level of

delta incentive compensation experienced within small groups of leader firms (e.g., Expedia). We then

explore the economic consequence of the dramatic delta increase. We document that a small group of

firms’ substantial growth in delta incentive compensation predicts the stock returns of their industry

peers.1Furthermore, we find that the positive externality of a large Δ𝐷𝑒𝑙𝑡𝑎 in one firm to its peer

firms’ market performance is induced by peer CEOs’ extra efforts. Peer CEOs exert extra efforts in

their firms’ operations in response to the increasing competitive pressure caused by leader firms.

As a corporate governance device (e.g. Acharya & Volpin, 2009; Holmström, 1999), delta com-

pensation is designed to align CEOs’ interests with those of shareholders. However, if CEOs have

decreasing marginal utility on incentive pay, interest alignment can hardly explain the substantial in-

crease in delta such as the 10-fold increase in delta for Expedia Inc.’s CEO. It is therefore of interest

to explore reasons beyond interest alignment. Our evidence reveals two commonalities among these

firms with a substantial increase in delta (incentive leader firms). First, incentive leader firms are con-

centrated in industries experiencing industry-wide negative shocks, such as import tariff cuts. These

industry negative shocks can deteriorate industry market conditions, driving the firms to stimulate their

CEOs to exert greater efforts.

Next, within industries experiencing negative shocks, we explore the determinants of leader firms.

More specifically, we find that large firms and value firms are the ones that react first. The two common-

alities enhance our understanding of which firms are incentive leaders. Facing negative industry-wide

shocks, industry leaders with larger market capitalization, more tangible assets and a higher degree of

irreversibility are the ones exposed to severe losses. In response to the potential losses in profit and

in industry position, industry leaders initiate increases in delta compensation and stimulate CEOs to

exert greater efforts.2

Consequently, the extra efforts of leader firm CEOs improve their firms’ operating efficiency

(Lilienfeld-Toal and Ruenzi, 2014), putting competitive pressure on industry peer firms (e.g. Dixit,

1986). Prior literature in industry organization concludes that peer firms experience product price cuts

and negative market performance, implying a negative externality from one firm to its peers.

Prior studies emphasize the negative influence of product market competition on industry peers

while ignoring peer CEOs’ active response to the competition. Peer CEOs’ implicit incentives, such as

mitigating turnover threats and protecting their reputation, can alleviate the negative impact of product

market competition on peer firms. To mitigate turnover threats and maintain their reputation, CEOs in

peer firms can increase their efforts to run their firms more efficiently, suggesting a positive change

in future stock price among these firms. Thus, the competitive pressure generated by the substantial

increase in one firm’s delta can lead to two opposite effects on its peer firms: negative externality on

peer firms’ market performance due to product price cuts generated by the increased industry com-

petition (e.g. Dixit, 1986); and positive externality on peer firms’ market performance resulting from

the increased operating efficiency due to peer CEOs’ extra efforts. Which effect dominates is then an

empirical question to explore.

In this study we explore leader firms’ CEO incentive spillover to their peer firms’ market per-

formance and fundamentals. We document a positive CEO incentive externality by showing that a

1For instance, the dramatic growth in delta for Expedia was followed by its main competitor--Priceline’sstock price increased

from $1,084.87 (February 1, 2016) to $1,445.83 per share (September 8, 2016). This is not an isolated case. We observe that when

large firms such as Best Buy, P&G, and IBM significantly increased their delta, the stock prices of their industry competitors

jumped.

2We thank the referee for the suggestion to identify which firms are the leaders in the first place.

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