Stack of Money

The connection between executive compensation schemes and performance was brought into sharp focus again in November 2015 after Deutsche Bank’s co-Chief Executive John Cryan stated that bonuses do not encourage banking executives to work harder. He specified that bankers shouldn’t be rewarded as entrepreneurs, highlighting the underlying belief that bonuses may not drive the behaviours they are intended to drive.

Bonuses and other forms of results-driven compensation schemes are part of a wider discussion scientifically framed by agency theorists. It is believed that agency problems — misalignments between shareholders and executives/managers — tend to be solved using compensation schemes oriented towards shareholder’s interests. Alignment, or the perfect match, is achieved when executive compensation is materially linked with shareholders’ return through stocks/equity, technically known as managerial ownership (MO).

The perfect match

Agency theory not only claims that executives’ interests will converge with those of the shareholders when executives increase their own level of equity (Jensen & Meckling, 1976), but also fuels the argument that by increasing executives’ level of equity their firm’s performance will improve. As Short & Keasey (1998) stated:

Jensen & Meckling’s convergence of interest hypothesis contends that, as managerial ownership in a firm increases, a firm’s performance increases uniformly, as managers are less inclined to divert resources away from value maximisation’.

To have a clear view of how managerial ownership would assure shareholder return, in 2014 I developed a thesis to find links between executive compensation and performance. To ensure the best possible outcome, my sample needed to represent a business context where managerial ownership is widely viewed and applied as a key compensation scheme to drive performance. I chose to analyse private equity-backed buyouts and my objective was to understand why management teams improve operating performance in private equity-backed buyouts. Is it an obvious matter of increasing managerial ownership or is there something else? Are material incentives enough to drive performance?

Favoured over bonuses, managerial ownership is used by private equity-backed buyouts as a key compensation instrument. Kaplan (1989) found that the managerial ownership percentage increases by a factor of four when the company turns private in a sample of 76 management buyouts.

What if there’s no correlation between managerial ownership and operating performance?

During my analysis I found that several authors have explored the correlation between managerial ownership and operating performance (OP) but, surprisingly, the scope of findings does not allow any definitive conclusion. Contrary to what seemed to be supported by agency theory, Mickkelson et al (1996) intersected (sample of 283 companies) adjusted levels of OP with MO, both in the years after the the company first issued stocks (Initial Public Offering, or IPO) and the first ten years ahead of the IPO, although no relationship was found between operating performance and managerial ownership. Demsetz & Villalonga (2001) also stated that no statistically significant relation between ownership structure and firm performance was found for a sample of 223 firms. Nevertheless, Short & Keasey (1998) underlined that the analysis of the causality between managerial ownership and OP has evolved throughout the years to non-linear analysis, bringing more doubts to any linear conclusions.

To illustrate the variety of thoughts, Demsetz (1983) underlined that high levels of managerial ownership may even intensify firm agency problems rather than promote alignment between shareholders and managers, because managers may become entrenched – their gains from privileges like salary or benefits may compensate any loss in the value of the firm (Short & Keasey, 1998). Morck et al (1988) have shown that there is a positive relation between MO and OP up to certain levels of ownership followed by a negative relation for higher ownership levels, validating the entrenchment effect.

Private equity firms

I decided to complement these perspectives by interviewing private equity (PE) industry senior executives (from different regions) in order to validate this poor correlation between managerial ownership and operating performance. It became clear from my research that ownership as an agency problem-solving tool does not get extensive consensus. Four in ten of the senior executives interviewed declared that managerial ownership was not used as an incentive to provoke value generation.

The same level of disagreement was found when these executives were asked about the relationship between MO and OP. A private equity firm executive raised a relevant insight about the use of managerial ownership as an alignment tool:

‘Managerial ownership does not solve agency problems. If an executive makes 20 million or 30 million dollars on stock valuation in one year he is a very wealthy individual no matter the rate of return measured from his own work or capital, but, if a private equity firm does not achieve a return on equity above industry average it has a problem.  The personal wealth of executives and PE firm’s wealth are different concepts measured in different ways.’

Owning stocks, as this senior executive highlights, does not mean the level of ambition of the executive/manager (measured in the internal rate of return of the investment) will be equal to level of ambition of the private equity firm, since the opportunity cost of capital between the two will always be different. So, if it is not possible to clarify the personal ambition of each executive, how much equity should the private equity firm give away to executives in order to align incentives?

The PE senior executives that use managerial ownership as an alignment instrument or the ones that benefit from it reported that equity in the hands of the management team has increased from the pre to the post buyout reality, reaching 10 per cent of the equity in some cases. For these executives, managerial ownership is considered to work as a way to align incentives, as mentioned by an executive working in an Azerbaijan manufacturing company acquired by the major local PE firm: ‘Salaries were reduced and managerial ownership increased which guided managers to be more aggressive in cost cutting programs’. But, even within this group of believers and users of MO, some of the executives could not report any relationship between MO and OP.

If it is not obvious for managerial ownership, why should it be for bonuses?

If the convergence of interest between shareholders and executives through the use of managerial ownership cannot be proven or, at least, it can be seen as a highly controversial hypothesis, why should the convergence happen when bonuses, rather than equity, come into play?



  • This article was originally posted in the LSE Management blog
  • This post gives the views of its author, not the position of LSE Business Review or the London School of Economics.
  • Featured image credit: Pixabay Public Domain

Miguel DuarteMiguel Duarte is a Partner at EY (Ernst & Young) Brazil, Advisory – Performance Improvement practice and specialises in strategy and innovation; he holds a bachelor degree in Economics from Universidade de Coimbra, Portugal, and an Executive Global Master’s in Management (MSc) from LSE.