Performance Pay, CEO Dismissal and the Dual Role of Takeovers by Mike Burkart and Konrad Raff

1. Performance Pay, CEO Dismissal and the Dual Role of Takeoversby Mike Burkart and Konrad Raff Discussion by A. Simonov (Michigan State University)

2. What is the paper all about? • Building unified model of boards, takeovers and performance pay • Not an easy task • Justified by the need for study of interaction between the mechanism • Main insights: substitability between internal and external governance, externality coming out possibility of incentivizing managers via taking over other firms (empire building)

3. Literature • Jensen (1986, 1989), Scharfstein (1988) suggest that the takeover threat plays a disciplinary role which improves performance • Stein (1988), Shleifer and Summers (1989) argue to the contrary that takeover pressure can have detrimental effects, leading to distorted investment decisions. • Hirshleifer and Thakor: (1) substitution effect between internal and external governance (2) the board is stricter with the manager because it may be dismissed by a successful acquirer. • Almazan and Suarez (2003): bad IG may be optimal when incentive provision through future control rents is cheaper than through incentive pay.

4. Model primitives: T=1, CF X1, manager can be fired, launch (or receive) takeover bid • Manager: good or bad, type is unknown to anyone. • Compensation based on CF. If no effort for P1, private benefits Z1. Private benefits Z2 for survivors at T=2 • Bad manager always fail at T=1 • Can be fired at T=1 T=0 manager is hired Effort level is chosen T=2: final CF is realized

5. Results: • Both better boards and more takeover threats/opportunities are decreasing CEO pay • Chances to run larger firm at T=2 (and getting higher private benefits due to running larger firms) lowers cost of providing incentives and benefits shareholders • External and internal governance are substitutes • For given level of EG, better IG results in lower pay • No monotonic prediction for level of compensation or prob of dismissal (How to reconcile it with monotonic empirical result of Huang and Zhao 2009?)

6. What I like: • To my knowledge, first paper that justifies Harford & Li 07 empirics: • “... even in mergers where bidding shareholders are worse off, bidding CEOs are better off three quarters of the time” • ...And this does not even count private benefits! • Relatively tractable model (for the level of details authors want to model)

7. My doubts • Is it really first order effect? What kind of savings in compensation shall we expect? How big are those savings in overall compensation expense? And w.r.t. firm equity? • Why strong boards do not prevent takeover (taking AMS results)? Is it really efficient equilibrium? • What about the board? What are incentives there? • Jenter and Kanaan (08): boards only partially adjust for mkt shocks while firing CEO

8. Andrade, Mitchell, and Stafford:

9. Andrade, Mitchell, and Stafford:

10. Literature review: a lot to be desired • Hirshleifer and Thakor in a series of papers are dealing with substitution effect between internal and external governance, quite similar in spirit to the one in BR paper • Osano: Same conflict, but additional complication if bad managers can acquire as well