People are influenced by their peers. The quality of peers can have a significant impact on a person’s performance. Parents know this fact very well for their children. Educators know this as well for their students. Yet, it remains unclear whether this peer effect is true for one of the most sophisticated professionals in the world: CEOs of large companies.
In one of my research studies with my colleague Bill Francis, Iftekhar Hasan, and my Ph.D. student Suresh Mani, we hand-collected the actual peers for each S&P 1500 member firms over the period of 2006-2010 and empirically investigated whether the relative quality of a firm’s peers can affect its performance.
We found strong results showing that firms with (relatively) high quality peers tend to earn superior risk-adjusted stock returns and experience higher profitability growth. These results hold for both peers included in the pay-setting process (compensation peers) and peers used exclusively for relative performance evaluation (performance peers). In other words, even for CEOs, they will tend to work harder or smarter when they find that their peers are better, no different from kids or students.
Nowadays, more and more firms are adopting peer-based incentive contracts to reward and motivate corporate executives. Yet, studies found that many CEOs seem to manipulate the peer selection process toward their own favor, such as choosing the high-paid peers to justify their own excess pay.
Our findings can help design more effective incentive contracts in two ways. First, by stressing the relative quality of peers, we can limit a powerful CEO’s ability to choose weak peers. Second, in doing so, we also introduce the competitive forces into the peer-based contract.