Optimize Executive Incentives

Mar 07, 2018
Finance

Women Leading Research: M. Cecilia Bustamante

SMITH BRAIN TRUST – Leaders might deserve dismissal when they behave badly or underperform, but some can lose their jobs for simply having the right skills at the wrong time when market conditions shift. “Over time changes in business conditions may call for a change of top management to seize new opportunities,” professor M. Cecilia Bustamante and her co-authors write in a forthcoming Journal of Finance paper.

Adopting new production techniques, for example, might require someone with technical or manufacturing skills. Expanding overseas might require someone with global experience. Bringing diverse teams together during a merger or acquisition might require a master communicator.

“If the incumbent lacks the vision or skills necessary to implement such transformations, the appointment of new management is the only way for the firm to successfully pursue its course,” the authors write.

Bustamante, a finance professor at the University of Maryland’s Robert H. Smith School of Business, says growth-induced turnover complicates the process of creating optimal incentive packages for executives.

If leaders anticipate that their tenure will be short — especially in high-growth industries — they will resist deferred compensation, a standard feature of incentive contracts designed to reduce firm costs.

Instead, managers will demand generous signing bonuses and other features to front-load their contracts. “Thus the firm may face a dilemma,” the authors write. “By changing management to adapt to evolving business conditions, it may increase the costs of incentive provision.”

In some cases a firm might actually be better off skipping growth opportunities and saving the costs of inefficient terminations. Bustamante and her co-authors present a model that predicts these dynamics and offers guidance to firms facing the dilemma.

“The optimal dynamic contract may grant partial job protection whereby the firm insulates its managers from the risk of growth-induced dismissal and foregoes attractive opportunities when they come after periods of good performance,” they authors conclude.

Read more: Anderson, Ronald W. and Bustamante, Maria Cecilia and Guibaud, Stéphane and Zervos, Mihail, “Agency, Firm Growth and Managerial Turnover.” Journal of Finance (2018).

M. Cecilia Bustamante is an assistant professor of finance at the University of Maryland’s Robert H. Smith School of Business.

Research interests: Executive compensation; dynamic corporate finance; industrial organization; asset pricing implications of corporate decisions.

Selected accomplishments: Chosen as one of six finance scholars who presented papers on March 4, 2017, at the inaugural Showcasing Women in Finance series, organized by the Academic Female Finance Committee (AFFECT) of the American Finance Association; papers published in the Journal of Finance, Review of Financial Studies and Journal of Financial and Quantitative Analysis, among others.

About this series: The Smith School faculty is celebrating Women’s History Month 2018 in partnership with ADVANCE, an initiative to transform the University of Maryland by investing in a culture of inclusive excellence. Daily faculty spotlights support activities from the school’s Office of Diversity Initiatives, starting with the seventh annual Women Leading Women forum on March 1, 2018.

Other fearless ideas from:  Rajshree Agarwal  |  Ritu Agarwal  |  T. Leigh Anenson  |  Kathryn M. Bartol  |  Christine Beckman  |  Margrét Bjarnadóttir  |  M. Cecilia Bustamante  |  Jessica M. Clark  |  Rellie Derfler-Rozin  |  Waverly Ding  |  Wedad J. Elmaghraby  |  Rosellina Ferraro  |  Rebecca Hann  | Amna Kirmani  |  Hanna Lee  |  Hui Liao  |  Jennifer Carson Marr  |  Wendy W. Moe  |  Courtney Paulson  |  Louiqa Raschid  |  Rebecca Ratner  |  Debra L. Shapiro  |  M. Susan Taylor  |  Niratcha (Grace) Tungtisanont  |  Vijaya Venkataramani  |  Janet Wagner  |  Yajin Wang  |  Yajun Wang  |  Liu Yang  |  Jie Zhang  |  Lingling Zhang

Photo credit: ElenaR

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