Volume 19, Number 1
January 2013

Frank Li has found a unique way to measure talent in CEOs - by exploring their pay packages.

li-impact-13.jpgTheories suggest that corporations perform better when led by CEOs with high ability and tolerance for risk.  But these qualities are difficult to evaluate, and empirical researchers have been unable to come up with any reliable measures.

Ivey Professor Frank Li conducts research in the field of empirical corporate finance, with a focus on corporate governance and executive compensation.  In an award-winning paper, he became the first empirical researcher to measure innate ability and risk aversion in top executives.

In the study, Li looked at both managerial and firm attributes. He divided these attributes into those that are "observable" and those that are "unobservable." For example, managerial attributes such as age, gender, education, and experience, are easy to observe.

On the other hand, attributes such as ability and risk aversion are not observable, particularly to those outside the company, such as investors. So how do researchers come up with reliable information? In his study, Li extracts this information from executives' compensation contracts. 

For example, when a firm board recognizes that a CEO has high ability, it will likely offer strong performance incentives, such as stock options. When a CEO has a high tolerance for risk, a board will often offer contractual incentives to implement riskier policies. At the same time, a CEO with these qualities will likely negotiate for contracts that reward performance and risk-taking.  "We found that these unobservable qualities explain some 80 percent of the pay incentives in executive contracts," says Li. "The observable variables, on the other hand, generally do a bad job in explaining contracts."

Li found that the information extracted from compensation contracts can be used to predict firm performance. "Our study confirmed that a CEO with higher innate ability will improve firm performance, both in the short run and long run," says Li. "A CEO with high risk tolerance will implement riskier investment policies and increase the volatility of firm stock returns."

Li's study was based on empirical data from 4,000 public firms over a 20-year period. His approach, based on the application of an econometrics program, depends on executives moving between companies. "We cannot say that high pay in itself means a CEO is highly capable, because some firms always pay more than others," says Li. "But when CEOs switch firms, we can eliminate all the firm attributes, and just keep the managerial attributes."

In another related project, Li uses econometrics to evaluate the entire field of empirical corporate finance research. In the study, he divided corporate finance into 20 subfields, such as corporate governance, financial policy, payout policy, investment policy, and performance.

For each of the 20 subfields he identified the importance of firm and manager-specific variables, both observable and unobservable. For example, managers' compensation, as we saw from the previous study, is largely dependent on unobservable manager information. On the other hand, he found that financial and investment policies are dependent on unobservable firm characteristics, such as firm culture. "In most cases we found that the unobservable attributes, whether firm specific or manager specific, explain the corporate finance research much more than the observables," says Li.

This study had a very broad and ambitious goal - to gauge the overall state of progress in empirical corporate finance research. "We tried to identify what's unknown to current researchers and what is already known," he says. "This helps to point out, for both theorists and empiricists, where they should be looking to direct future financial research."

In another stream of research, Li looks at "under-explored" topics in corporate governance. In a recent study, he focused on the number two executive in the firm.

One of the big challenges for boards is monitoring the CEO. Boards meet infrequently, and directors don't always understand the business. So how does the board ensure that the CEO is making decisions that are in the best interests of the company?

One way to do this, suggests Li, is by giving more authority and influence to the number two executive. In his study he found that firm value increases when the number two executive is given the role of monitoring the CEO, particularly when the board is weak or knows little about the firm's business. This option is usually much less expensive than beefing up the monitoring activities of the board.

Li says that creating a powerful number two doesn't necessarily lead to hard feelings and friction at the top. "The CEO usually wants the board to better understand the business, so the number two can help to serve as an alternative source of information."


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