Managerial Compensation and the Threat of Takeover

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Abstract
The threat of takeover acts to discipline managers and so reduces the agency problems between managers and shareholders. But it also makes shareholder assurances to managers less reliable and so interfered with contracting between them. These two effects have opposing implications about the level of executive compensation: the disciplinary effect implies a reduction in compensation; the contracting effect implies an increase. Which of the two effects dominates is an empirical issue. We examine the relation between managerial compensation and the (industry-wide) threat of takeover to address this issue. Using compensation data for the CEOs of over 500 firms and after controlling for other determinants of executive compensation found in prior studies, we find a consistently positive effect of the threat of takeover, indicating that the contracting effect dominates. The magnitude of this net contracting effect is economically significant. A 10% increase in the annual probability of takeover from 4.6% to 5.06% results in an increase of $7,300 in the typical CEO’s annual salary plus bonus and an increase of $10,100 in his annual total compensation. Among CEOs without golden parachutes, this increase is even larger at $11,200 in salary plus bonus and $15,000 in total compensation. We also find a direct positive direct effect of the presence of a golden parachute on CEO compensation. These results do not seem to be driven by industry effects and are robust to alternative specifications. Together, they provide evidence on an important way in which the market for corporate control affects internal contracting and add to the growing literature on the determinants of the level of executive compensation.
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