1. Founding Family CEO Pay Incentives and Investment Policy: Evidence from a Structural Model Mieszko Mazur IESEG School of Management Betty Wu University of Glasgow Adam Smith Business School Young Finance Scholars' Conference 8 May, 2014

2. Introduction In modern corporations, there exists a common organizational form noted for its separation of ownership and control. Several studies argue that this Berle and Means (1932) type of firms is not a comprehensive form of publicly traded firms (e.g., Demsetz and Lehn, 1985; Shleifer and Vishny, 1986; La Porta et al., 1999; Morck et al., 2000; Claessens et al., 2000; Faccio and Lang, 2002). Other than its prevalence, families represent a persistent class of shareholders even decades after going public (Anderson and Reeb, 2003; Villalonga and Amit, 2006; Anderson et al., 2009). 2

3. Motivation Two types of agency costs, i.e., conflicts of interests between: – Large versus minority shareholders <= closely held firms – Managers versus shareholders <= diffusely held firms Incentive compensation systems that make managerial wealth sensitive to both risk and performance should be adopted to alleviate the owner-manager conflict. Anderson et al. (2012) study the relations between family firms and investment choices and test two hypotheses with opposing predictions. In this paper, we examine how founding families influence corporate investments through incentives rendered by CEO compensation. 3

4. Literature Review Family Firms, Agency Theory, and Investment Choices – Family Firms and Dual Agency Problems Type I: separation of ownership and control (Jensen and Meckling, 1976) Type II: expropriation of minority shareholders in family- controlled firms – private benefit of control: extraordinary dividend payouts, risk avoidance, excessive compensation schemes, related party transactions, management entrenchment, etc. (e.g., Shleifer and Vishny, 1986; La Porta et al., 1999; Faccio et al., 2001; DeAngelo and DeAngelo, 2000; Anderson and Reeb, 2003 and 2004) Empirical Evidence: – Lower agency cost of debt (Anderson et al., 2003) – Non-linear relation between turnover-performance sensitivity and family firm type (Chen et al., 2007) – Lower agency costs (Ang et al., 2000) – Inferior corporate governance (Bartholomeusz and Tanewski, 2006) 4

5. Literature Review (cont’d) – Family Firms and Investment Choices Anderson et al. (2012): – Risk aversion hypothesis: (-) – Investment horizon hypothesis: together with effective monitoring from ownership (+)  They find a negative relation between family firms and riskier R&D projects, and the market seems to discount below- industry investment levels. Anderson and Reeb (2003b): Family firms diversify less and maintain similar levels of debt as nonfamily firms, which seems against risk aversion hypothesis. 5

6. Literature Review (cont’d) CEO Pay Incentives and Risk-Taking – Option Portfolio Sensitivities Jensen and Meckling (1976) argue managerial risk- aversion creates severe agency conflicts resulting in lower shareholder value. A remedy: compensation with a convex function of performance (Haugen and Senbet, 1981; Smith and Stulz, 1985) 6

7. Literature Review (cont’d) – Vega: Risk seeking incentive Defined as the change in the value of manager’s option holdings for a 1% change in stock return volatility Estimated as the partial derivative of the stock option value with respect to stock return volatility Empirical evidence shows a positive relation between vega and riskiness of corporate policies (e.g., Coles et al., 2006; Hagendorff and Vallascas, 2011) – Delta: Incentive alignment through pay-for-performance Defined as the change in the value of manager’s stock and option holdings for a 1% change in stock price Estimated as the partial derivative of the stock option value with respect to stock price Mixed evidence regarding the relation between delta and riskiness of corporate policies (e.g., Coles et al., 2006; Mehran and Rosenburg, 2007) 7

8. Literature Review (cont’d) Family Firms and CEO Compensation – Gomez-Mejia et al. (2003): lower total income, further reinforced by family ownership – Bartholomeusz and Tanewski (2006): lower total compensation consisting of fixed income and option portfolio – Li et al. (2012): lower levels of both delta and vega when families participate in management. Family ownership is negatively associated with both pay incentives as well. 8

9. Hypotheses Firm Type Classification 9 Founding-Family CEONon-Founding-Family CEO Founding-Family Ownership Active Family Firm (I)Passive Family Firm (II) No Founding-Family Ownership Non-Family Firm (III) => Capital Expenditure, R&D expenses, M&As, and Segments

10. Sample Selection and Data We start with firms in the S&P600 SmallCap Index between 2001 and 2005. We exclude utility and financial firms, non-surviving firms, and spin-offs. We manually check the proxy statements for each company and collect the following information: identity, ownership, tenure, and biographies of founder(s), board members, blockholders, and the top 5 managers, whenever available. We classify a firm as having family ownership as long as one of the following two criteria is met: – founder or descendant of the founder sits on the board and/or is a blockholder => founding family – at least two board members are related, either by blood or marriage => family We match this sample with available accounting data in Compustat, compensation data in ExecuComp, corporate governance data in RiskMetrics. The final sample has 1,756 firm-year observations that correspond to 362 unique firms. 10

11. Pay Incentives We follow Core and Guay (2002) and Brockman et al. (2010) to calculate CEO option portfolio sensitivities. 11

12. Sample Statistics 12

13. Univariate Comparisons: CEO-Specific 13

14. Univariate Comparisons: Firm-Specific 14

15. 15 The Model

16. Family Influence, CEO Pay Incentives, and Long-term Investments 16

17. Family Influence, CEO Pay Incentives, and Long-term Investments (cont’d) 17 CAPEXR&D Firm Size − Growth Opportunity ++ Firm Age −− Cash + Leverage − Asset Tangibility +− Dividend − CEO Duality

18. Family Influence, CEO Pay Incentives, and Long-term Investments (cont’d)(cont’d) 18

19. Family Influence, CEO Pay Incentives, and Other Investments (cont’d)(cont’d) 19

20. Family Influence, CEO Pay Incentives, and Other Investments (cont’d) 20

21. Discussion: firm age, ownership, and vega 21

22. Concluding remarks, so far In this paper, we provide evidence that CEO pay incentives are different in family firms. These CEO pay incentives induce investment policy contingent on firm risk. Overall, the preference for lower risk dominates that for effective monitoring and/or longer horizon in active family firms, which manifests in their lower pay incentive vega. Still, there is some evidence that the preference for longer investment horizon enhances once the CEO is replaced by an outsider. 22

23. To take away… Family firms are a prevalent and unique organizational form. Families have different incentives and preferences that affect corporate behaviour and performance as a result. Family ownership, together with CEO family affiliation, are needed to identify family firms to avoid spurious relations and ramifications. Capital expenditure and R&D investments are not necessarily substitutes. 23