Why Do CEOS Increase Their Equity-Based Compensation? Because They Have to

We study whether firms tend to make the compensation of their managers dependent on the relative level of valuation. We consider compensation in the sample period between 1992 and 2003 and show that an increase in company valuation leads to an increase in the pay-for-performance sensitivity. This is rejecting the hypothesis that managers skim the company by setting their own compensation in a way consistent with the market timing theory. However our findings are consistent with the interpretation that this increase in the pay-for-performance sensitivity and increase in equity-based compensation is a way for effective boards to incentivize CEOs in the light of uncertainty whether the high valuation is due to the ability of the managers or due to luck. We find that firms with better governance are more likely to make their managers' compensation more sensitive to performance if the firm displays a high market-to-book ratio relative to its past or relative to the industry. We also find that firms which increase the compensation of their managers experience a price decrease in the following months, suggesting that the board is successfully timing the market or that their doubts about the high market-to-book ratio being due to skill was justified