What You Make = Who You Know
From the Briefcase: Research produced by America's Best Business Schools
Study: "But, Mom, All the Other Kids Have One! CEO Compensation and Director Networks"
Authors: Ilan Guedj and Amir Barnea (McCombs School of Business, the University of Texas–Austin)
Status: Working paper
Summary: Why do some CEOs make so much more than others? Not necessarily because they're better, according to a new paper, which finds that the more socially "connected" the members of a company's board are, the bigger the paychecks going to their CEOs.
Being "well connected" has long been an aspiration for most people, whether it is to help score tickets to the big game, get a kid into a top school, or give a boost to a career. As it turns out, even CEOs, who already are at the peak of power, have an interest in well-connectedness–perhaps even more than most, at least in terms of absolute dollars.
Recent research by Ilan Guedj and Amir Barnea of the McCombs School of Business at the University of Texas–Austin showed just that. Their paper, "But, Mom, All the Other Kids Have One! CEO Compensation and Director Networks," demonstrates that social networks of directors among the corporate elite affect CEO compensation.
"We find that firms that have more connected directors award their CEOs a higher compensation," says Guedj, an assistant professor of finance. "A CEO of a firm that is in the top quintile of connected firms receives a 10 percent higher salary and 13 percent in higher total compensation than a CEO of a firm that is in the bottom quintile of connected firms."
Guedj and Barnea collected data on all S&P 1,500 firms between the years 1996 and 2004, resulting in a sample of 25,621 unique directors. They then generated a map of directors and their ties to one another and assigned each firm a rank based on connectedness. With this information, Guedj and Barnea used regression analysis to look at the relationship between how well connected a firm is and the pay it awards its CEO.
In addition, the paper shows that well-connected directors are in return more likely to be awarded more directorships in the future. "These results highlight the instrumental role social networks have on the inner workings of boards and their influence on the governance of the firm," Guedj says.
In the paper, Guedj and Barnea also dispel alternative theories that would explain this higher compensation. The main one was that "good" CEOs get paid higher salaries (they are good, after all), and they also bring in connected board members (since they are good, too). But their research shows that when the connectedness of a board increases during a CEO's tenure, a salary increase will follow.
Because executive compensation is a hot-button issue these days, Guedj thinks this research can add to the discussion in two ways.
"First, it is now common to assume that the CEO controls the board and hence the board is not important," Guedj says. "However, we find that it is important, and understanding who sits on the board and what shapes their worldview can help understand and perhaps anticipate their decisions."
"Second," Guedj continues, "people like to look at connections between directors and the CEO and assume that if they are friends there could be a problem in the governance of the firm. Our paper highlights that this issue is more delicate. We conclude that even if the CEO and the board members don't know each other but belong to the same social circles, it can induce (unintentionally even) a more homogeneous worldview which may ultimately hinder the capability of the board to be critical and perform as thorough a governance as one would want."
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