The effect of firm performance on executive remuneration in the Netherlands

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BACHELOR’S THESIS

“The effect of firm performance on executive remuneration in the Netherlands.”

Maria Doncheva

Supervisor: Dr. Evgenia Zhivotova

Student number: 11104198

Programme: Economics and Business Track: Finance and Organization

ABSTRACT

This study examines the relation between firm performance and executive remuneration in Dutch listed companies, during the period 2013-2015. The research focuses on two Dutch indexes, namely the AEX and AMX. Previous literature concentrates on the relation between firm performance and executives’ pay in the United States. I implement this analysis for the Netherlands. I try to overcome the problem of endogeneity by performing a fixed effect regression and a TSLS regression. The data on executive remuneration is collected manually, which adds value to this study. I find previous year return on shareholder’s equity and previous year’s return on assets to have a positive effect on total compensation. There is statistical evidence that the stock return and EBIT have a positive effect on variable remuneration. CEO tenure, measured in years of experience of the CEO, has a positive effect on fixed compensation.

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Statement of Originality

This document is written by Student [Maria Doncheva] who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document are original and that no

sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision

of completion of the work, not for the contents.

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however, conflicts arise between the different stakeholders. These conflicts are also known as “agency problems”. In this thesis I will focus on the agency problem between managers and shareholders. This conflict arises when managers have different objectives than maximization of shareholder value. Shareholders provide the needed capital for the effective start of a business. They require sufficient return on these funds which will justify their investment. In addition, shareholders participate in the decision making process, and their interests should be protected by the management board. The board of executives is elected by the

shareholders to manage the company and act on their behalf. Moreover, the management board is directly responsible for governing the interests of shareholders. Very often the interests of the above mentioned parties are aligned – shareholders observe the performance of the company, by looking at the annual reports and executives are awarded remuneration plans based on their efficient way of managing the business.

Firm performance is very important in Corporate Finance. It is not only a way to send a signal to potential investors how profitable the company is, but it is a sign to existing shareholders how effectively the current executives are making use of the provided funds. Better performing companies attract new investors and capital, and stand out from

competitors. Executives’ responsibility is to strive for a better firm performance every year, to engage in profitable projects and to obtain a high return on the invested capital. In return, executives receive compensation packages which consist of a fixed salary, bonus, stocks and options, and many other benefits as well. The remuneration of executive directors has been greatly discussed in the existing academic literature. This topic is often present in the media as well. In his article, Richard Milne (2009) explains how shareholders in the Netherlands began exercising their right of a binding vote on executive pay. This means that investors can vote against an increase in a remuneration package if they feel certain target levels have not been met. The discussion was provoked by the fact that the large Dutch corporations Philips, Heineken and Royal Dutch Shell sought to increase the compensation packages which their

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managing directors received. It is clear that investors would like to participate in the decisions, regarding compensation. In addition, in a recent publication by Eshe Nelson (2018), it is revealed that the CEO of the largest Dutch bank is paid only a tenth when compared to his American counterparts. Following this, ING announces that it considers raising CEO Ralph Hamer’s pay by 50% this year. However, the public opinion is sensitive to such discussions, given the 2008 financial crisis, during which ING bank has received a ten million bailout. The Netherlands has rules about variable compensation – limiting it to around 20% of the fixed salary for banks and financial institutions (Nelson, 2018). Very often questions arise as to whether these big compensation plans are justifiable and whether there is a link between compensation and firm performance.

In my Bachelor’s Thesis I am examining the effect of firm performance on the compensation of executive directors. A more precise formulation of my research question is “How did firm performance affect the compensation of executives in the Netherlands in the period 2013-2015?” My sample of observations consists of 32 companies, part of two Dutch indexes, namely the AEX (index for large capitalization companies) and AMX (index for medium capitalization companies). 22 of the companies are part of the AEX index and the remaining 10 are listed on the AMX index. I will test the hypothesis H1: “There is a positive relation between firm performance and executive compensation.” Rejecting the null

hypothesis will mean that there is sufficient statistical evidence to conclude that firm performance has a positive effect on directors’ remuneration.

Existing literature focuses on the structure of compensation packages and the effect the different components of these packages have on the performance of companies. Other studies research the sensitivity of remuneration to new regulations. CEO gender and magnitude of pay is also a topic which is present among academic articles. Many scholars examine how the various firm performance measures affect executive compensation. The purpose of this thesis is to contribute to the current research on executive compensation and firm performance by implementing the analysis on the Dutch market.

This thesis has six chapters and they are as follows: Chapter one presents the

introduction and motivation of the chosen research question, Chapter two is literature review, which discusses the main findings and arguments of existing scholars, Chapter three provides information about the data and methodology of the research, Chapter four presents the

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empirical results, which will lead to answering the research question, Chapter five

concludes with discussion and Chapter six provides a detailed list of the references used in the thesis.

CHAPTER 2 Literature review

The remuneration of executives and its relation to company performance has been tested empirically in the existing academic literature. Various studies have been conducted, examining the existence of such relation both internationally and domestically. In an early article Kevin Murphy (1985) discusses whether the performance of manufacturing firms in the U.S has an effect of managerial pay over time. He argues that previous research suggests sales growth has the greatest impact on executive compensation and performance measures, such as return on equity and profits do not play a significant role. However, these studies have focused on the most visible part of the remuneration package, namely salary and bonus. Murphy (1985) emphasizes the importance of stock-options, stock awards and deferred compensation, since individual components of compensation may have a significant effect on company performance. Deferred compensation is defined as the sum of restricted shares of common stock and different types of contingent remuneration. Murphy’s research concludes that there is significant statistical evidence that return on shareholder’s equity and sales are positively and strongly related to firm performance during the period 1964-1981. This

conclusion adds value to previous research which finds no such relation. In addition, Murphy (1985) explains that managerial pay will partly depend on past year’s performance, but current year’s as well.

Hamid Mehran (1995) focuses his research on the structure of CEO compensation and discusses its relation to board and firms’ ownership structure. He argues that the nature of compensation drives managers’ incentive to increase firm value, as opposed to the level of pay. Mehran (1995) suggests that the main difference between shareholders and managers is risk-aversion – shareholders are risk-neutral, since they can diversify risk by investing in different stocks. Managers, on the other hand, are risk-averse and they prefer a compensation

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structure which will minimize the personal risk they are bearing. Consequently, managers should prefer fixed cash compensation rather than equity payment, because the latter is directly connected to the firm’s stock performance and it is not in the control of the manager. Angie Low (2009) suggests that executive directors might turn down positive NPV projects if the cost of risk to them is greater than the benefits from the project. The author examines the effect of equity-based compensation on risk-taking behaviour of CEOs and finds that an increase in the volatility of stock options can encourage managerial risk-taking. Managers’ investment in effort, and the amount of effort exerted is also connected to the stock

performance. Mehran (1995) argues that in order for executives to decrease their compensation risk, they will engage in activities which in turn also reduce firm risk. Connecting compensation to firm performance is presented as a way of approaching this conflict of risk.

An important part of the awarded compensation packages is stock and option based pay. CEO remuneration is linked to stock prices in order to align the interests of the

management board and shareholders. In their article, Bergstresser and Philippon (2006) present evidence that at firms, where the CEO’s total compensation is closely tight to stock-based and option-stock-based pay, accruals (components of earnings that are not reflected in current year cash flows) are used to manipulate reported earnings, based on a sample of US companies during the 1990s.The authors define accruals as the difference between earnings and cash flows from operations. One implication of earnings management is the use of accruals to temporarily increase or reduce reported net income. In addition, executive incentive measures the dollar change of a CEO’s stock and option holdings, coming from a percentage point increase in the firm’s stock price. The authors find that highly incentivized CEOs are more likely to manipulate reported performance measures, ceteris paribus.

Furthermore, they appear to be converting their equity into cash when reported earnings are artificially high.

Another aspect of corporate governance is discussed by Kang et all. (2006). In their article, the authors examine the connection between executive compensation and firm investment in the U.S. Furthermore, they emphasize on the concept of agency conflicts which influences investment decisions, because they depend on costly managerial effort. This study is driven by the idea that powerful executives could engage in empire building (engage in projects with negative NPV) as that increases the size and power of a company, and this does not align with shareholders’ interests. Baker and Hall (2004) discuss the sensitivity of CEO

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compensation to firm size. They find that CEO wealth increases dramatically with firm size. The main goal of Kang et al. (2006) is to design an optimal contract for investment decisions which takes into account shareholders’ preferences as well. The most significant finding of their research is that long-term investment spending is strongly and positively related to the compensation structure of CEOs for the period 1992-2000. In addition, since larger firms are harder to monitor, equity-based compensation tends to be higher in such firms and plays the role of a substitute of monitoring. Equity-based remuneration can also be higher due to

liquidity constraints. Less liquid firms have a higher proportion of equity pay, in order to save internal funds for other purposes. In addition, Kang et al. (2006) argue that the proportion of stocks, owned by a CEO, is negatively related to the equity-based pay rewarded, as a way of reducing non-diversifiable risk for the CEO. This conclusion is supported by Mehran (1995) who also finds an inverse relation between stockownership and equity compensation in CEOs remuneration packages, based on his research for U.S manufacturing firms for the period 1973-1983.

In his study, Matthew Lilling (2006) addresses the problem of simultaneity. He mentions that CEO compensation and firm performance are jointly determined, therefore endogenous. To solve this problem, he uses a Generalized Method of Moments regression, in order to account for unobserved firm-specific effects. Lilling finds a positive relation

between the market value of a firm and the realized stock return with CEO remuneration. He also states that CEO compensation is linked stronger to current year’s firm performance, as opposed to past year’s performance.

Many academic studies focus on the relation between the gender of executives and firm performance. Khan and Vieito (2013) evaluate this relation and examine how gender affects the risk level of a firm. Moreover, the authors research whether compensation components, awarded to female directors, are less risky than those awarded to their male counterparts, pointing out that women are more risk-averse than men. They find that firms, managed by female CEOs, are associated with better performance, based on a study of US firms during 1992-2004. In addition, the authors argue that ROA increases more if the CEO is female, ceteris paribus. During the period 1992-2004 the proportion of fixed compensation to total remuneration decreases by 10,9% and stock options increase by 7,9%. After 2000, Khan and Vieito (2013) observe that female CEOs are awarded higher proportion of stock

options when compared to male CEOs.

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Gan and Park (2016) complement this finding by arguing that better performing managers are awarded a steeper pay-to-performance sensitivity in their equity based compensation. The authors measure managerial ability by using CEO tenure, media mentions, past abnormal returns and ability to generate revenue, as proxies.

CHAPTER 3

Data and methodology

The Data, Variables and Hypotheses

The data for firm performance measures and characteristics were obtained from AMADEUS, part of the University of Amsterdam database and it is a panel data for the period 2013-2015. The remuneration data is unique, because it was collected by hand from the annual reports of the selected companies. The data can be found in Tables 12, 13 and 14 in the Appendix. Since these companies are public, they are required by law to present in detail all information for the compensation packages of the board of directors. Nevertheless, this was a very laborious task which required a significant amount of time and effort. The sample of companies includes 32 public Dutch companies listed on the Amsterdam Stock Exchange. 22 of the firms are part of the AEX index for large capitalization firms and the remaining 10 are part of the AMX index for medium capitalization firms. All variables include 96 observations, with variable compensation being the only exception. The reason for this is that 7 of the observations do not contain short-term or long-term bonuses, but they compensate with a higher fixed salary and other benefits.

Descriptive statistics for this research are presented in Table 1. Total Compensation, Variable Compensation, Fixed Compensation, EBIT and Sales were transformed into a logarithmic form for better interpretation and residuals which have a more symmetrical distribution. Total executive compensation is the dependent variable and it is divided between fixed compensation, which consists of a fixed salary and variable compensation, which encompasses short and long-term incentive. I perform regressions with each one of the three as dependent variable. The mean for total executive compensation is 15.1 (€4,120,413).

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Details on CEO compensation can be found in Table 14 in the Appendix. One of the explanatory variables is “EBIT” with a mean of 22.6. As control variables I use total sales, D/E ratio, Board size and CEO tenure, which are also listed in Table 1. Table 2 presents the correlation matrix.

In the existing academic literature, a lot of different performance measures are used to determine the sensitivity of executive pay and company performance. Murphy (1985) uses stock market return of common equity as a firm performance measure. In this study I will incorporate both market return on equity and accounting rate of return on equity. Moreover, I use current ratio - liquidity ratio which indicates the ability of a company to meet its current obligations, EBIT - a financial ratio that captures the amount of profit that can be achieved by the current operations and assets of a company, and return on assets - ratio that shows the profitability of a company relative to its total assets, to measure company performance. In addition, my sample consists of companies with different size, namely medium and large capitalization. Executive directors of bigger firms may receive bigger rewards, and a control variable for size is needed – in this research I will use Sales. CEO experience is also included as a control variable – CEO tenure, as more experienced directors could earn more that their less experienced colleagues. Following the study of Palia (2001), I also include the debt to equity ratio and executive board size as control variables.

It can be argued, based on intuition, that better performing companies will reward their directors with higher pay, in order to incentivize them to continue exerting effort. The

purpose of this thesis is to test whether there is a link between firm performance and

executive compensation. In his study on executive compensation, Matthew Lilling suggests there is a positive relation between firm performance and CEO pay, for North American public companies during 1993-2003 (2006). I will test if this relation is positive for Dutch public companies with Hypothesis #1:

Hypothesis #1: There is a positive relation between firm performance and executive compensation.

The Model and Methodology

One of the main issues in determining the relation between firm performance and executive remuneration is the presence of endogeneity. This issue comes from the fact that firm performance and executive remuneration are determined simultaneously.

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TABLE 1 Descriptive statistics

Statistics Standard

Variable Obs. Mean deviation Min. Max.

Total Comp* 96 15.1 0.8 12.3 16.5

Variable Comp* 89 13.8 1.1 11.1 16.2

Fixed Comp* 96 14.2 0.7 11.7 15.2

CEO tenure (years) 96 5.1 0.6 4 6.4

D/E ratio (%) 96 53.3 18.7 6.2 89.1 Board size 96 6.2 2.35 2 13 Sales* 96 21.3 2.6 14.1 26.8 EBIT* 96 22.6 0.4 18.4 24.1 Return on assets (%) 96 4.3 7.1 -35.9 16.8 Return on equity (%) 96 11.3 17.9 -62.8 60.2 Stock return (%) 96 11.9 28.3 -74.6 126.4 Current ratio (%) 96 1.4 0.7 0.1 3.8

Executive Compensation data for a sample of Dutch public companies during (2013-2015) obtained manually. Firm Characteritics for a sample of Dutch public companies during (2013-2015) obtained from AMADEUS. 1) * natural logaritms of variables

TABLE 2 Correlations

Total Variable Fixed CEO D/E ratio Board Lagged Lagged Stock Current

Sales* EBIT* Return on Return on return

Comp* Comp* Comp* tenure (%) size ratio (%)

assets (%) equity (%) (%) Total Comp* 1.000 Variable Comp* 0.749 1.000 Fixed Comp* 0.554 0.665 1.000 CEO tenure 0.040 0.181 0.051 1.000 Sales* 0.289 0.581 0.727 0.137 1.000 EBIT* -0.075 0.390 0.704 -0.153 0.049 1.000 D/E ratio (%) 0.093 -0.160 0.030 0.092 0.009 -0.026 1.000 Board size 0.291 0.370 0.382 -0.481 0.335 0.145 -0.018 1.000

Lagged Return on assets (%) 0.066 0.286 0.162 -0.150 0.080 0.142 -0.072 0.290 1.000

Lagged Return on equity (%) -0.041 0.166 0.121 -0.223 -0.013 0.162 -0.049 0.330 0.810 1.000

Stock return (%) 0.140 0.151 0.312 -0.073 0.153 0.071 0.123 -0.031 -0.300 -0.213 1.000

Current ratio (%) 0.079 0.105 0.254 -0.091 -0.062 -0.265 -0.141 0.121 -0.111 -0.093 0.014 1.000

Executive Compensation data for a sample of Dutch public companies during (2013-2015) obtained manually. Firm Characteritics for a sample of Dutch public companies during (2013-2015) obtained from AMADEUS.

1) * natural logaritms of variables

Stock and Watson (2011) define this problem as simultaneous causality – causality runs from the regressors to the dependent variable and vice versa. This is a threat to the internal validity of the regression and makes the OLS estimator biased and inconsistent. Shin-

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Ping and Chen (2011) point out that firm performance can be taken as a determinant of executive remuneration. Moreover, director’s abilities are reflected in the realized firm performance and to create firm value CEOs engage in the most beneficial investment plans which in turn enhances their compensation. According to the authors, a solution to mitigate this problem is to use instrumental variable regression. For an instrumental variable to be valid it needs to conform to two requirements: the instrumental variable has to be correlated with the independent variable, but uncorrelated with dependent variable. Darius Palia (2001) performs fixed effect regression, which takes away some of the variation and acts as a solution to endogeneity. In addition, he includes CEO experience and quality (defined as the prestige of the school the CEO attended, leadership traits and social networks that the prestigious schools provide) as instrumental variables in his model.

I will estimate 15 regressions in total – 5 regressions using total compensation as the dependent variable, 5 regressions using fixed compensation as the dependent variable and 5 regressions using variable compensation as the dependent variable. To avoid possible multicollinearity in the regression models I will use one performance measure per

regression, controlling for firm size and CEO experience, because the performance measures may be correlated with each other and this would bias the model. In this study fixed effect regression will be estimated, to account for possible simultaneous causality. Moreover, Lilling (2006) argues that directors’ compensation depends on past year’s firm performance as well. Therefore, I will include a lag on return on assets and return on equity.

For robustness check I will control for firm size by using total assets, to check if my results still hold.

CHAPTER 4 Empirical results

The empirical results chapter will be divided in three parts. First, I will discuss the regression models with total compensation as the dependent variable. Second, the

regression results with variable compensation will be presented and lastly, the regressions with fixed compensation as the dependent variable.

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Following the analysis of Palia (2001) I collected data for the instrumental variable the author uses in his study, namely CEO tenure. This variable is used as an instrument in several other studies, as well. Shin-Ping and Hui-Lu (2011) argue that CEO tenure has a significant negative effect on firm performance, since CEOs may become more conservative as tenure increases. According to the authors, this suggests that CEOs with longer tenure could lose their opportunity for profit. My idea was to incorporate this variable as an instrument in my research as well. However, after the first step of the Two Stage Least Squares estimation the F-statistic was well below 10, which according to Stock and Watson (2011) is an indication for a weak instrument, which is prone to give invalid results.

Performing an instrumental variable regression could help with the problem of endogeneity between firm performance and executive compensation. Nevertheless, tables 6,7 and 8 present TSLS regression results. In addition, fixed effect regression is also a solution to the above mentioned problem, and Focke, Maug and Niessen-Ruenzi (2016) mention that employing a fixed effect method allows to control for unobserved heterogeneity.

Total Compensation

I estimate the following regressions:

ln(TotalComp)t = β0 + β1*ln(EBIT) + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

β5*Boardsize + ε (1)

ln(TotalComp)t = β0 + β1*ROEt-1 + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio + β5*Boardsize + ε.

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ln(TotalComp)t = β0 + β1* ROAt-1 + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

β5*Boardsize + ε. (3)

ln(TotalComp)t = β0 + β1*CurrentRatio + β2*ln(Sales) + β3*CEOtenure β4*D/E ratio +

ln(TotalComp)t = β0 + β1*Stockreturn + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

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Regression (1) shows a significant relation between EBIT and Total Executive

Compensation (EBIT is significant at 10%). The coefficient is negative, which shows a negative relation between this firm performance measure and the remuneration of executives for the period 2013-2015. Furthermore, this suggests that 1% increase in EBIT leads to an expected 0,03% decrease in total executive compensation, ceteris paribus.

In regression (2) I estimate the effect of previous year return on equity on current year’s total compensation, as the existing literature suggests that better performing managers are paid more. I find a positive relation between return on shareholder’s equity, measured as Net Income/Shareholder’s Equity, and total compensation. The result suggests that if ROE_t-1 increases by 1%, total executive remuneration is expected to increase by 2,9%, ceteris

paribus. This confirms Murphy’s (1985) argument that the compensation of directors depends on past year’s firm performance. Contrary to his analysis, current year’s ROE is not

significant, based on Dutch public companies in the period 2013-2015. The coefficient of ln(Sales) is insignificant and Focke et. al. (2016) point out that insignificance of the control variables could be due to little time series variation in these variables, because of the included fixed effects. In addition, past year’s return on assets appears to be significant for total

executive compensation which supports existing literature results. Based on the above

regression results, there is enough statistical evidence to conclude that EBIT, past year’s ROE and past year’s ROA have an effect of total executive compensation. As for the one-sided hypothesis, there is a positive relation between past year’s ROE and ROA, and total compensation.

Variable compensation

ln(VarComp)t = β0 + β1*ln(EBIT) + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

ln(VarComp)t = β0 + β1*ROEt-1 + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

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ln(VarComp)t = β0 + β1* ROAt-1 + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

ln(VarComp)t = β0 + β1*CurrentRatio + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

ln(VarComp)t = β0 + β1*Stockreturn + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

Regression results are presented in Table 4.

Variable compensation is an important component of executives’ remuneration packages. It is often divided between short-term and long-term incentive and it is considered to be linked with firm performance as a way to incentivize managers to perform better every year. From regression (1) I find EBIT to be significant and a 1% increase in this variable leads to an expected 0,06% increase in executive remuneration, holding everything else constant.

Contrary to the analysis of Mcknight and Tomkins (2004), CEO tenure was found to have an insignificant effect on variable compensation of executives of Dutch listed companies. In their study, based on UK organizations, CEO tenure had a negative relation with CEO bonus pay. The significance of the variable Stock return confirms Murphy’s (1985) finding that the bonus of top executives is affected by stock performance. The null hypothesis of Hypothesis #1 can be rejected for regressions (1) and (5). There is enough statistical evidence to conclude that EBIT and Stock return have a positive effect on variable compensation (regression (1) has a p-value of 0,023 for a one-sided test and regression (5) has a p-value of 0,045 for a one-sided test).

Fixed Compensation

ln(FixedComp)t = β0 + β1*ln(EBIT) + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

ln(FixedComp)t = β0 + β1*ROEt-1 + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

ln(FixedComp)t = β0 + β1* ROAt-1 + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

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TABLE 3

Total compensation regression results

(1) (2) (3) (4) (5) Explanatory variables ln Sales -0.079 (0.049) -0.082 (0.052) -0.080 (0.044)* -0.078 (0.057) -0.079 (0.058) ROAt-1 0.012 (0.006)* ROEt-1 0.029 (0.017)* Current ratio -0.001 (0.060) Stock return 0.001 (0.001) CEO tenure 0.112 (0.074) 0.110 (0.076) 0.091 (0.073) 0.108 (0.071) 0.108 (0.068) ln EBIT -0.030 (0.018)* D/E ratio 0.125 (0.040)*** 0.121 (0.042)*** 0.118 (0.041)* 0.125 (0.041)*** 0.125 (0.041)*** Board size 0.030 (0.017)* 0.034 (0.016)* 0.027 (0.016)* 0.035 (0.019)* 0.034 (0.017)* 14.372 (1.185)*** 14.066 (1.361)*** 14.020 (1.272)*** 13.891 (1.372)*** 13.922 (1.557)*** Constant N 96 95 95 96 96 R2 15.02 14.03 18.75 14.90 14.91 Total com pensati on

Firm Fixed Effects Yes Yes Yes Yes Yes

Industry Fixed Effects Yes Yes Yes Yes Yes

1) Standard errors are in parentheses.

2) * significant at 10%; ** significant at 5%; ***significant at 1%.

ln(FixedComp)t = β0 + β1*CurrentRatio t-1 + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

β5*Boardsize +ε. (4)

ln(FixedComp)t = β0 + β1*Stockreturn + β2*ln(Sales) + β3*CEOtenure + β4*D/E ratio +

Regression results are presented in Table 5.

An interesting finding comes from regression (4) where the previous year Current ratio is found to be significant. This ratio represents the ability of a firm to meet its current

obligations. This ability can signal a good management strategy and therefore it is reasonable to think that good managers will be rewarded to reflect this. CEO tenure is statistically significant in regressions (2), (4) and (5), representing a positive effect on fixed

compensation. EBIT is also found to have an effect on fixed compensation. The negative coefficient, however, suggests than an increase in EBIT leads to an expected decrease in fixed

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compensation. Past year’s ROA has a positive effect on fixed compensation (the p-value for regression (3) is 0,01 for a one-sided test).

Robustness check

To check if the empirical results still hold, I will estimate size using total assets, as a replacement for total sales. Regression results can be found in Tables 9,10 and 11 in the Appendix. All of above the regressions have been re-estimated using total assets as a control variable.

TABLE 4

Variable compensation regression results

(1) (2) (3) (4) (5) Explanatory variables ln Sales -0.011(0.075) 0.002 (0.093) -0.041 (0.075) 0.012 (0.088) -0.163 (0.179) ROA t-1 -0.012 (0.014) ROEt-1 -0.006 (0.007) Current ratio -0.065 (0.138) Stock return 0.053 (0.031)* CEO tenure 0.163 (0.147) 0.166 (0.136) 0.135 (0.140) 0.150 (0.143) 0.199 (0.150) ln EBIT 0.061 (0.030)** D/E ratio -0.093 (0.389) -0.102 (0.382) -0.265 (0.385) -0.215 (0.347) 0.104 (0.336) Board size 0.034 (0.027) 0.029 (0.022) 0.023 (0.026) 0.035 (0.027) 0.041 (0.026) Constant 11.683 (2.979)*** 13.578 (2.893)*** 14.855 (2.435)*** 13.164 (2.675)*** 13.356 (2.187)*** N 89 88 88 89 89 R2 13.56 13.75 12.72 13.67 16.85

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TABLE 5

Fixed compensation regression results

(1) (2) (3) (4) (5) Explanatory variables ln Sales -0.137 (0.080)* -0.133 (0.076)* -0.131 (0.062)** -0.117 (0.083) -0.096 (0.089) ROAt-1 0.013 (0.005)** ROEt-1 0.0008 (0.003) Current ratiot-1 0.094 (0.036)*** Stock return -0.001 (0.0007) CEO tenure 0.137 (0.078)* 0.127 (0.077) 0.142 (0.072)* 0.128 (0.069)* ln EBIT -0.035 (0.020)* D/E ratio -0.023 (0.212) -0.030 (0.216) -0.265 (0.385) -0.215 (0.346) 0.104 (0.336) Board size -0.022 (0.018) 0.030 (0.022) 0.023 (0.026) 0.035 (0.027) 0.041 (0.025) Constant 15.746 (2.926)*** 17.309 (1.766)*** 17.243 (1.589)*** 16.891 (1.852)*** 16.621 (2.004)*** N 96 95 95 95 96 R2 _15.77 _16.03 _22.23 _21.38 _20.63

TABLE 6

Total compensation TSLS regression results

(1) (2) (3) Explanatory variables ROA 0.074 (0.040)* m ROE 0.029 (0.016)* Stock return 0.082 (0.139) Constant 14.730 (0.221)*** 14.744 (0 .206)*** 14.085 (1.715)*** N 96 96 96

2) * significant at 10%; ** significant at 5%; ***significant at 1%. 3) Instruments: CEO tenure

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TABLE 7

Variable compensation TSLS regression results

(1) (2) (3) Explanatory variables ROA 0.139 (0.070)** c o m p e n s a t i o n ROE 0 .057 ( 0.030)* Stock return 0.184 (0.376) Constant 13.157 ( 0.432)** 13.207 ( 0.380)*** 11.583 ( 0.288)*** N 89 89 89 1) Standard errors are in parentheses.

TABLE 8

Fixed compensation TSLS regression results

(1) (2) (3) Explanatory variables ROA 0.093 (0.046)** ROE 0.037 (0.021)* Stock return 0.104 (0.153) Constant 13.815 (0.288)*** 13.832 (0.247)*** 13.002 (1.860)*** N 96 96 96

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CHAPTER 5

Conclusion and discussion

In my Bachelor’s Thesis I investigate the effect of firm performance on directors’ compensation in the Netherlands. Prior studies suggest (e.g., Khan & Vieito, 2013; Lilling, 2006; Palia, 2001) there is a link between company performance and compensation. Executives need to have an incentive to exert effort and perform better every year.

Consequently, the awarded compensation package reflects this incentive. Khan and Vieito (2013) observe that the proportion of variable compensation to total compensation increases during the period 1992-2004, while fixed compensation decreases. Other studies (e.g., Kang et al., 2006; Mehran, 1995) suggest that equity-based compensation may depend on the monitoring level in a company (bigger firms may be harder to monitor and equity

compensation acts as a substitute for monitoring) and liquidity constraints. Current literature focuses the analysis of executive compensation on the U.S. market. Remuneration in the Netherlands is not significantly present in existing academic sources. Therefore, this thesis adds value to current literature by implementing the relation between company performance and directors’ pay on the Dutch market.

I hypothesize there is a positive relation between firm performance and executive remuneration. In addition, I examine whether variable and fixed compensation are affected by performance. I employ several performance measures to test this hypothesis, namely EBIT, ROE, ROA, Current ratio and stock return. Based on previous research, I include a lag on ROE and ROA to reflect the fact that executive remuneration depends on past year’s performance as well.

Using a unique, manually collected data of the compensation packages of 32

companies, listed on the Amsterdam Stock Exchange, I find performance to have an effect on executive compensation, both variable and fixed. Previous year return on shareholder’s equity has a positive relation with total compensation, whereas the stock return and EBIT have a positive relation with variable compensation. In addition, I find previous year’s return on assets to have a positive effect on total compensation, during the period 2013-2015.

One of the issues I encountered while conducting this research is the presence of endogeneity between firm performance and executive compensation. This issue

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arises, because these variables are determined simultaneously. I try to overcome this problem by performing a TSLS regression, which according to Stock and Watson (2011) produces a more reliable result, as opposed to an OLS regression. However, the employed instrument for the TSLS regression can be considered as weak and the empirical results should be

interpreted with caution. Some academics point out that a fixed effect regression is also a way to approach the endogeneity problem. Therefore, I include fixed firm and industry effects, in order to take away some of the variation in my models. The time period of this research is relatively short when compared to other studies. The obtained results may be different and more significant if the analysis is made for a longer period. Executive compensation plays an important role in Corporate governance. Even though it is a topic that is greatly discussed in the existing academic literature, further research in the relation between firm performance and executive remuneration is needed.

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CHAPTER 6

Bibliography

Baker, G. P., & Hall, B. J. (2004). CEO Incentives and Firm Size. Journal of

Labor Economics, 22, 767-798.

Bergstresser, D., & Philippon, T. (2006). CEO incentives and earnings management.

Journal of Financial Economics, 80(3), 511-529.

Focke, F., Maug, E., & Niessen-Ruenzi, A. (2016). The impact of firm prestige on executive compensation. Journal of Financial Economics (123), 313-336. doi:http://dx.doi.org/10.1016/j.jfineco.2016.09.011

Gan, H., & Park, M. S. (2016). Are more able CEOs getting more compensated? Evidence from the pay-for-performance sensitivity of equity-based incentives.

Advances in Accounting, incorporating Advances in International q1(34), 64-76.

Kang, S.‐H., Praveen, K., & Lee, H. (2006). Agency and Corporate Investment: The Role of Executive Compensation and Corporate Governance. The Journal of Business,

79(3), 1127-1147. Retrieved from http://www.jstor.org/stable/10.1086/500671

Khan, W. A., & Vieito, J. P. (2013). Ceo gender and firm performance. Journal of

Economics and Business, 67, 55-66.

Lilling, M. S. (2006). The Link Between CEO Compensation and Firm Performance: Does Simultaneity Matter? Atlantic Economic Journal, 34, 101-114. doi:10.1007/s11293-006-6132-8

Low, A. (2009). Managerial risk-taking behaviour and equity-based compensation. Journal

of Financial Economics (92), 470-490.

Mcknight, P., & Tomkins, C. (2004). The Implications of Firm and Individual Characteristics on CEO Pay. European Management Journal, 22, 27-40. doi:10.1016/j.emj.2003.11.013

Mehran, H. (1995). Executive compensation structure, ownership, and firm performance.

Journal of Financial Economics, 163-184.

Milne, R. (2009, August 31). Dutch pioneers blaze trail on executive pay. Retrieved from Financial Times: https://www.google.com/amp/s/amp.ft.com/content/c75416a6-9647-11de-84d1-00144feabdc0

Murphy, K. (1985). CORPORATE PERFOMANCE AND MANAGERIAL REMUNERATION . Journal of Accounting and Economics, VII, 11-42.

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Nelson, E. (2018, March 13). The CEO of the biggest Dutch bank is paid a tenth of his

American counterparts, and it's a national scandal. Retrieved from Quartz Media

LLC: https://qz.com/1227973/ing-ceo-ralph-hamers-is-paid-a-tenth-of-his-american-counterparts-but-its-a-dutch-national-scandal/

Palia, D. (2001). The Endogeneity of Managerial Compensation in Firm Valuation: A Solution. The Review of Financial Studies, 14, 735-764.

Shin-Ping, L., & Chen, H.-L. (2011). Corporate governance and firm value as determinants of CEO compensation in Taiwan:2SLS for panel data model. Management Research

Review, 34(3), 252-265.

Stock, J. H., & Watson, M. W. (2011). Introduction to Econometrics Third Edition. Boston: Pearson Education Inc.

APPENDIX

TABLE 9

Total compensation regression results

(1) (2) (3) (4) (5) Explanatory variables ln Total Assets 0.046 (0.321) 0.150 (0.310) -0.080 (0.044)* 0.091 (0.364) 0.081 (0.372) ROAt-1 0.006 (0.003)* ROE t-1 0.032 (0.019)* Current ratio -0.002 (0.058) Stock return 0.001 (0.001) CEO tenure 0.115 (0.071) 0.112 (0.077) 0.108 (0.072) 0.106 (0.077) 0.106 (0.074) ln EBIT -0.022 (0.013)* D/E ratio 0.001 (0.004) -0.001 (0.003) 0.001 (0.004) 0.002 (0.004) 0.001 (0.004) Board size 0.028 (0.018) 0.027 (0.016)* 0.025 (0.016) 0.028 (0.017) 0.028 (0.017) Constant 12.006 (2.567)*** 12.082 (2.105)*** 11.760 (2.208)*** 11.694 (2.301)*** 11.693 (2.300)*** N 96 95 95 96 96 R2 14.05 16.99 15.39 14.47 12.91

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TABLE 10

Variable compensation regression results

(1) (2) (3) (4) (5) Explanatory variables ln Total Assets - 0.266 (0.461) -0.019 (0.371) -0.163 (0.473) -0.317 (0.514) -0.166 (0.570) ROAt-1 -0.013 (0.010) ROEt-1 0.008 (0.004)** Current ratio -0.097 (0.147) Stock return 0.005 (0.003)* CEO tenure 0.165 (0.148) 0.183 (0.145) 0.156 (0.152) 0.149 (0.144) 0.186 (0.140) ln EBIT 0.095 (0.045)** D/E ratio 0.003 (0.005) -0.003 (0.005) 0.001 (0.004) 0.002 (0.006) 0.005 (0.003) Board size 0.039 (0.029) 0.041 (0.029) 0.034 (0.028) 0.039 (0.028) 0.037 (0.029) Constant 16.645 (3.790)*** 16.097 (2.726)*** 14.689 (3.582)*** 15.448 (3.780)*** 13.145 (4.566)*** N 89 88 88 89 89 R2 14.23 18.16 13.54 14.35 19.75

TABLE 11

Fixed compensation regression results

(1) (2) (3) (4) (5) Explanatory variables ln Total Assets 0.266 (0.238) 0.318 (0.228) 0.319 (0.239) 0.229 (0.194) 0.238 (0.214) ROAt-1 -0.006 (0.006) ROEt-1 0.002 (0.001)* Current ratiot-1 0.092 (0.029)*** Stock return 0.001 (0.0001)** CEO tenure 0.140 (0.077)* 0.142 (0.075)* 0.153 (0.079)* 0.138 (0.074)* 0.124 (0.071)* ln EBIT -0.028 (0.015)* D/E ratio -0.002 (0.003) -0.003 (0.002) -0.003 (0.003) -0.001 (0.003) -0.002 (0.003) Board size 0.015 (0.017) 0.016 (0.018) 0.015 (0.018) 0.014 (0.019) 0.016 (0.017) Constant 13.340 (1.770)*** 13.083 (1.678)*** 12.870 (1.650)*** 13.051 (1.358)*** 13.174 (1.551)*** N 96 95 95 95 96 R2 16.15 17.60 18.47 21.28 18.96

Variable compens at ion F ixed comp ens at ion

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Table 12

Firm Industry

Aalbert Industries

industrial goods and services

ABN AMRO banks

Aegon food retailers and wholesalers Ahold Delhaize insurance

Akzo Nobel chemical goods Altice industrial machinery

AMG iron and steel

Aperam business support services

Arcadis semiconductors

ArcelorMittal technology services

ASM telecommunication services ASML construction services BAM Group construction and materials

Boskalis business training and employment agencies Brunel International chemicals

DSM retail REITs

Eurocommercial Properties technology

Gemalto food and beverage Heijmans heavy construction Heineken telecommunications

KPN basic resources

NN Group investments

Philips industrial consumer goods and services Randstad Holding HR services

RELX Group oil and gas industry Royal Dutch Shell media

SBM Offshore oil and gas

Unilever personal and household goods VastNed Retail retailREITs

Vopak cardboard supplies

Wereldhave industrial and office REITs Wolters Kluwer publishing

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TABLE 13

TOTAL EXECUTIVE COMPENSATION 2013-2015

2013 2014 2015

Firm Fixed Variable Fixed Variable Fixed Variable

Compensation Compensation Compensation Compensation Compensation Compensation

Aalbert Industries € 1,538,000.00 € 1,015,200.00 € 1,803,000.00 € 1,028,000.00 € 1,510,000.00 € 1,233,000.00 ABN AMRO € 3,476,460.00 € - € 3,525,600.00 € - € 3,847,200.00 € - Aegon € 2,304,026.00 € - € 3,156,386.00 € - € 3,472,689.00 € - Ahold Delhaize € 2,777,500.00 € 2,471,975.00 € 2,847,000.00 € 2,277,600.00 € 2,423,000.00 € 3,270,000.00 Akzo Nobel € 1,837,400.00 € 939,000.00 € 1,318,800.00 € 1,197,100.00 € 1,480,000.00 € 1,321,200.00 Altice € 1,700,000.00 € 1,250,000.00 € 1,100,000.00 € 1,700,000.00 € 840,000.00 € 1,500,000.00 AMG € 2,374,000.00 € 1,542,000.00 € 2,215,000.00 € 2,704,000.00 € 2,139,000.00 € 2,019,000.00 Aperam € 2,910,000.00 € 470,000.00 € 1,692,037.00 € 207,611.10 € 1,599,000.00 € 179,700.00 Arcadis € 980,000.00 € 588,000.00 € 1,038,300.00 € 778,725.00 € 1,080,000.00 € 248,400.00 ArcelorMittal € 1,760,000.00 € 530,000.00 € 1,852,000.00 € 1,916,000.00 € 1,746,000.00 € 1,910,000.00 ASM € 895,000.00 € 918,000.00 € 905,988.00 € 1,064,844.00 € 969,582.00 € 971,070.00 ASML € 2,333,000.00 € 6,542,002.00 € 3,708,000.00 € 10,400,393.00 € 3,783,000.00 € 10,486,411.00 BAM Group € 1,602,000.00 € 145,000.00 € 1,823,000.00 € 58,000.00 € 2,030,000.00 € 653,000.00 Boskalis € 2,244,000.00 € 2,479,000.00 € 2,357,000.00 € 2,969,000.00 € 2,441,000.00 € 3,884,000.00 Brunel International € 886,000.00 € 551,000.00 € 1,067,000.00 € 381,000.00 € 1,160,000.00 € 270,000.00 DSM € 3,655,000.00 € 1,809,257.00 € 3,720,000.00 € 1,120,478.00 € 2,580,000.00 € 1,384,891.00 Eurocommercial Properties € 1,031,000.00 € 596,000.00 € 1,092,000.00 € 617,000.00 € 1,124,000.00 € 1,058,000.00 Gemalto € 800,000.00 € 1,027,669.00 € 714,687.00 € 850,000.00 € 850,000.00 € 697,000.00 Heijmans € 1,285,086.00 € 192,763.00 € 1,285,086.00 € 205,613.76 € 1,285,086.00 € 257,017.00 Heineken € 1,800,000.00 € 4,621,000.00 € 1,920,000.00 € 4,800,000.00 € 1,772,384.00 € 4,156,983.00 KPN € 1,929,000.00 € 405,000.00 € 1,608,000.00 € 780,000.00 € 2,633,000.00 € 2,516,000.00 NN Group € 3,309,000.00 € - € 1,550,000.00 € 1,550,000.00 € 1,180,000.00 € 214,000.00 Philips € 2,375,000.00 € 2,140,978.00 € 2,493,700.00 € 764,380.00 € 1,864,801.00 € 1,163,969.00 Randstad Holding € 3,889,000.00 € 2,916,000.00 € 3,625,000.00 € 2,488,000.00 € 3,647,000.00 € 3,261,000.00 RELX Group € 1,677,000.00 € 1,743,000.00 € 1,321,000.00 € 1,855,000.00 € 1,797,000.00 € 1,889,000.00 Royal Dutch Shell € 4,097,000.00 € 8,790,000.00 € 1,435,000.00 € 4,163,000.00 € 2,460,000.00 € 4,059,000.00 SBM Offshore € 1,822,000.00 € 1,340,000.00 € 1,883,000.00 € 3,224,000.00 € 2,362,000.00 € 3,778,000.00 Unilever € 2,030,000.00 € 2,743,000.00 € 2,136,000.00 € 2,430,000.00 € 2,130,000.00 € 3,385,000.00 VastNed Retail € 675,000.00 € 175,500.00 € 620,000.00 € 228,000.00 € 685,000.00 € 235,560.00 Vopak € 1,565,000.00 € 306,000.00 € 1,597,000.00 € 972,000.00 € 1,640,000.00 € 1,117,000.00 Wereldhave € 722,242.00 € 417,731.00 € 1,058,918.00 € 330,784.00 € 890,000.00 € 311,500.00 Wolters Kluwer € 1,394,000.00 € 1,520,000.00 € 1,394,000.00 € 1,397,000.00 € 1,396,000.00 € 1,423,000.00

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TABLE 14

TOTAL CEO COMPENSATION 2013-2015

2013 2014 2015

Firm Fixed Variable Fixed Variable Fixed Variable

Compensation Compensation Compensation Compensation Compensation Compensation

Aalbert Industries € 529,000.00 € 110,000.00 € 540,000.00 € 393,000.00 € 600,000.00 € 450,000.00 ABN AMRO € 759,000.00 € - € 759,000.00 € - € 767,000.00 € - Aegon € 900,000.00 € - € 900,000.00 € - € 955,000.00 € - Ahold Delhaize € 975,000.00 € 868,000.00 € 987,000.00 € 444,000.00 € 1,000,000.00 € 1,350,000.00 Akzo Nobel € 820,000.00 € 630,900.00 € 834,000.00 € 783,000.00 € 859,000.00 € 915,800.00 Altice € 415,000.00 € 145,250.00 € 380,000.00 € 117,800.00 € 265,000.00 € 92,750.00 AMG € 1,032,000.00 € 872,000.00 € 1,082,000.00 € 1,514,000.00 € 1,028,000.00 € 1,121,000.00 Aperam € 315,788.00 € 164,209.76 € 302,000.00 € 166,100.00 € 391,407.00 € 234,844.20 Arcadis € 196,000.00 € 115,000.00 € 210,000.00 € 165,000.00 € 210,000.00 € 185,000.00 ArcelorMittal € 1,340,000.00 € 230,000.00 € 1,593,599.00 € 245,000.00 € 1,502,389.00 € 270,000.00 ASM € 420,000.00 € 132,000.00 € 420,000.00 € 145,000.00 € 450,000.00 € 165,000.00 ASML € 681,500.00 € 550,000.00 € 935,000.00 € 790,880.00 € 954,000.00 € 810,230.00 BAM Group € 470,000.00 € 59,000.00 € 508,000.00 € 64,000.00 € 620,000.00 € 350,000.00 Boskalis € 708,000.00 € 431,880.00 € 743,000.00 € 453,230.00 € 770,000.00 € 462,000.00 Brunel International € 500,000.00 € 325,000.00 € 600,000.00 € 200,000.00 € 600,000.00 € 180,000.00 DSM € 855,000.00 € 470,250.00 € 870,000.00 € 320,812.00 € 870,000.00 € 522,000.00 Eurocommercial Properties € 375,000.00 € 111,000.00 € 375,000.00 € 231,000.00 € 689,000.00 € 386,000.00 Gemalto € 432,000.00 € 324,000.00 € 550,000.00 € 715,000.00 € 635,000.00 € 697,000.00 Heijmans € 493,714.00 € 43,460.00 € 493,714.00 € 79,132.00 € 493,714.00 € 98,753.00 Heineken € 1,150,000.00 € 1,127,000.00 € 1,150,000.00 € 2,769,200.00 € 1,150,000.00 € 2,930,940.00 KPN € 808,000.00 € 670,000.00 € 850,000.00 € 548,000.00 € 850,000.00 € 1,049,000.00 NN Group € 820,000.00 € - € 850,000.00 € 170,000.00 € 1,180,000.00 € 214,000.00 Philips € 1,100,000.00 € 1,081,520.00 € 1,137,500.00 € 349,600.00 € 1,168,750.00 € 768,920.00 Randstad Holding € 800,000.00 € 520,000.00 € 800,000.00 € 560,000.00 € 900,000.00 € 747,000.00 RELX Group € 1,077,000.00 € 1,134,000.00 € 1,104,000.00 € 1,170,000.00 € 1,131,000.00 € 1,189,000.00 Royal Dutch Shell € 1,640,000.00 € 5,904,000.00 € 1,400,000.00 € 4,163,000.00 € 1,472,000.00 € 3,663,000.00

SBM Offshore € 738,600.00 € 295,440.00 € 1,063,000.00 € 584,650.00 € 888,000.00 € 444,000.00 Unilever € 1,010,000.00 € 594,000.00 € 1,251,000.00 € 1,652,000.00 € 1,392,000.00 € 2,573,000.00 VastNed Retail € 375,000.00 € 102,250.00 € 375,000.00 € 237,500.00 € 440,000.00 € 143,400.00 Vopak € 600,000.00 € 135,000.00 € 612,000.00 € 397,000.00 € 625,000.00 € 469,000.00 Wereldhave € 402,000.00 € 132,340.00 € 412,000.00 € 166,000.00 € 510,000.00 € 265,520.00 Wolters Kluwer € 860,000.00 € 921,000.00 € 912,000.00 € 892,000.00 € 760,000.00 € 774,000.00

The effect of firm performance on executive remuneration in the Netherlands