The Effects of Top Management Team Pay and Firm Internationalization on MNC Performance

Journal of Management 2004 30(4) 509–528

The Effects of Top Management Team Pay and Firm Internationalization on MNC Performance Mason A. Carpenter∗ School of Business, University of Wisconsin-Madison, 975 University Avenue, Madison, WI 53706, USA

Wm. Gerard Sanders The Marriott School, Brigham Young University, Provo, UT 84602, USA

We examine relationships among top management team (TMT) compensation, a firm’s degree of internationalization (DOI), and its subsequent levels of market and accounting performance. Consistent with our contingency view of information-processing theory, we find that non-CEO total pay and the use of long-term incentive pay are positively associated with subsequent performance, whereas the CEO–TMT total pay gap has negative effects on firm performance. CEO pay has no relationship with performance and TMT pay effects are much stronger in MNCs with high DOI. © 2004 Elsevier Inc. All rights reserved.

Comprehensive reviews of the corporate governance literature have found systematic effects of executive pay level and pay structure on organizational characteristics like performance to be elusive, with the single-most consistent correlation to be between firm size and the amount of pay (Murphy, 1999; Tosi, Werner, Katz, & Gomez-Mejia, 2000). Paralleling such research on the consequences of executive pay are studies that suggest that, beyond the role of firm size, CEOs are typically paid more and receive a larger share of their pay in long-term incentive forms, such as options, when they manage firms that are relatively complex. For instance, Henderson and Fredrickson (1996) found that CEOs were paid most when they managed highly diversified or technologically intensive firms. Sanders and Carpenter (1998) similarly showed that the level of CEO pay and relative emphasis on long-term incentives were positively associated with a firm’s degree of internationalization (DOI). Both studies claimed support for their theorized link between organizational complexity and executive compensation and implied that such incentive arrangements would likely lead to better firm performance in firms with high levels of complexity.

∗

Corresponding author. Tel.: +1-608-262-9449; fax: +608-262-8773. E-mail addresses: [email protected] (M.A. Carpenter), [email protected] (Wm.G. Sanders). 0149-2063/$ – see front matter © 2004 Elsevier Inc. All rights reserved. doi:10.1016/j.jm.2004.02.001

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The purpose of our paper is to further develop this complexity-compensation theoretical logic and specifically examine the performance consequences of top management team (TMT) pay arrangements which are posited but not actually studied in prior research. We empirically test hypotheses regarding the effects of executive pay arrangements in the context of U.S. multinational corporations (MNC). Our theoretical framework is developed from three related literatures: the theory of MNCs which documents the relationship between the transfer and sharing of important managerial responsibilities owing to the complexity of international operations (Bartlett & Ghoshal, 1989; Egelhoff, 1982; Roth, 1995); theory linking complexity and managerial pay arrangements (Henderson & Fredrickson, 1996) suggesting that managerial pay can facilitate superior TMT information processing (Sanders & Carpenter,1998); and information-processing theory which suggests that firms are best positioned to make the strategic choices leading to high performance when informationprocessing capacity meets or exceeds information-processing demands (Tushman & Nadler, 1978). Consequently, we argue that TMT pay arrangements can be structured so as to provide information-processing benefits and accordingly affect a firm’s future levels of performance, especially when an MNC has extensive global operations. There is great practical and theoretical need to recognize the importance of the TMT as a unit of analysis in executive-compensation research. For instance, research on executive compensation typically focuses on the CEO, not members of the top management team. Perhaps a partial explanation for the dearth of studies on TMT member pay is that CEO compensation research generally assumes that the findings and theory applicable to the CEO will generalize directly to members of the team. Admittedly, a few studies have examined lower level executive pay in the context of tournaments (Lambert, Larcker, & Weigelt, 1993; Main, O’Reilly, & Wade, 1993; O’Reilly, Main, & Crystal, 1988) or frameworks linking firm strategy and human capital to SBU manager pay (Balkin & Gomez-Mejia, 1990; Fisher & Govindarajan, 1992; Galbraith & Merrill, 1991), but such studies are the exception. Moreover, recent work has shown that CEO compensation typically differs somewhat from TMT member pay (Carpenter & Sanders, 2002), and economics-based perspectives such as tournament theory actually predict that these differences will be very great by design (Henderson & Fredrickson, 2001; Lazear & Rosen, 1981). And yet, with several notable exceptions (cf. Bloom, 1999; Bloom & Michel, 2002; Carpenter & Sanders, 2002; Henderson & Fredrickson, 2001), most executive-compensation research is still directed primarily at the CEO. Shifting the research lens to the level of the TMT allows us to consider the potential performance effects of team pay level, long-term incentive structure, and the gap between the total pay garnered by CEOs and members of their TMTs. In combination, these observations suggest an opportunity to develop theory regarding some behavioral and human capital underpinnings of information-processing capacity, and that the MNC may provide the unique opportunity to test how and when TMT member pay may be reflected in subsequent firm performance.

Theory We focus our framework on multinational firms because, controlling for such factors as industry, firm size, diversification, and technological intensity, multinational firms are

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likely to provide one of the most complex managerial contexts (Prahalad, 1990). Admittedly, our framework may apply to domestic and multinational firms alike. In the sections that follow we rely on earlier arguments that multinational firms face information-processing demands that are typically greater than those faced by purely domestic firms (Egelhoff, 1982; Sanders & Carpenter, 1998; Weick & Van Orden, 1990). These authors point to such external factors as cultural diversity (Gomez-Mejia & Palich, 1997; Hofstede, 1980) and the variety of customers, competitors, and regulations. Moreover, as firms increase the global scope of their operations they must also typically wrestle with the added complexity of integrating and coordinating an increasingly far-flung web of businesses and value chain activities (Roth, 1995; Roth & O’Donnell, 1996). TMT Compensation and Multinational Firm Performance Compensation is associated with levels of managerial human capital; human capital includes age, managerial expertise, education, and functional expertise (Becker, 1962; Harris & Helfat, 1997), and Leonard (1990) suggested that human capital acts as an internal sorting criterion to indirectly influence executive pay. Carpenter and Wade (2002) showed that lower level executives were paid more for their human capital when they held strategically sensitive positions, and members of the TMT are generally recognized as occupying the most strategic positions in the firm (Finkelstein & Hambrick, 1996). Research documents that organizations are often very public in their proclamations that compensation arrangements are critical to the attraction and retention of key executive personnel (Wade, Porac & Pollock, 1997; Westphal & Zajac, 1994). In addition, compensation arrangements can influence executives’ behaviors through their effects on perceptions of the environment (Gomez-Mejia, 1994), risk-taking propensity (Jensen & Murphy, 1990), willingness to cooperate across business units (Kim & Mauborgne, 1991), and group dynamics and cooperation among TMT members (Hambrick, 1995). In combination, the human capital of the executives who are attracted and retained in the TMT and behavioral factors are important determinants of how well particular TMTs may process information, which in turn allows them to make the strategic choices affecting firm performance (Haleblian & Finkelstein, 1993). Consequently, we explore how MNC performance may be a consequence of TMT total pay level, TMT incentive pay structure, and the pay gap between CEO and TMT member total pay. TMT member total pay level. It is often argued that the task of managing the complexity arising from dependence on foreign markets typically requires executives with more highly developed managerial skills, and a willingness to fully apply them, than is required in largely domestic firms of equal size in the same industry (Bartlett & Ghoshal, 1989; Prahalad, 1990). Such a combination of managerial abilities and motivations is an important building block of information-processing capacity, which has implications for firm performance. There is some evidence that higher levels of pay are associated with executive human capital (Carpenter & Wade, 2002; Leonard, 1990). High levels of TMT member compensation may reflect the fact that, since such human capital is somewhat rare and valuable (Barney & Wright, 1998; Carpenter, Sanders & Gregersen, 2001), the firm has acquired executives whose better and needed skills command a higher price in executive labor markets (Hogan & McPheters, 1980; Leonard, 1990).

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We expect that the complexity inherent in today’s MNC will correspond to an increased level of responsibility for members of the TMT. While the responsibilities of the CEO do not necessarily diminish, from an information-processing perspective complexity requires that more tasks be shifted toward the collective effort of the TMT. Greater reliance on non-CEO TMT members requires commensurately greater levels of human capital reporting to the CEO. Consequently, firms that make required investments in TMT human capital through higher levels of TMT pay enhance their ability to attract and retain talent. For the multinational firm this may mean that executives have experience with international markets, or have demonstrated exceptionally strong performance such that they may be expected to apply this human capital in a similarly effective manner in the multinational context. Strategic initiatives in a global context typically take longer to execute than in purely domestic ones (Kim & Mauborgne, 1991), which implies greater risk for both the firm and its managers. Executives may need to be paid more commensurate with the burden of shouldering this additional risk (Eisenhardt, 1989). As a result, if high pay allows a firm to attract the best top managers and encourages them to take risks requisite to MNC success, then we expect a positive association between the level of TMT pay in MNCs and subsequent levels of firm performance. On this basis we hypothesize that: H1a: TMT member total pay level will be positively related to subsequent MNC performance. TMT member long-term incentive pay structure. The second hypothesis in our information-processing framework predicts that long-term incentive compensation, such as that based on stock options, will be positively related to subsequent firm performance. Cash (e.g., salary and bonus) and long-term incentive forms of compensation have very different attributes and have been shown to differentially affect executive behaviors and strategic choices (Sanders, 2001a). For those reasons, the form of such pay is now recognized as critical (Barkema, Geroski, & Schwalbach, 1997; Jensen & Murphy, 1990). Prior research has reported that environmental and firm conditions associated with high levels of complexity tend to shift the emphasis in executive pay from cash forms of pay to greater reliance on long-term incentives (Finkelstein & Boyd, 1998; Henderson & Fredrickson, 1996; Sanders & Carpenter, 1998). Our framework extends that logic in two ways. First, we examine the performance effects of this shift in incentive structure from cash pay to long-term incentives. Second, we focus on the increasing importance of the incentive structure provided to non-CEO members of the TMT. Accordingly, we are interested in how the distribution of total compensation between cash and long-term incentive pay affects information processing and examine both the proportion and amount of total compensation that is paid as the latter. Incentive pay has important implications for both human capital and TMT behaviors, which affect firm information-processing capacity. High levels of total compensation are typically correlated with pay packages that have been skewed toward long-term incentives such as stock options (Murphy, 1999). Particularly skilled executives with high levels of human capital should be able to bargain for greater levels of stock option pay, relative to cash forms of pay, because such pay affords them the greatest opportunity to amass wealth. Likewise, firms turn increasingly to long-term forms of pay to reward stars because these

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forms of pay are tied to firm performance. Consequently, those executives with the human capital that is the greatest value to the MNC may be able to bargain for high pay, in large part because of its incentive pay structure. And while cash pay may appear to be less risky and therefore preferable, research on pay practices seems to indicate that it has been more common for powerful executives to amass large amounts of stock option pay (cf. Sanders, 2001b). Thus, long-term pay structure may be a signal of the level of human capital the firm has attracted—international experience, exceptional managerial and functional skills, and comfortable with taking risks—and the multinational firms with greater human capital of this kind should have greater information-processing capacity. Beyond the human capital implications, though, incentive pay may benefit informationprocessing capacity for a number of behavioral reasons. Specifically, beyond the benefits of high total pay (as addressed in H1a), long-term incentives may help orient the TMT’s information-processing activities toward issues that are long-term in nature. Larker (1983), for instance, showed that the adoption of long-term incentive plans resulted in increased capital investment. Capital investment typically reflects the fact that management is relatively comfortable making decisions with long time horizons, and a long-term orientation is generally viewed as beneficial for MNC performance (Prahalad, 1990; Weick & Van Orden, 1990). A related factor is that an emphasis on long-term incentives helps the TMT to focus on firm-level outcomes, rather than be myopically preoccupied with division or business unit performance at the expense of firm performance. Because incentives that are composed primarily of salary and bonus are often tied to subunit performance, Hambrick (1995: 123) considered this a cause of TMT fragmentation, because “everyone starts pulling in their own direction, and collaboration and coordination suffer.” Consistent with our framework, Kim and Mauborgne (1991) found that firm-level rewards by MNC divisions promoted the willingness of executives to engage in cross-unit subsidization, which in turn improves its information-processing effectiveness (Hambrick, 1995). Indeed, when TMT members are rewarded for longer term and firm-level thinking, they also may be more likely to function as an integrated team. This is important in that teams are expected to provide information-processing benefits over and above those provided by individuals or collections of individuals who do nothing to coordinate or integrate their actions with the interests of the team (Hambrick, 1995). As MNCs engage in multipoint competition they must be effective at intrafirm coordination and cooperation (Knickerbocker, 1973), then firm-level rewards, like those inherent in long-term compensation, should promote the cooperation (an important covariate and behavioral underpinning of information-processing capacity; Pinto, Pinto & Prescott, 1993; Stajkovic & Luthans, 2003; Tsai, 2002) that is needed to insure firm performance across diverse markets. Consequently, MNCs that emphasize long-term, firm-level rewards should perform better than their peers that use long-term rewards to a lesser degree. This logic leads to the following hypothesis: H1b: TMT member long-term incentive pay will be positively related to subsequent MNC performance. CEO–TMT member total pay gap. The previous hypotheses suggested that TMT pay should affect firms’ ability to reap information-processing benefits—that is, when an MNC’s

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pay practices (i.e., level and structure of TMT pay) are superior to those of comparable firms, then such firms should be able to attract top talent and expect that talent to be motivated to give their best individual and collective efforts to the firm. However, internal pay equity is equally likely to affect TMT information-processing capability, and in this hypothesis we focus on the gap (or difference) between CEO total compensation and the compensation paid to members of the CEO’s own TMT. Consistent with that view, Henderson and Fredrickson (2001) showed that gaps between CEO and TMT member pay were lowest when top executive coordination needs were very high. Developing that logic further, we predict that large positive gaps (i.e., signals that the CEO is paid significantly more then TMT members) will result in lower subsequent MNC performance. As we noted in the introduction, global firms face the greatest pressures to diffuse responsibilities from single executives like the CEO to members of their TMT. At the very least, top teams provide division of labor. For that reason an MNC’s global operations will create information-processing demands for the entire TMT, and not simply the CEO. Though such diffusion of responsibility may not mean that CEOs will be paid less, there are a number of reasons why smaller CEO–TMT pay gaps should facilitate superior TMT information processing and result in higher levels of subsequent performance. Henderson and Fredrickson (2001) pointed out that tournament theory and behavioral theories differ in their implications regarding the performance effects of pay gaps between CEOs and TMTS. Tournament theory suggests that large gaps serve to motivate members of the TMT to greater levels of effort aimed at eventually winning the monetary prize associated with winning the tournament (i.e., the winner is typically the executive who eventually ascends to the position of CEO and gains the disproportionate pay package (Lazear & Rosen, 1981). Alternatively, behavioral theory argues that beneficial social dynamics of TMT members are impeded by disparity in wages among top executives. Firms with large gaps in pay may unwittingly promote counterproductive behaviors (Henderson & Fredrickson, 2001). Specifically, when pay for work inputs such as human capital and effort is less than that given to perceived referents, then individuals will perceive inequity and experience psychological distress (Adams, 1963). In tests of that theory, Pfeffer and Langton (1993) and Bloom (1999) found that large pay differences had negative effects on job performance. Similarly, Bloom and Michel (2002) reported that TMT pay differences resulted in higher managerial turnover, and both poor job performance and turnover are likely to have negative effects on a TMT’s information-processing capacity. Somewhat consistent with the information-processing implications of this view, Carpenter and Sanders (2002) found that firms performed best when compensation awarded to members of the TMT was based on factors similar to those predicting CEO pay, and that firms performed better when non-CEO top team members were overpaid for those factors relative to the level of CEO pay. If the TMT members in MNCs are expected to shoulder responsibilities comparable to those of the CEO and function as an integrated team, then our framework suggests that large gaps in pay may unnecessarily create perceived inequities and lead to behavioral fragmentation. Moreover, great pay inequities may promote disagreement within the MNC top team about the desirability of longer term strategic initiatives, since they are unequally compensated for shouldering the additional risk. Such fragmentation and disagreement can dampen effective information processing by members of the TMT. The harmful MNC firm performance consequences of large pay gaps are summarized by the following hypothesis:

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H1c: The gap between CEO total pay and TMT member total pay will be negatively related to subsequent MNC performance. Larger gaps in pay will be associated with lower levels of performance, while smaller gaps in pay will be associated with higher levels of performance. DOI as a moderator of TMT member pay effects. Our final hypotheses suggest that variance in DOI across multinationals will moderate the main effects we have hypothesized previously. Among firms that are typically considered to be multinational, that is, having sales or production in three or more countries (Stopford, 1992), DOI actually varies widely. A multinational’s DOI reflects the extent to which it is dependent on foreign markets for customers, factors of production, and the capacity to create value, along with the global and cultural dispersion of such dependence (Dunning, 1977; Sullivan, 1994). Importantly, both the theoretical construct and the measurement of DOI include the international activities that the firm owns and excludes those activities that may be conducted through third parties such as alliances or brokers. For this reason, the international business literature often refers to DOI activities as the international operations that are “internalized” in the firm’s hierarchy (Dunning, 1977; Mishra & Gobeli, 1998). Sullivan (1994) demonstrated how the construct and its measurement provides a reliable basis for comparing the extent to which particular MNCs must manage the internalized facets of their global reach (Dunning, 1977; Kim, Hwang, & Burgers, 1989; Sullivan, 1994). From the perspective of our theoretical framework, high DOI firms do experience greater information-processing demands (Sanders & Carpenter, 1998). Accordingly, informationprocessing effects of TMT compensation arrangements should be strongest or most pronounced in firms with high levels of DOI. After all, information-processing theory argues that processing capacity will result in performance benefits to the extent that it is somewhat commensurate, relative to other firms, with processing demands (Tushman & Nadler, 1978). Moreover, because governance arrangements like executive compensation are a financially costly remedy (Zajac & Westphal, 1994), at the limit performance may actually be unaffected or reduced in those firms with high information-processing capacity but low information-processing demands, at least with respect to DOI. From a practical standpoint, our isolation of DOI as a moderator provides a vehicle for testing whether our informationprocessing framework is reasonable—specifically, whether the complexity associated with a MNC’s DOI allows TMT member compensation to influence subsequent firm performance. As we have noted already, the fact that a firm is multinational already places great information-processing demands on its TMT (Prahalad, 1990). Performance may be enhanced in any multinational that adopts the pay practices hypothesized previously. However, our final hypotheses suggest that the performance effects of pay may be more finely contingent on an MNC’s DOI. Some empirical support for this contingent view is provided by Finkelstein and Boyd (1998), who reported that high-performing firms showed the strongest relationship between CEO total pay and managerial discretion—a construct that is also indicative of complexity and uncertainty (Haleblian & Finkelstein, 1993). Looking at firm wide compensation practices, Gomez-Mejia (1992) found performance highest in firms matching pay to diversification strategy. As summarized in the following hypotheses, we take this contingency view a step further to predict that a multinational’s DOI will

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partly determine the extent to which TMT member pay, TMT member long-term pay, and CEO–TMT total pay gap affect subsequent firm performance: H2a: There will be a joint positive relationship between TMT member pay level, DOI, and subsequent firm performance. The positive relationship between TMT member pay level and subsequent MNC performance will be strongest in MNCs with the greatest DOI. H2b: There will be a joint positive relationship between TMT member long-term pay, DOI, and subsequent firm performance. The positive relationship between TMT member long-term pay and subsequent MNC performance will be strongest in MNCs with the greatest DOI. H2c: There will be a joint negative relationship between CEO0-TMT member pay gap, DOI, and subsequent firm performance. The negative relationship between CEO–TMT member pay gap and subsequent MNC performance will be strongest in MNCs with the greatest DOI.

Method Sample, Data, and Chronology of Observations We followed Stopford’s (1992) criterion that a firm is multinational if it has sales or production in at least three foreign countries. Using the Standard and Poor’s 500 as our sampling frame, 245 MNCs met Stopford’s (1992) definition of a multinational. We had complete data for 224 U.S. multinationals. Compensation data came from Compustat’s ExecuComp, which extracts compensation data from firm proxy statements. Data on board structure and TMT size came from Standard and Poor’s Register of Directors and Executives. Firm financial information came from PC-Compustat and CRISP, and data on foreign offices came from the Directory of Corporate Affiliations. In terms of compensation, the Securities and Exchange Commission (SEC) requires that compensation information be made public for these four individuals in addition to the CEO. Consequently, TMT compensation was gauged as that reported for the four highest paid members of the top management team reporting to the CEO (and excluding CEO compensation, which is included separately as a control). All hypotheses use a lagged data structure to test predictions regarding subsequent performance. Accordingly, the independent, moderating, and control variables are all observed in 1992, while firm performance is observed in 1993. Measures—Dependent Variables Subsequent firm performance. We measured subsequent firm performance using the ratio of market to book value, an accepted indicator of a firm’s market-anticipated growth opportunities (Brush, Bromiley, & Hendrickx, 2000; De Carolis, 2003; Hawawini, Subramanian & Verdin, 2003). This ratio measures how much value the market expects

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the firm to be able to extract from its pool of tangible and intangible assets. Following others (Brush et al., 2000; Wiggins & Ruefli, 2002), we measured it as market value divided by book value at the end of the year following the measure of our independent variables (i.e., one-year lag). Our results were similar when we averaged this value for each year 1993 through 1995. Importantly, because we also controlled for prior market-to-book (using an instrumental variable to avoid problems of autocorrelation; see Analysis section), our measure essentially captures how much new value was created by a focal firm in the year following our measurement of compensation and DOI. Supplemental analyses not reported using the accounting measure return on assets yielded identical results in terms of hypothesis support. Measures—Independent Variables TMT pay level. Level of TMT pay was measured as the natural log of the sum of all forms of compensation granted the top four non-CEO executives during 1992. Incentive pay (e.g., stock options and long-term investment plans) was valued at present value as provided by the company. When firms chose to report the Black-Shoals value for stock options (as opposed to SEC present value method), we replaced this value with the value derived using the SEC method. Previous research has shown that the various option-pricing methods produce highly correlated values. Long-term incentive pay structure. Long-term incentive pay (LTIP) was measured in two ways. First, we measured long-term incentive pay structure (LTIP structure) as the proportion of total pay granted in long-term incentive forms (e.g., present value of stock options, restricted stock, and long-term accounting-based incentive plans divided by total compensation), a measure common in prior studies (Gomez-Mejia, 1994). In addition, LTIP structure was also measured as the level of LTIP (LTIP level). This second measure was included because TMT members with high levels of human capital may bargain for both higher levels of long-term and short-term pay and thus not affect the proportion of long-term pay in the manner anticipated. Because results did not differ across the two measures we report only results for LTIP structure, though the second measure allows for a robustness test of the arguments. CEO–TMT member pay gap. Following Henderson and Fredrickson (2001), pay gap was measured as the natural logarithm of the difference between the level of total CEO compensation and the average of the total compensation paid to the four members of the TMT. Although TMTs may be considerably larger than the four executives identified here, particularly given the large average size of our sampled firms (average revenues of US$ 9.3 billion) and the fact that our controls for TMT size indicate an average number of seven executives, the greatest gaps typically are seen between the CEO and the next-highestranking executive. Even when compensation data are available for a larger number of TMT members, the pay of other executives has been shown to be much more compressed around this latter member’s pay (Lambert et al., 1993). In partial support of this contention, precautionary analyses controlling for the variance in TMT member pay left our results unchanged. Thus, even if we do not have compensation data for the entire TMT, it is

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unlikely that the inclusion of such data would have much impact on the calculated size of CEO–TMT pay gaps (Henderson & Fredrickson, 2001). In a few firms, the gap was actually negative. Because we log transformed our measure of pay gap (and you cannot take the log transformation of a negative number), we first made an adjustment so that all pay gap numbers were positive. For the handful of cases where pay gap was zero or negative, we set the value to 1. It is important to note that this transformation simply reduced the heteroskedasticity in the models. The transformations had no effects on the signs or significance levels reported in our tables. The results were unchanged in sign or significance when we either dropped firms with negative pay gaps or did not perform the log transformation (and necessary adjustment). Measure—Moderator Variable Degree of internationalization. Following other researchers (Sanders & Carpenter, 1998), we measured a firm’s DOI using a form of Sullivan’s (1994) composite measure of firm internationalization, which gauges international depth on three important dimensions (foreign sales percentage, foreign production percentage, and geographic dispersion of sales). These are summed to form our composite measure of DOI. The composite measure has a theoretical range of 0–3. We found that the three variables demonstrated high inter-item reliability (α = .84), loaded on one factor with a high eigenvalue and explained variance, and that the component variables and composite measure were normally distributed. Although there are multiple possible single-indicator measures of DOI, Sullivan (1994) found that these measures were highly correlated among large U.S. multinationals. Measures—Control Variables We specified our regressions with a number of control variables that might otherwise explain variance in our dependent variables, be a source of unobserved heterogeneity in terms of our independent theoretical variables, or be jointly associated with both our independent and dependent variables (Jaccard, Turrisi, & Wan, 1990). For instance, firm size is typically related to the level of executive compensation as well as the complexity and informationprocessing demands placed on them (Henderson & Fredrickson, 1996). It has also long been viewed as a predictor of firm performance (Kimberly, 1976). We controlled for firm size, measured as the logarithm of firm sales. As firms become more dependent on international operations, they are also likely to become more diversified (Bartlett & Ghoshal, 1989). Diversification is also related to the complexity of the firm and to levels of compensation and firm performance (Henderson & Fredrickson, 1996). The control for diversification was measured using the entropy measure (Palepu, 1985): diversificationa = Pia ln(1/Pia ), and Pia is the proportion of a firm a’s sales in business segment i. In models predicting TMT pay level and pay structure, we included a control for firm performance. High levels of prior performance allow some firms to pay TMTs more and must be accounted for. Prior firm performance was measured as 1992 market-to-book (instrumental variable; see discussion in Analysis section). We also controlled for CEO compensation because earlier research reported relationships between DOI and CEO total pay and CEO incentive pay structure (Sanders & Carpenter,

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1998), CEO pay and TMT member pay (Lambert et al., 1993), and CEO pay and firm performance (Jensen & Murphy, 1990). Accordingly, CEO total pay is a control in models testing H1a, H1c, H2a, and H2c (i.e., pay level and pay gap, respectively), and CEO pay structure is a control in models H1b and H2b (TMT pay structure). As with TMT pay, we gauged CEO total pay level as the logged value of total compensation and incentive pay structure as the ratio of long-term pay to total compensation. TMT size was included as a control because larger teams may be more likely to use incentive pay as a way to manage internal tournaments (Henderson & Fredrickson, 2001), and teams are likely to be larger in global firms (Sanders & Carpenter, 1998). Haleblian and Finkelstein (1993) also linked team size to firm performance. TMT size was measured as the number of corporate officers reported in Standard and Poor’s Register of Directors and Executives. Vigilant boards may affect the compensation of executives and firm performance (Mehran, 1995). We control for the effect of board vigilance, board outsiders, using the percentage of board members who are not employed by the firm (Boyd, 1994). Research and development (R&D) intensity affects both executive pay (Henderson & Fredrickson, 1996) and firm performance (Barkema et al., 1997). Therefore, we controlled for R&D intensity, using the standard measure R&D expenditures/total sales. Finally, because all of our variables may vary systematically by industry, the regressions incorporate eleven industry dummy variables (to preserve space, the coefficients and standard errors of the industry controls are omitted from the tables). This control for industry is similar to that used in other strategy research (i.e., Amburgey & Miner, 1992).

Results Analysis The MNC performance models were estimated using two-stage least squares regression, because the two-stage procedure allows us to treat prior firm performance (i.e., market-tobook or return on assets) as an endogenous variable in models using TMT pay to predict subsequent MNC performance. Also, to the extent that the models using TMT pay encompass a larger system of equations in which some variables that predict firm performance might be independently related to pay, OLS regression could yield biased estimates in modeling MNC performance (Johnston & Dinardo, 1997). Two-stage least squares corrects for this bias by generating a reduced form estimate of prior firm performance, and then including the predicted value from this equation as an instrument in a second-stage equation estimating subsequent MNC performance. In addition to the reasons suggested in our discussion of the pay gap variable, we conducted supplemental analyses to rule out the concerns of aggregation bias, that within-TMT pay skewness was unduly biasing the results reported in the next section. First, as mentioned earlier our results were insensitive to the inclusion of variance in TMT pay level or pay structure in the regressions. This means that the average TMT pay and average incentive pay structure are good indicators of our theoretical construct. Moreover, indices for skewness and kurtosis returned values close to zero, demonstrating distributions that are very close to normal. Thus, the results reported in this study do not appear to suffer from aggrega-

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tion bias. Additional precautionary analyses for all regressions indicated that outliers do not explain our results; variable inflation factor scores, for each variable and the overall models, indicated no problems of multicollinearity. Results were also robust to measures of market and accounting performance averaged over two or three subsequent years. As noted above, other models (not reported) using the accounting measure of three-year average return on assets returned similar results to those reported for our one-year and three-year average stock market based measures, market-tobook. Specific tests of the hypotheses are reported in Table 2. Results were robust in a model that included all of the tests simultaneously (not shown). Descriptive Statistics Descriptive statistics and correlations for all of the variables are presented in Table 1. The average level of TMT member pay was found to be US$ 741,000 (after converting the logged values shown in the table to absolute values); the average level of TMT long-term incentive structure was 33 percent but varied widely across firms, with a range of 0–70 percent. The average gap between CEO and TMT member pay was US$1,521,726. As previously mentioned, the VIF scores for all regressions suggest no problems of multicollinearity. However, as a further precaution given the high intercorrelations among CEO and TMT pay constructs, we ran supplemental analyses which excluded CEO pay level or structure and the results for our independent variables remained unchanged. Consequently, only the fully-specified models are presented in the tables. Hypothesis Tests Table 2 reports the results for the test of the hypotheses. Because the CEO pay controls will vary by hypothesis, respective coefficients and standard errors for the control variables are reported in separate respective models. Model 1 reports the control model for hypotheses involving TMT pay level and pay gap (i.e., both sets of hypotheses require a control for CEO total pay). Model 3 reports the control model for the hypotheses involving compensation structure, which require a control for CEO pay structure instead of CEO pay level. While not reported in the tables to preserve space, five of the eleven control variables for industry were significant. Recalling that our two-stage least squares procedure controls for prior performance, Model 2 shows support for H1a. The coefficient for TMT member pay level is positive and significant as predicted and the theoretical model explains a significant amount of performance variance over the control model. Models 4 and 5 provide a similar pattern of support for hypotheses H1b and H1c. TMT pay structure is positively related to subsequent MNC performance, whereas pay gap shows negative effects. Models 6–8 report results for the interaction hypotheses H2a through H2c, where DOI is predicted to accentuate the relationships established in H1a through H1c. Support for these hypotheses would be shown by a significant interaction coefficient with a sign in the predicted direction (i.e., positive for H2a and H2b and negative for H2c) and a significant increase in variance explained over the variance explained in the main-effects models. Based on these criteria, all three hypotheses were supported—moreover, decom-

1 2 3 4 5 6 7 8 9 10 11 12 ∗

Variable

Mean

SD

1

2

3

4

5

6

7

8

9

10

11

Subsequent performance TMT pay level (log) CEO pay level (log) TMT LT incentive pay structure CEO LT incentive pay structure CEO–TMT pay gap (log) DOI Log sales Diversification level TMT size Board outsiders R&D intensity

2.88 6.88 7.42 .33 .34 6.42 .59 8.41 .57 6.37 .77 .02

2.39 .66 .38 .21 .09 1.98 .52 1.08 .52 3.17 .11 .04

.39 .19 .26 .10 −.11 .27 .01 −.03 .16 −.04 .18

.50 .67 .28 .19 .19 .45 .15 .17 .04 .01

.36 .70 .14 .19 .53 .44 .45 .06 .08

.36 .13 .20 .27 .13 .16 .07 .06

.15 .32 .39 .47 .31 .05 .26

.12 .17 .15 .08 .08 −.01

.08 .15 .12 −.02 .44

.22 .16 .08 −.17

.09 .14 −.14

.02 .08

−.15

p = .05 for correlations greater than .13; two-tailed tests.

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Table 1 Correlation matrix and descriptive statistics (n = 224)∗

521

522

Variable

Model 1, controls for H1a, H1c, H2a & H2c

Model 2, test of H1a

Model 3, controls for H1b & H2b

Model 4, test of H1b

Model 5, test of H1c

Model 6, test of H2a

Model 7, test of H2b

Model 8, test of H2c

Intercept Sales Prior firm performance (instrument) Diversification level Board outsiders R&D intensity TMT size DOI CEO pay level CEO pay structure

1.01 (1.89) −.15 (.15) .96∗ (.43) −.21 (.34) −.30 (1.39) −9.05 (7.12) .08† (.04) 1.21∗∗∗ (.36) −.60 (1.18)

−.48 (7.64) −.36† (.21) .38 (.45) −.03 (.42) −.15 (1.32) −1.93 (7.40) .08 (.06) 1.01∗∗ (.35) −.60 (1.18)

1.57 (1.86) −.35† (.20) .81† (.44) −.39 (.37) −.41 (1.37) −8.91 (7.12) .06 (.05) 1.10∗∗ (.36)

1.57 (1.86) −.35† (.20) .81† (.44) −.39 (.37) −.41 (1.37) −8.91 (7.12) .06 (.05) 1.10∗∗ (.36)

.04 (7.95) −.13 (.22) 1.00∗∗ (.44) −.23 (.44) −.14 (1.37) −9.94 (7.48) .07 (.06) 1.31∗∗∗ (.36) .25 (1.21)

−1.27 (7.09) −.47∗ (.20) .55 (.42) .002 (.39) .08 (1.22) −.09 (6.87) .08 (.05) .76∗ (.32) −.50 (1.10)

2.07 (1.81) −.37† (.20) .92∗ (.43) −.23 (.37) −.56 (1.33) −6.30 (6.96) .07 (.05) .97∗∗ (.35)

−.87 (7.83) −.08 (.21) 1.06∗∗ (.44) −.28 (.43) −.56 (1.36) −11.28 (7.37) .07 (.06) 1.38∗∗∗ (.35) .37 (1.19)

2.27 (3.65)

2.27 (3.65)

F Adjusted R2 Change in adjusted R2 over prior model (control or main-effect)

.99 (3.56)

1.27∗∗∗ (.27)

TMT pay level (H1a) TMT pay structure (H1b) CEO–TMT pay gap (H1c) TMT pay level × DOI (H2a) TMT pay structure × DOI (H2b) Pay gap × DOI (H2c)

1.32∗∗∗ (.25) 2.06∗∗ (.72)

2.37∗∗∗ (.70) −.19∗∗ (.07)

−.23∗∗ (.07)

2.10∗∗∗ (.36) 4.55∗∗∗ (1.30)

−.40∗∗ (.15) 3.62∗∗∗ .18

4.96∗∗∗ .26 .08∗∗∗

3.66∗∗∗ .18

4.02∗∗∗ .21 .03∗∗

7.95∗∗∗ .20 .02∗∗

Hypotheses are one-tailed tests; industry dummy variables are included in regressions but not in the table, to preserve space. ∗ p < .05. ∗∗ p < .01. ∗∗∗ p < .001. † p < .10.

7.15∗∗∗ .36 .10∗∗∗

4.65∗∗∗ .25 .04∗∗∗

8.88∗∗∗ .22 .02∗∗∗

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Table 2 TMT pay level, TMT pay structure, and CEO–TMT pay gap predicting subsequent performance (n = 224)

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523

Subsequent Market-to-Book

6 5 4 Pay Gap LT Incentives

3 2 1 0 Low

Avg

High

Level of DOI

Figure 1. Moderating effects of DOI on the effects of TMT pay arrangements on subsequent performance. Note: The functional form of total pay variable is nearly identical to that of long-term incentives graphed above.

position of the interaction terms into their simple effects (Jaccard et al., 1990) showed the hypothesized relationships to indeed be stronger at high levels of DOI (p > .05, adjusted Bonferroni procedure). Thus, the effects of TMT total pay, pay structure, and CEO–TMT pay gap were consistently a function of DOI. An illustrative graph of the moderated effects of pay structure and gap is provided in Figure 1; the functional form of pay level, while not graphed, is nearly identical to that of pay structure.

Discussion Our objective was to develop a theoretical framework that linked human capital and behavioral perspectives with information-processing theory. In doing so we sought to make and test predictions regarding TMT compensation and subsequent MNC performance. The results of our hypothesis tests provide some evidence that our objective was achieved. We argued that multinational firms, particularly those with extensive international operations, face heightened information-processing demands that will be increasingly borne by the TMT, not just the CEO. Those firms best able to adapt TMT compensation to meet such information-processing demands should then realize better performance. A consistent pattern of support for this prediction was found, and financial performance was indeed most affected by TMT pay arrangements in those MNCs with the highest degree of internationalization. Primary Findings Our results resonate with Eisenhardt (1989) and Henderson and Fredrickson’s (2001) assertions that compensation that favors collective action may be particularly applicable to situations demanding coordination and cooperation among individuals. Of note, perfor-

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mance is more greatly enhanced by high TMT member compensation than by high CEO compensation. In addition, at least among these U.S. MNCs, the benefits of long-term forms of pay appear to be more pronounced at the level of the TMT than at the level of the CEO. This may be striking evidence of the transfer of greater responsibility from CEOs to TMTs in complex firms, particularly those with high levels of DOI. Indeed, MNCs were more profitable when the CEO and compensation committee were willing to “show the money” to the members of the entire top team and reduce the gap in pay between the CEO and other members of the TMT. Two implications of these findings, one theoretical and one practical, are noteworthy. Recall that tournament theory and our information-processing perspective make competing predictions about the behavioral consequences of pay gaps. Tournament theory argues that large pay gaps motivate managers to work harder, which should be reflected in higher firm performance. In contrast, our theory and results support the notion that pay parity results in higher firm performance because of its positive effect on informationprocessing capacity. Carpenter and Sanders (2002) similarly found that firms performed better when TMT member pay was based on criteria comparable to that used to determine CEO pay. Taken together with our results, both studies suggest that some aspects of distributive justice (i.e., how the pie is divided proportionally among team members) and procedural justice ( i.e., the process used to divide the pie) may underlie the relationship between TMT member pay and firm performance. At the same time, and consistent with Henderson and Fredrickson (2001), we found that the relationship between pay gaps and organizational outcomes depends significantly on the context—in our case, low pay gaps benefit firm performance most when the MNC has extensive global operations. From a practical standpoint, the fact that TMT effects overshadowed CEO effects may lead boards of directors and other influential stakeholders to wrongly conclude that it is more important to have able TMT members than a high quality CEO—assuming that pay is an accurate indicator of human capital and executive behavior as our theory and others have suggested. However, we suggest that firms should not look at this as a strong TMT versus CEO question, and instead give close attention to the need for the entire top team, including the CEO, to function as an integrated team. Hambrick (1995) identified five major threats to TMT integration—(1) inadequate executive capabilities, (2) common team-wide shortcomings, (3) harmful rivalries, (4) groupthink, and (5) fragmentation—incentives like the level of pay and pay equality are important precautions against TMT dis-integration, but provide only part of the solution. Boards need to recognize that, in addition to issues of compensation, integrated TMT’s also require frequent meetings and shared, active responsibility for corporate-wide endeavors. Limitations and Future Research Like all studies, ours faced certain limitations, which in turn create opportunities for future research. One limitation is the fact that we looked only at compensation in U.S. multinationals and, by design, excluded domestic-only U.S. firms and non-U.S. firms. This sampling choice was made in order to provide the strongest test of our theory. And yet, even when the interactions with DOI were entered into the regressions, the coefficients of our main

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effect compensation variables remained significant and in the predicted direction showing that all the MNCs benefited to some degree. To expand the generalizability of our theory future research should incorporate a broader sampling of firms or replicate the study in other contexts. For instance, non-U.S. MNCs could be compared to U.S. MNCs regarding pay and pay gaps and their implications for firm performance. Similarly, our theoretical framework can be expanded beyond the MNC context to look at domestic only firms to see if other determinants of information-processing demands create like compensation arrangements in response. A second limitation is that we were not able to gauge the degree to which firms actually sought to integrate and coordinate their international activities and instead used DOI as a proxy for those pressures. Though we suggested that DOI will generally create increased information-processing demands for the firm, our theorizing partly emphasized the information-processing requirements arising from the pressure to integrate and coordinate activities across and between geographic markets, and therefore focused on how TMT pay can engender the skills and behaviors that support an integrative strategy. Prahalad (1990) presented this problem as the integration-responsiveness dilemma— an increasing need to promote both global economies of scale and scope and local responsiveness. Clearly, the work of Bartlett and Ghoshal (1989), Egelhoff (1982), Kim and Mauborgne (1991), Ghoshal and Nohria (1989), Prahalad (1990), and many others point to greater complexity and greater information-processing demands in global competition and, consequently, a much more difficult and complex task at coordination and integration. A third limitation relates to the performance variables that we used, along with the period in which those variables were observed. Even though market-to-book is considered to reflect long-term expectations of firm performance which take into account both tangible and intangible assets (Hawawini et al., 2003), some critics of this measure point out that it may be unduly biased because it does not account for off balance sheet items like intellectual property. While recent research has shown that results do not systematically vary if you use market to book instead of return on assets or more complex value measures like EVA or MVA (Hawawini et al., 2003), the opportunity to test our framework with these latter measures nonetheless remains. A related issue arises from our argument that certain TMT member compensation would give them a longer term orientation and our use of a one-year lag period between compensation and firm performance. As noted earlier, we also found similar results when performance was averaged over three subsequent years. Financial economists view market-to-book as a long-term performance measure (Mehran, 1995; Perfect & Wiles, 1994). Even so, our assessment of long-term performance is based on information known at one time in the market and does not take into account unforeseen changes in internal or external conditions. In conclusion, by developing human capital and behavioral explanations for the information-processing benefits of particular governance mechanisms such as executive compensation, this paper begins to integrate disparate yet complementary research in strategy, organizational theory, and international business. Overall, we hope that the framework developed in this paper contributes to the growing stream of research that considers how firm governance interacts with the organizational and industry complexities accompanying and accelerating the global imperative.

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Mason A. Carpenter is the William J. Nasgovitz Fellow and an associate professor in the School of Business and the Weinert Center for Entrepreneurship at the University of Wisconsin-Madison. He received his Ph.D. in strategic management and organization science from the University of Texas at Austin. His research concerns corporate governance, top management teams, the strategic management of global firms, and global new ventures. Wm. Gerard Sanders is the J. Earl Garrett Fellow in Management and an associate professor in the Department of Organizational Leadership and Strategy in the Marriott School of Business at Brigham Young University. He received his Ph.D. in strategic management from the University of Texas at Austin. His research focuses on the role of corporate governance in decision making, firm strategy, and performance.