Pay-for-Performance and Firm Diversification

We find that CEO compensation is less sensitive to stock-price performance the greater the extent of firm diversification. Our empirical evidence is consistent with a theory of managerial entrenchment as well as with a theory of optimal contracting between shareholders and managers. To distinguish between the theories we examine the association between firm value and the structure of the compensation contract along with the use of alternative governance mechanisms in diversified firms. We find only a weak relation between the sensitivity of compensation to stock-price performance and the size of the value loss from diversification. Moreover, we find that the use of alternative governance mechanisms is not suppressed in diversified firms. Our results appear to be more consistent with optimal contracting, and suggest that the existence and magnitude of the diversification discount cannot be attributed to agency problems between managers and shareholders.