Does hometown connection between chairmen and CEOs improve compensation-performance sensitivity in China?

This research explores the relationship between hometown connections (specifically, the "laoxiang" relationship, meaning fellow villager) between CEOs and chairmen of Chinese-listed companies and the sensitivity of CEO compensation to firm performance. This is a critical area of study because CEO compensation is a key mechanism for addressing agency problems in corporate governance. Prior research has focused on factors like firm size and market conditions, but the influence of informal social contracts, particularly prevalent in Chinese culture, remains relatively understudied. The "laoxiang" relationship represents a unique aspect of Chinese culture, characterized by strong ties and trust among individuals from the same hometown. Understanding its impact on CEO compensation is crucial for comprehending corporate governance in the Chinese context and has both theoretical and practical value. The study aims to address the gap in existing literature by examining whether the "laoxiang" relationship between CEOs and chairmen impacts the effectiveness of CEO compensation contracts, specifically focusing on how this impacts the alignment of CEO incentives with firm performance. This study uses a micro dataset of private Chinese-listed companies, focusing exclusively on this sector to avoid the complexities of state-owned enterprises where compensation is largely administratively determined.

The study draws upon agency theory, specifically Jensen's view that well-designed compensation contracts are crucial for aligning the interests of owners and managers. It also incorporates social identity theory, highlighting the importance of group identity and reputation within the "laoxiang" network. The literature review discusses the dual mechanisms of reputation and collusion that might arise from the "laoxiang" relationship. The reputation mechanism posits that shared hometown connections create strong reputational pressures, deterring opportunistic behavior and enhancing compensation-performance sensitivity. Conversely, the collusion mechanism suggests that close ties could lead to reduced chairman independence and weaker performance-based compensation. Existing research on informal contracts and their role in corporate governance is reviewed, with a particular emphasis on studies examining how social networks and relationships affect firm behavior and managerial decisions within the Chinese business environment. The review also assesses previous research on the impact of various factors (e.g., firm size, market conditions) on compensation-performance sensitivity to provide a theoretical foundation for the study hypotheses.

The study uses a sample of 1293 private Chinese-listed companies from 2011 to 2020, excluding financial institutions, special treatment companies, and those where the chairman and CEO are the same person. Data were obtained from the CSMAR database, supplemented by manual extraction of executive birthplace information using online resources. The dependent variable is the natural logarithm of CEO total compensation, while the key independent variable measures whether the chairman and CEO share the same province of origin. Firm performance is measured as return on equity (ROE). The study utilizes an OLS regression approach, justified by the lack of substantial variation over time in the main variable of interest, which makes fixed effects estimation less appropriate. Several control variables are included to account for factors such as firm size, financial leverage, firm growth, largest shareholder ownership, proportion of independent directors, existence of a compensation committee, and region of incorporation. Industry and year fixed effects are also included in the regression model. To mitigate concerns about outliers, a winsorizing technique is applied. The study employs various diagnostic tests, including variance inflation factor (VIF) analysis to check for multicollinearity and stationarity and cointegration tests to ensure the reliability of the data. Furthermore, to address the potential endogeneity issue arising from omitted variable bias (specifically, CEO ability), the study uses topographic relief of the CEO's hometown as an instrumental variable in a two-stage least squares regression.

The study finds strong evidence supporting the hypothesis that a hometown connection between the chairman and CEO enhances CEO compensation-performance sensitivity. This is demonstrated through both a grouping regression comparing companies with and without this connection, revealing a significantly higher compensation-performance sensitivity coefficient for the former group (prob > chi2 = 0.0265), and by the positive and significant coefficient on the interaction term between ROE and the hometown connection variable in the main OLS regression. The positive effect of the hometown connection on compensation-performance sensitivity is more pronounced in regions with a strong hometown culture (as measured using dimensions of collectivism from Minkov and Blagoev (2012)) and high degrees of marketization. In regions with weak hometown culture or low marketization, the positive impact is less significant or absent. Further analysis indicates that the positive effect of the hometown connection weakens with increasing CEO tenure, suggesting that the reputation mechanism is dominant in earlier stages of the relationship. Conversely, the effect is stronger when the CEO is externally hired rather than internally promoted, further supporting the role of the reputation mechanism. Robustness checks, including using return on assets (ROA) as an alternative measure of firm performance and varying the measurement of the hometown connection (province versus city), confirm the study's findings. Instrumental variable regression using topographic relief as an instrument for the hometown connection addresses endogeneity concerns and strengthens the results. The study also excludes family-owned firms from the analysis to ensure the focus remains on the hometown connection and not family ties.

The findings highlight the importance of informal institutions and social networks in shaping corporate governance and executive compensation in emerging markets like China. The study demonstrates that the "laoxiang" relationship, despite its potential for collusion, primarily operates through a reputation mechanism, influencing CEO compensation and incentivizing performance. The moderating role of hometown culture and marketization level underscores the complex interplay between formal and informal institutions. The diminishing effect of the hometown connection with longer CEO tenure and its stronger effect with external CEO appointments provides further support for the reputation mechanism. The results have implications for both company managers and policymakers, emphasizing the need to consider the influence of informal social networks in the design of compensation contracts and corporate governance structures. The study contributes to the growing body of research on the impact of social relationships and cultural contexts on firm behavior.

This study makes several important contributions. First, it expands our understanding of CEO compensation-performance sensitivity by considering the influence of informal social networks in the context of Chinese culture. Second, it provides strong empirical evidence for the positive impact of hometown connections between chairmen and CEOs, particularly in regions with strong cultural ties and well-developed markets. Third, the analysis of the mechanisms involved offers valuable insights into the dynamics of reputation and collusion in the context of CEO compensation. The research suggests that future research could explore how other informal relationships might influence corporate governance and compensation practices in different cultural contexts, investigate other dimensions of the "laoxiang" relationship, and assess the generalizability of the findings to other emerging economies. The study highlights the vital importance of understanding how informal institutions interact with formal regulatory frameworks in shaping business outcomes.

The study's limitations include potential unobserved heterogeneity across firms. Although the study incorporates a wide range of control variables and instrumental variable methods to address endogeneity, there might still be unobserved factors influencing the relationship between hometown connections and compensation-performance sensitivity. Another limitation is the reliance on self-reported data for executive hometowns, which could potentially contain errors. The study focuses specifically on private Chinese-listed companies, so the generalizability of the findings to other types of firms (e.g., state-owned enterprises, publicly listed companies in other countries) might be limited. Future research might also explore the interactions between the hometown connection and other governance mechanisms in more detail.