Implicit Contracts and the Explanatory Power of Top Executive Compensation for Future Performance

Recent research suggests that implicit incentive contracts may be based on performance measures that are observable only to the contracting parties. We derive and test implications of this insight for the relationship between executive compensation and firm performance. If corporate boards optimally use both observable and unobservable (to outsiders) measures of executive performance and the unobservable measures are correlated with future firm performance, then unexplained variation in current compensation should predict future variation in firm performance. Further, compensation should be more positively associated with future performance when observable measures are less useful for contracting. Our results are consistent with these hypotheses.