Last June, Benedetto Vigna became the new CEO of Ferrari NV, joining the company from semiconductor manufacturer STMicroelectronics NV. The chairman of Ferrari noted Vigna’s “deep understanding of the technologies driving much of the change in our industry,” and the subsequent press release stressed Vigna’s experience “at the heart of the semiconductor industry that is rapidly transforming the automotive sector.” The emphasis on the new CEO’s technological background was emblematic of an important yet underexplored development: the growing impact of technological expertise on the executive labor market. In a new paper, we study that development, examining whether the degree to which companies share an expertise in technology drives competition for managers and, hence, compensation.

Our focus is based on the notion that firms with similar technologies are likely to value similar managerial attributes. As CEOs gain experience with and knowledge of the businesses they run, they are also likely to gain expertise in technological domains associated with managing firms in certain technological areas. Therefore, managers’ expertise in certain technological domains is valuable not only to their firm but also to other firms that focus on similar technology. This will ultimately be manifested in CEO compensation policies.

Studies show that a manager’s technological expertise plays an important role in determining how much the manager and his firm complement each other. Our focus on the role of technological-expertise similarities in shaping firms’ compensation policies is also consistent with how many proxy statements treat technological considerations as important in choosing peer groups for benchmarking executive compensation.

We use patent technology classifications to measure firms’ technological expertise and focus on certain patent technologies to measure their similarities. Studies have noted that technological similarities do not reflect mere similarities in companies’ products. For example, Monsanto Co. shared many technologies with firms from industries (such as food and pharmaceuticals) that were different from the agricultural chemicals industry in which it was historically positioned. Monsanto’s proxy stated that, for technological reasons, it benchmarked CEO compensation to firms operating in different industries, such as Baxter International (medical equipment), Genzyme (pharmaceuticals), Colgate-Palmolive (consumer goods), and General Mills (food). Although Monsanto and the aforementioned firms did not directly compete in the same industry, they exhibited high technological similarity.

Using compensation-benchmarking peer-firm data and the technological overlap measure, we begin by showing that similarity in technological expertise is a significant determinant of whether a certain firm is used as a compensation benchmarking peer. We find that a one standard deviation increase in technological similarity is associated with a 51 percent increase in the odds of being a benchmarking peer. This compares with a corresponding 217 percent increase in the odds associated with being in the same industry, a 71 percent increase in the odds associated with a one standard deviation increase in the stock return correlation, and a 34 percent decrease in the odds associated with a one standard deviation increase in the firm size difference, implying an economic importance of technological similarity that is comparable to other prominent determinants of compensation benchmarking. Moreover, even within the same industry and size groups, we show that a firm’s choice of peer firms is determined by its technological similarity to those firms. Our results suggest that technological similarity plays a crucial role in firms’ choice of peer group and that considering the role of technological fit is critical for demonstrating the efficiency of the labor market and the composition of the peer group.

We then present evidence consistent with compensation benchmarking being an efficient approach to estimating the market wage for human capital, as opposed to its use reflecting managerial opportunism. We show that higher technological similarity with benchmarking peer firms increases the likelihood that a CEO who received above-median (below-median) pay in the previous year received at or below-median (above-median) pay in the following year. This result is obtained even after controlling for other important compensation determinants from previous studies, and is consistent with the market-based theory of CEO compensation in that firms set CEO pay to remain competitive with firms that are competing for similar managerial talent.

After establishing that technological similarity has an important effect on CEO compensation benchmarking patterns, we provide evidence that its use reflects CEOs’ outside options. In particular, we show that a one standard deviation increase in technological similarity increases the odds of the CEO joining a similar firm by 86 percent. Our finding reflects the notion that the marketability of CEOs’ technological expertise is at least partly reflected in firms’ technological similarity and that firms prefer to hire CEOs with a better technological fit.

Finally, we show that the CEO compensation levels of technologically similar peer firms are positively associated with CEO pay at the focal firm: CEO compensation increases by 0.258 percent when the median CEO compensation of technologically similar firms increases by 1 percent. We thus provide evidence that technological similarity plays a crucial role in the market for CEO talent and that the labor market consistently reflects CEOs’ outside opportunities.

Overall, our study contributes to the literature focusing on the effect of similarities in technological expertise on corporate policies, shows that technological expertise is a distinct and previously overlooked aspect of transferable CEO skill, adds to the literature on optimal contracting for CEO compensation, and shows that technological similarity plays an important role in determining compensation benchmarking peers – consistent with an efficient contracting motivation.

This post comes to us from professors Fred Bereskin at University of Missouri, Seong Byun at Virginia Commonwealth University, and Jong-Min Oh at SungKyunKwan University. It is based on their recent paper forthcoming in the Journal of Financial and Quantitative Analysis, “Technological Fit and the Market for Managerial Talent,” available here.