|
 It’s hard not to get angry when you see someone getting paid a lot of money for doing nothing or making things worse. We don’t have to look far to find evidence of a company experiencing a long-term decline in stock price and economic value while executive pay increases. For the most part, traditional executive incentive plans are a formula for mediocrity that in many cases encourages the destruction of shareholder value.
The real issue with executive compensation is not the amount being paid to CEOs. In fact, provided they’ve made shareholders obscenely wealthy and that the wealth created is sustained for the long term, executives deserve to become wealthy. They would have earned it.
Unfortunately, with the way most compensation plans are structured, executive pay for performance has become synonymous with “we’ll make an exception if things go bad so we don’t lose good people, and we’ll limit how much is paid if things go too well.”
At best, this is socialistic; at worst, it’s communistic. A healthier definition of pay for performance is one used by Jim Skinner, CEO of McDonald’s. “Simply put, pay goes up with positive results and down when the business doesn’t fare as well.”
Fix the dysfunction
The first step in fixing executive pay practices is to identify the primary issues (figure 1). The five characteristics that typically lead to dysfunctional incentives are:
- Wrong definition of performance, often with several conflicting performance metrics
- Threshold and caps on bonuses
- Budget negotiations
- One-year incentives independent of prior-year performance
- Targets that are independent of shareholder value creation
One might expect that defining performance would be easy for the top-level executives, but in practice, there are different operating performance measures used with arbitrary weightings that can lead to the destruction of value to shareholders. For instance, one of the most common measures of executive performance is reported earnings.
One needs only to look at an excerpt taken from Enron’s inhouse risk management manual to see what can happen when the wrong performance measure is used to compensate executives (figure 2). “Reported earnings follow the rules of and principles of accounting. The results do not always create measures consistent with the underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Therefore, risk-management strategies are directed at accounting, rather than economic, performance.” Sadly, we know what happened to Enron, its employees, and its shareholders.
As a result of all the shortcomings in earning measures, one last-ditch attempt is often made to make these dysfunctional incentive plans work by throwing employee stock options at the problem. Although on the surface this might make sense, under the context of a traditional compensation design, the implications can be devastating to shareholders.
Indeed, one might argue that the current US economic climate and the near-collapse of the financial industry were caused by the way banks compensated their executives.
With investment bankers being paid significant sums of cash compensation for short-term performance, which is supplemented with stock options, they were being paid to take greater risks. Imagine being paid $5 million a year but having stock options that were worth $100 million. You have $5 million to live on, but with enough leverage, you can take your $100 million of stock options and make it a cool $1 billion.
This example is not imagined; it is reflective of the compensation of banks with the most toxic investments. They took on the greatest risk and, as a result, destroyed the greatest amount of value to shareholders.
Get rid of caps
Thresholds and caps are often imposed to mitigate exaggerated risk-taking by management, allowing a bonus only if a minimum level of performance is exceeded and capping the upside to encourage a healthy level of conservatism.
But these caps and thresholds are where the real dysfunctional behavior begins. It motivates managers and employees to pull back on performance once they’ve hit their cap and sand-bag performance for the next year. Furthermore, if a manager feels that there is no way to meet the threshold, then it’s best to really miss the mark.
By really missing the mark in a dismal year where managers feel they cannot meet the threshold, they put themselves in a better position to negotiate their annual budget on the basis that the last budget was unrealistic and too high. Conversely, when managers exceed their budget beyond the cap, they hurt themselves for the next year, as it is naturally assumed that the budget was too easy. As a result, once they’ve hit their cap, the best course of action is to begin coasting.
To make matters worse, goals are set for only one year, with no accountability for cumulative performance. This leads to managers making decisions that maximize short-term results at the expense of long-term value creation.
A better plan
The answer is a proper incentive compensation plan designed to align management and shareholder interests such that managers are rewarded for creating long-term shareholder value (figure 3).
There are five key elements of an incentive plan that drives long-term shareholder value. It is critical that all elements are applied (otherwise the plan will not work):
- No caps or thresholds. This motivates managers to push hard until the last day of each year.
- Target bonuses are based on labor-market forces. This ensures that management is given competitive pay for competitive performance.
- Bonus reserve treats management like shareholders. This mechanism ensures exceptional short-term performance is not sought after at the expense of long-term value creation. It also helps to self-fund bonuses during cyclical downturns so that good managers don’t leave due to macro-economic forces.
- Use economic value improvement as the performance metric. This ties directly to shareholder value creation, eliminates the confusion as to which metric to maximize, and embodies all the key metrics of performance while acting as an automatic balanced scorecard to determine the correct trade-off between profit margins and capital efficiency.
- Set economic value improvement targets for three years based on shareholder expectations and non-biased empirical data. This eliminates dysfunctional and costly budget negotiations.
With this plan, managers receive a share of the excess value created, in essence giving them a part-ownership position without requiring them to take a second mortgage on their home to purchase shares of the company.
Shareholders receive the benefits of aligning management interests by simulating ownership without having to dilute their legal share of the company.
Of course, no incentive plan can guarantee that managers will maximize long-term shareholder value, but this plan does guarantee that managers will receive a commensurate level of pay for the long-term value they’ve created or destroyed for shareholders.
Marwaan Karame is a managing director for Economic Value Advisors, consulting businesses in the areas of value based management (VBM) and M&A. Previously, he worked in investment banking for Donaldson, Lufkin & Jenrette and Credit Suisse First Boston advising companies in the areas of M&A, private placement, debt financing, IPOs, and VBM.
|
