New Approach Links Exec Compensation to Corporate Debt
Risks taken by leaders to build up corporate equity (along
with their compensation packages) has been tied to the financial industry’s
house of cards that came crashing down in 2008. The time may have come, according
to a Knowledge@Wharton (K@W)
article, to reconsider adjusting those packages, not based on how much a company
appears to be worth on paper but how solvent it is in real terms.
In a new paper, Inside
Debt, written by Wharton finance professor Alex
Edmans and doctoral student Qi Liu, to be published in the Review of Finance,
the authors contend that in companies run by executives with packages based
largely on equity, there is a natural inclination to take risks.
The rationale
for tying executive compensation to a company’s equity has been the defacto
standard for three decades. The idea is that shareholders and execs share a
common purpose — increasing the value of a company’s stock. The issue is that
the pursuit of that goal (as well as other factors) does not always lead to
an ever upward path for share values.
“If the risk pays off, the value of the equity shoots up,” said
Prof. Edmans. “If the risk doesn’t pay off, the worst their (executives’)
equity can be is zero.” Bondholders and other creditors, however, are
not as fortunate.
Prof. Edmans pointed to Bear Stearns, Enron and Lehman Brothers
as three companies that took the “gamble for resurrection” and failed.
In
the case of Enron, Prof. Edmans told K@W, the company should have
been upfront about what it was facing. “Instead, they tried to conceal
the problems, hoping that one of their gambles would pay off before the problems
became noticed. But they only became worse.”
AIG, another poster child
for the financial industry’s collapse, might offer a picture of compensation
packages that balance equity and debt. Executives at the company are now paid
bonuses based on “long-term performance units.” Roughly
20 percent of these units are tied to the company’s common stock while 80 percent
is based on AIG’s junior debt.
Discussion Questions: Is it time for a lower percentage of executive compensation
to be tied to share prices? Does tying more executive compensation to performance
of a company’s bondholders work for successful companies as well as those in
a turnaround mode?
One of the problems we run into here is that often the price of a company’s stock in no way reflects the performance of the company. When there is abnormal dumping of shares due to circumstances unrelated or beyond the control of a company, executives could be unfairly punished. Eventually these market dips correct themselves so it would need to be evaluated over a longer period of time.
The issue at hand is that in our society, “the primary purpose of a corporation is to build shareholder wealth.” That’s MBA 101. So regardless of what compensation is tied to, a CEO will drive towards that goal, and hide or defer anything that appears to threaten that goal.
There is some talk about changing this very explicit purpose to include other factors that include other stakeholders like the communities, employees and customers the company serves. Of course, the metrics for that are currently soft and there’s a lot of space between where we are and where something like that would work.
I am not remotely advocating socialism here, but there’s a level of accountability that is missing…without that accountability leaders will continue to do what they have done–focus on short to medium-term profits. Wall Street pummels any other focus.
This question falls into the “It depends” category. Most public companies should (or already do) tie their CEO and executive compensation to a variety of goals. Sales and earnings growth should be at the top of the list for most retailers. The share price itself is less easy for the CEO and his/her team to manage, with macroeconomic factors always at play. If one of the company objectives is to improve its debt position or otherwise manage its cash flow, by all means make that a compensation goal too…but not all retailers will view this as an equal priority, given the ongoing need to fight for market share.
Tying compensation to equity had its merits when the risk to the executive is comparable to the corporation’s risk. However, that is not typically how it is put together or analyzed. The fundamental thinking as I have understood it is: If the company does well, you’ll do well. However, that’s not exactly the case. There is usually a base salary that could be sufficient for many to live on (and then some), while the equity package is icing on the cake. So if the company’s performance is not the goal; greed is the goal. Consequently executives begin to focus on profitability, not long term growth for the corporation. Immediate profitability can influence stock prices. Long-term corporate growth doesn’t do a thing for the executive’s compensation.
Further, linking compensation to equity suggests that there is an understanding of what makes stocks worth more. Time and again we learn that stock prices are not controllable. Prices may be predictable within the context of other stocks. Take a look at the past week’s performance of the US stock market as an example. There are many outside forces that influence stock prices. Typically, corporate executives are not asked about Elliot waves and how they predict their company’s performance.
The authors of the article are definitely correct. I just think there are additional factors they might have considered to bolster their argument.
It’s just one factor. Tying anything to one factor opens up the opportunity to manage to just one thing. Success of a company and share price are never tied to one sole factor. Delivering overall performance is far more important and there are easily defined key performance measures that can be much more broad based and more difficult to manipulate than one factor alone.
Share price is determined by one factor. Equity is one, but certainly not all. Even with a broad based KPI determining compensation, market conditions or activity can skew share price performance.
The entire case study can be invalidated by one prime example–Costco. Other retailers might take a look at their measurements for executive compensation. They might just set share price aside, focus, and share price takes care of itself. No matter what the price its never going to be what Wall Street wants. But there is a lot to be said for all the other factors including sustainability.
We as a country still equate growth, wealth, and success as one in the corporate environment. There should come a time when the compensation package of the executive teams more closely mirrors that of the sales teams. I am referring to the successful sales person is compensated by the results accomplished. They bring in the business and are compensated. They do not bring in the business and the financial package is limited to a base salary. The same theory can be developed for executives. It will be difficult to convince one to accept a position because past culture says pay me now and continue to pay me no matter if I succeed or not.
It is never the fault of “greedy CFOs and/or the corporate elite” that large rewards are paid to them for a falsely reported successful result. The details of these compensation plans are worked out by the board of directors and sold to the highest bidder(s). That’s right, the highest bidder(s). You see, these compensation contracts must be signed for and approved by the board of directors. The terms and conditions are never fully disclosed to the shareholders prior to or after the signing. Changing this aspect alone might make it better for the company and its employees and investors.
You can bet that’ll never happen!!
Executive compensation is solely the province of the owners of the entity compensating the executive. Harvard professors can write all they want but they really make less of a contribution to our society than the average policeman or fireman (who’s opinion I value more).
Each company/corporation has a mechanism in place to determine compensation for its executives that protects the best interests of the company. What the general public considers excessive, is often not enough to retain executive talent. Most people don’t realize that a talented executive can make the difference between success and failure. The success of a company often influences the wellbeing of thousands or even hundreds of thousands of employees.
I live in a community which lost a major employer a few years back. We not only lost a revenue source and the taxes that 2,000 employees paid, we also lost the president of the PTA, 8 to 10 scout masters, 3 church deacons, 9 brownie scout leaders, 12 girl scout leaders, etc, etc, etc.
The cost of failure is horrible and I would ask Harvard professors to spend more time dealing with this horror and less time worrying about headline grabbing studies that no sane leader would ever implement. Again we seem to put our priorities in the wrong place. The progressives/academics are so busy trying to create a level playing field and selling imaginary equality that they overlook the principles that have allowed them the leisure time to ponder these questions.
This is part of a growing body of research that suggests executive compensation needs to be revisited. Recently Harvard Business Review published a paper that linked high executive compensation to meanness toward employees. Executive packages should be optimized to help the executive focus her attention on key stakeholders. Debtholders, employees, government, and the community all play a role in business–whether we like it or not. Companies that recognize this and address all stakeholders do better financially. If we, as practitioners, apply this body of research to our organizations, profits will increase and stocks will rise. There is more and more evidence of this every day.
I believe there is too much talk on executive compensation. Each company has a board that needs to determine this and live with the results.