No skin in the game

This is from the February 23, Harvard Business Review Ideacast with Mihir Desai. The topic was CEO pay and this part of the discussion was about whether capitalism was failing (emphasis mine).

I actually think capitalism is wonderful. I actually think shareholder capitalism is a wonderful thing. I don’t have a problem with that. What I see is a significant deviation from it. Which is, again, I see managers and investment managers doing remarkably well, and shareholders doing fairly poorly if one looks at the last 15 years. That’s not shareholder capitalism. That’s capture of capitalism by managers and investment managers. That, I think, is not sustainable. That, I think, is destructive to the long-term health of shareholder capitalism.

I think this well-said. Many people often mistake distorted capitalism for capitalism.

But, the question is how can this happen in capitalism? As I like to say, the problem usually lies in the feedbacks. Desai contends that stock-performance based compensation for investment managers creates several distortions in incentives, yet the “you get paid when I get paid” logic is so alluring that it has become the generally accepted way to pay investment managers.

Desai hits on a few of these distortions, but I believe the key distortion is in the risk-taking. Investment managers share in the upside, but don’t lose their pants on the down side. The have no true skin in the game. The managers might not get paid on the downside and they may lose their contract on the downside, but they don’t actually lose their own money. So, they have more incentive to take more risk than they would if they were betting with their own money.

The next question is why hasn’t capitalism sorted out this problem? My answer is that few people know it exists.

So, here is one example where having no skin in the game has caused our financial markets to become more fragile.

3 thoughts on “No skin in the game

  1. I would like to make the argument that greed plays a large role.

    Now, I’ll bet that your immediate reaction is that I’m referring to the “greedy” CEOs and investment managers. Nope! I’m referring to greed on the part of the shareholders. Let me explain. I believe that a part of the “irrational exuberance” of the 1990s involved an excessive risk taking on the part of investors and shareholders who became accustomed to double digit returns and, in return, accepted compensation arrangements for CEOs and investment managers that, in more “normal” times would have been seen as outlandish, but which in these outlandish times came to be accepted as normal. Shareholders and investors, greedy for outsized returns, accepted the ever more “obscene” compensation packages demanded by CEOs and managers as long as they (the shareholders and investors) saw themselves as getting rich, also.

    Investors/shareholders convinced themselves that any market drop was merely temporary and was an opportunity to buy more. Why insist that CEOs/managers participate in the downside when it didn’t really exist? After all, that could risk upsetting and running off one’s financial guru/savior. In an environment where gains seemed to be permanent and setbacks were always temporary, greed trumped prudence.

    • Thanks. Good thoughts.

      If Desai is correct that shareholders have been doing poorly for the past 15 years, it doesn’t seem like their greed is working in their favor — especially if they’re buying the ‘temporary setbacks’ excuses.

      • Strange as it may seem, I don’t think that the financial blood bath (thus far) from the economic meltdown has been bad enough (when measured in depth times duration) to really change behaviors. Sure, it may have woken some people up, but as a whole investors/shareholders don’t want to take the time and effort to crunch the numbers themselves and so they tell themselves that it’s OK to trust (and pay) the CEOs/managers.

        Unfortunately, government interventions that have softened the blows have delayed (but not prevented) the ultimate pain that we must go through. Only when the pain is deep and long enough will behavioral changes result that will permit a strong and lasting recovery (at least until we forget the lessons again and the cycle repeats itself).

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