Executive Pay

We spent a fair amount of time in b-school talking about aligning manager interests with shareholder interests. It seems like the simplest way to do that is to have the managers be owners.

I wonder how many executives would choose to stay in their jobs if their salaries were dropped to $100,000 and the Board of Directors told them if they want to make money, then they should invest their own funds in the business and they will make money when shareholders make money.

Now, I realize executive pay is a free market and a good manager is worth a good salary and much of CEO pay is really the cost cover the legal risk of being an executive, but still, I think it’s an interesting thought experiment.

It’s a thought experiment modeled after Warren Buffet, who takes a salary of $100,000 for running Berkshire Hathaway, but has become a billionaire by owning a fair size chunk of that company.

If this became the norm in executive pay, I would guess that we would see a different group of people occupying the executive suites. Speaking of executive suites, I’d bet those suites would not be as well-appointed if the managers were owners.

Now, some folks might argue that executives often do have significant portions of their pay and bonuses tied to the stock performance. On the surface, that seems like a logical way to align the interests. But, experience has proven otherwise and the explanations are simple.

For example, managers with stock options, stock grants and stocks bought with non-recourse loans from the company help align executive interests with shareholders on the upside, but not the down side. Managers personally lose nothing, except potential profits, for taking big risks to try to move the stock price up.

Not only that, but executives often have severance agreements that reward them relatively handsomely for getting fired. So, the only downside to taking big risks is the executive’s ego.

So, what happens under such pay schemes? Executives take big risks.

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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.

Hostile takeover in Wisconsin

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I heard a local radio talk show host this week discount a characterization made by a democrat of the Wisconsin union battle as a hostile takeover.

I agree with the democrat in this case.  It is a hostile takeover. But, I’m certain the democrat will disagree with me that it’s a good thing.

In corporations, hostile takeovers come after entrenched mismanagement has driven the value of the firm low enough to attracts folks who would like to either take control of board of directors by shareholder vote or buy the company outright from shareholders to try to make the company valuable again.

Of course, the entrenched managers do not want to lose their positions, power, salaries and the source of their big egos, so they fight against the people who want to takeover and try to fix their mess.  They call it hostile because the bad managers are forced out.

For years folks have rightly criticized a key weakness in corporate governance.  They contend the CEOs line the board of directors with their cronies and run the company to enrich themselves at the expense of shareholders, customers and associates for as long as they can get away with it.

I’ve watched it happen up close.

It’s the bane of concentrated benefits and disbursed costs.  The special interests — the CEO and board members in this case — have much to gain.  Each of the shareholders and associates don’t stand to lose enough to matter so they don’t do much, if anything, about it.  It all goes well until the company loses enough value to attract people who think they can fix it.

And, that’s exactly what’s happened in Wisconsin.  Except the part of CEO was played by  union bosses and board of directors played by government officials.  The taxpayers played the part of shareholders.

For years the union bosses used their power to get their cronies elected so they could have their way with taxpayers.  For a long time taxpayers didn’t care enough to do much about it.  In the last election they did.