Asymmetric Incentives: Investors and Boards Take Heed
The issue of executive compensation has been “hot” for quite some time, and it has only gotten hotter given the massive losses sustained on Wall Street and certain segments of the hedge fund industry. There is plain outrage that certain members of senior management get to keep tens of millions in pay even in the wake of tens of billions in lost shareholder value. It is hard to reconcile such asymmetries, yet the problem is rooted in the structure of the compensation culture that has emerged across Corporate America and the burgeoning hedge fund industry. I personally am less irked by the numbers themselves than the mis-aligned incentives that have contributed to today’s market crisis (as well as poor corporate performance). And it is unclear how this issue will be rectified in a rational manner, as populist rhetoric takes hold and deflects the analysis from the question of “how” to pay instead of the “how much” to pay. But one thing is for sure: there is a problem. And it needs to be addressed now.
James Surowiecki penned a recent piece in the New Yorker that did a good job outlining some of the complexities of executive compensation, and the skewed incentives that Boards and investors may be giving their charges in the name of building shareholder value. He also expanded the analysis to cover hedge fund managers, and the asymmetric risk/return profile they see under the standard 2/20 fee structure:
The havoc on Wall Street following the collapse of the subprime-mortgage market boils down to a simple truth: for years, lots of very smart people took lots of very foolish risks, betting borrowed billions on dubious mortgage derivatives, and eventually the odds caught up with them. But behind that simple truth is a more surprising one: the financial whizzes made bad decisions in part because that’s what they were paid to do.
Mr. Surowiecki, as usual, breaks down the fundamentals with great clarity. An interesting feature of his analysis is the fact that the very properties of hedge fund returns are in line with the compensation culture that has emerged. For instance, overall hedge fund returns tend to be negatively skewed and exhibit high kurtosis. In english, this means that when something big happens to impact overall returns it tends to be negative, and it tends to be very, very negative. This is similar to the properties of an out-of-the-money put selling strategy, where a premium seller will outperform over a wide range of outcomes until - oops - the sold puts move into the money and causes exponential losses over short time periods. The funny thing is that prior to the blow-up, the put seller a/k/a the hedge fund industry, exhibits returns that are both better and less volatile than the broad market. Whoo hoo! Unfortunately, it is just this that lulls investors into a kind of complacency that makes for a rude awakening when things go south. Mr. Surowiecki goes a little far when raising the issue of how the manager of a poorly performing fund below its high water mark can simply shut down and start again. The reality is that not every manager has this luxury and it certainly isn’t near the top of a manager’s play book when thinking of how to deal with a period of weak performance. But overall, his analysis of manager motivation given the prevailing incentive fee structure is pretty accurate.
Mr. Surowiecki’s discussion with respect to corporate executives gets very interesting when he cites a recent study on the use of stock options and its impact on company performance:
Not surprisingly, a recent study of almost a thousand companies by the management professors W. Gerard Sanders and Donald Hambrick found that C.E.O.s whose compensation was made up mostly of stock options tended to “swing for the fences,” making investments and acquisitions that were riskier than those made by other executives. As a result, the performance of the companies run by the risk-takers was far more volatile, and not for the good of the companies: the risky strategies were more likely to end in a big failure than a big gain. Generous options grants may also encourage fraud; the business professors Jared Harris and Philip Bromiley, who have made a study of hundreds of firms forced to restate earnings after accounting irregularities, found that companies that paid out most of their compensation in stock options were far more likely to end up restating earnings. And, as with hedge funds, the perverse effects of performance pay are exacerbated by the fact that big bonuses are often based on short-term performance.
The results of this study are pretty intuitive. And you know what is really interesting? If an analysis of hedge fund returns (and manager motivation) yields a profile that looks like a sold put option, an analysis of corporate manager motivation creates a profile more akin to a bought call option. Except in this case, the option is not bought by the manager but granted to him/her by the Board of Directors. Free optionality - it is the holy grail. The corporate manager’s risk/reward prism is, in effect, the converse of the hedge fund manager’s prism. The hedge fund manager wants to merely outperform with a high degree of certainty over the intermediate term, in order to “demonstrate” superior investment results, grow assets, capture ever-larger management and performance fees and accrue great wealth. If things go wrong after that, you have a hedge fund manager with egg on its face but a large bankroll. Now consider the corporate manager. Their motivation is to take risk. Big, big risk in order to shoot the moon and get the stock price to rocket upward. Small amounts of outperformance aren’t going to yield the types of market returns that get corporate Masters of the Universe excited. Lights out, leave your competitors in the dust-type performance will, however. And these are the types of gambles they are financially motivated to pursue. One thing is for certain; if you give highly intelligent, highly motivated, wealth-seeking individuals skewed incentives, they will push this skewness to the limit. And this is the real Achilles’ heel of mega-stock option grants that reward corporate managers for absolute stock price movements.
There have been periodic attempts to change the structure of executive option grants. Some companies have tried to structure “outperformance grants,” where the payoff was linked to the difference between company performance and a broad market index like the S&P. Others have sought to try and isolate outperformance between a company and its publicly-traded competitors. Each of these approaches has conceptual appeal but generally have failed in the marketplace. Either too difficult to administer, too unattractive for manager prospects or too unusual relative to the vanilla options used by competing companies.
But my biggest issue is that stock price performance - especially short-term performance - in a vacuum doesn’t begin to measure the effectiveness or long-term worth of a senior executive. How about building a new product pipeline? Employee morale? Talent management? Recruitment? Investor relations? Relations with all key stakeholders? The list goes on. Until compensation plans become more robust, and more focused on the real, sustainable, long-term value brought to the company and its stakeholders by senior executives we’ll get the problems of mis-aligned motives we’ve witnessed since the advent of large stock option grants. But both investors and their Boards need to acknowledge this need or nothing will change. And change is what’s needed. Right. Now.
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COMMENT:
AUTHOR: wcw
EMAIL: wcw@bignose.org
DATE: 11/24/2007 11:39:26 PM
..or you could go the old-fashioned route: cash bonuses and restricted stock grants. Sure, you need managers in place who can recognize and reward crazy newfangled ideas like building a new product pipeline or recruitment. If your management sucks so hard they can’t manage that, all the clever compensation structures in the world aren’t going to rescue your company.
Me, I find I can make plenty of money in the market without wedding myself in some long-term Buffetian way to managers who overpay themselves and their cronies for doing crap work. If I worked for CalPERS, though, I might be exercised about the terrifying wrongness of the acculturated compensation culture in the US.
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COMMENT:
AUTHOR: azeem
EMAIL: azeem@azhar.co.uk
URL:
DATE: 11/25/2007 09:00:22 AM
all of the non financial metrics can be games too… and will result in perverse behaviour. and in essence the stock price should reflect the material and relevant metrics like pipelines or retention. of course it doesn’t. but anyone who has worked in a lArge firm will know that the moment you create a measure that isn’t directly and objectively meaurrf any smart
manager will wlrk like hell to game it.
apple for iPhone typos.
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COMMENT:
AUTHOR: Roger
EMAIL: roger@informationarbitrage.com
URL: http://www.informationarbitrage.com
DATE: 11/25/2007 10:10:25 PM
Azeem, I have to say that I heartily disagree with you. Gaming comes when you set hard and fast rules (like the US system of rules-based regulation) as opposed to areas subject to interpretation (like the UK system of principles-based regulation). There is an overarching requirement for Boards and managers alike to exercise their fiduciary duty to stockholders. My argument is that a fiduciary should be thinking about not only short-term performance metrics but longer term measures of wealth creation. A static stock price, unfortunately, doesn’t begin to capture the texture of this issue. Thanks for commenting.
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COMMENT:
AUTHOR: azeem
EMAIL: azeem@azhar.co.uk
URL:
DATE: 11/26/2007 08:41:54 AM
Hi Roger,
Phrased like that I do agree with you. In practice, I have witnessed a breakdown between boards operating in an interpretative environment and managers who, rightly or wrongly, work in a much more binary environment.
Boards only have so many resources to assess what is happening with these ‘softer’ measures.
Managers who have been schooled in the ‘discipline of managerial capitalism’ or, with a hat tip to Stephen Jay Gould, the ‘mismeasure of management’ attempt to convert these things into numbers which they can then game.
To avoid that takes real discipline and hard thinking to get right, which without a doubt many firms can do. Questions like:
* What is a product?
* What does ‘talent’ mean?
* What comprises a healthy long-term pipeline of appropriate opportunities into which the firm can grow?
* How do you balance resources invested hitting short-term numbers vs the things which are harder to measure?
may seem simple but in practice are far from it.
I love the blog, BTW.
aa
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COMMENT:
AUTHOR: acepedro45
EMAIL: acepedro45@yahoo.com
URL:
DATE: 11/26/2007 06:00:49 PM
Crazy as it sounds, I would like to see executive compensation entirely in cash, just like regular working folks.
Incentives like stock options, vesting grants, ownership guidelines or even ownership requirements for insiders all are attempts to put the manager in the same economic boat as the long term shareholder. They try to “align the interests” of the CEO with his bosses, the stockholders.
”Performance-based” pay plans became popular in public companies because in the 90s investors became concerned that corporate bosses were enriching themselves while ordinary shareholders muddled along. Tax incentives like Section 162(m) of the Internal Revenue Code helped things along.
But after a decade or so of experimentation with these types of plans, it’s become clear that none of them successfully align the CEOís interests with that of long term shareholders for the reasons Roger mentions in his post. Short of granting stock and forcing management to keep large percentages of their net worth tied up in it ñ even long beyond their tenure at the company ñ thereís just no way to force mangers to assume the same risks and rewards a shareholder takes. I repeat, all these ideas of ìincentivizingî managers are doomed to fail at some level.
Whatís not to like about a paycheck of plain old cash, plus a few incidental benefits like healthcare and such? Itís clear and transparent, without the valuation problems associated with stock options, or the perverse and dangerous incentives to bet on long shots for CEOs. It also prevents investors from being seduced by the seeming safety of their fortunes tied to the CEOís pay ñ the idea debunked in James Surowieckiís piece. If the stock price collapses, the board of directors will soon be reloading the CEOís underwater options with new ones at the money. Will they be doing the same for those ordinary stockholders? Didnít think so.
In a sense, everybodyís pay is performance based, even for us regular Joes. Do a lousy job, and youíll get fired. Do a good one, and youíll keep making money.
Really interesting blog, really interesting issue.
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2 years ago
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