C-Sweet

Earlier this week I had the pleasure of attending a talk given by Hermann Stern, founder of financial research company Obermatt Inc., on the topic of executive pay. He speaks with ease and a great deal of clarity about a topic that is contentious to say the least — and not just politically but also from a practitioner’s stand-point. Some of his findings piqued my interest, on which I will expand a bit:

Imagine yourself the sole shareholder and heir to a Polish based SME pursuant to the untimely death of a distant relative. Naturally, you’re too busy to run the firm on a day-to-day basis. In fact, you would much prefer to pursue some other areas of interest while comfortably cashing in on a reliable stream of dividend payments at the end of each and every fiscal year. What you need is a reliable CEO to tend to your golden cow and thanks to some reliable market data on executive pay, finding the right compensation scheme shouldn’t pose much of a problem.

As it turns out, CEO annual pay ranges from US$290’000 all the way up to US$850’000 with a median rate of US$450’000. A considerable amount to be sure, but not unreasonable. Especially when considering that you will soon be able to sleep soundly in the knowledge that this diligent worker will burn the midnight oil to make you rich. For good measure you tender an offer slightly above the market median at US$470’000. After all, what is the point of hiring a below-average employee for such an important job?

What is completely rational behavior on the individual level has in aggregate helped drive up CEO to average worker pay ratios by 1000% since 1950. UK disclosure requirements for executive pay has backfired beautifully, where anchoring and wage priming effects push median wages ever higher. Such efficiency wages, i.e. where companies have an obvious interest to pay more than the minimum level, are especially prevalent in high qualification labor markets and wage transparency only increases the effect. This is particularly true of listed companies, who’s boards do not wish to signal bad performance to shareholders by proposing below average executive compensation.

Just ask Mr. van der Veer, former CEO of Royal Dutch Shell:

Source: : © www.obermatt.com

This is becoming an interesting dilemma: Paying below average wages might land you the wrong person but paying above average wages might also land you the wrong person. Remember, nobody sets out to intentionally hire a below average CEO.

But what if you tie executive remuneration to a performance based metric? Tying executive compensation to a quantifiable financial measures makes intuitive sense. This way at least you would only pay above average rates for above average results and align the CEO’s incentives with your own goals in the process. Let me pose to the reader the following question in regards to the performance metrics listed below: In which year should CEO compensation be highest?

2015 with record sales looks attractive, but then again in 2014 the firm enjoyed its comparatively highest revenue growth with a 24.4% yoy increase. On second thought, from a bottom line perspective, EBIT was at its highest in 2015, but experienced its most significant growth in 2013. None of these answers are inherently wrong, depending on what goals you may have as a business owner. If increasing market share is the objective then sales related KPIs may be the way to go. But if you take the hardnosed shareholder view that all you should really care about are earnings, then EBIT is your god.

The first obvious problem with this is that there are no objectively true measures for a “best performance”. A wonderful example of this occurred when ISS, an independent proxy advisor for institutional investors, recommended in 2012 voting down a generous compensation package for Duncan Niederauer, CEO at the time of NYSE. This was not surprising, given that the proposed compensation equaled 1.8x of peer group and total shareholder return was down 35% from its peak.

The response of the board was as follows:

“The company has responded by arguing that the peer group of other exchanges considered was not a fair one, given NYSE’s shift to becoming more of a branded technology company, and that total shareholder return was not a sufficient measure of the group’s performance.” (Financial Times, April 29, 2012)

(I can’t help but point out the delicious irony inherent in a stock exchange criticizing shareholder returns as a reliable measure for performance).

In other words, we simply don’t agree on financial measures — not even when discussing a ludicrously simple income statement such as the one above or when discussing shareholder returns.

The other perhaps more insidious problem is that such arbitrary measures, which as we’re about to see can all too easily be massaged and altered to suit most needs, may set counter-productive incentives.

Sales & EBIT

Attaching C-suit remuneration to revenue or profit is a dangerous game. If so inclined, a clever CEO could simply sacrifice the company’s long-term prospects by selling inventory at below recommended retail prices (RRP) or make debt-funded acquisitions, which doesn’t affect OPEX but drives up earnings. Growth figures may be even worse, as these can encourage postponement of incentives to perform. After all, bad results this year increase the odds for haymaker growth next year.

EVA

Economic value added, obviously a very popular industry metric, is by definition almost completely discretionary. This has to do with the rather flexible definition of WACC. Depending on which risk free rate, which market equity beta (selection of peer group and time span), and which market risk premium is chosen almost any EVA can be reasonably explained.

Margins

It’s tempting to think of good margins as indicative of profitable enterprising. Unfortunately, margin-based incentive schemes often wind up compensating management for simply cutting business segments that bring down profit margins, even if these are NPV positive and good for the company.

Return on capital invested

The problem with return on capital invested is similar to the margin issue. Except in this case, management is incentivized to reshuffle divisions and engage in all sorts of transfer pricing shenanigans.

For example, let’s consider two business segments consisting of divisions A, B and C.

Source: : © www.obermatt.com

By simply juggling the divisions a bit we can make both segments look far rosier individually without actually affecting the total returns.

Stock returns

Lastly, stock returns seem promising as a forward-looking, objective assessment of a company’s value to shareholders. Why not offer your CEO stock options with some adequate lockup agreement? However, market prices reflect far more than merely the quality of management and empirical data has as of yet not found any correlation between stock returns and CEO pay.

Source:Bloomberg

Ultimately, the problem comes down to financial performance measures. Financial performance cannot be motivating because humans can’t agree on financial performance! At best it is questionable whether performance based incentive schemes work and at worst the wrong incentives can do a lot of damage. So how should you compensate your Polish CEO? Good corporate governance and fixed salaries might be the way to go. Mr. Van der Veer’s famous words come to mind when asked to reflect on his stint as CEO of Royal Dutch Shell:

“You have to realize: if I had been paid 50 per cent more, I would not have done it better. If I had been paid 50 per cent less, then I would not have done it worse,” (Financial Times, June 9, 2009).