Alex Edmans makes a very good point today: it makes a great deal of sense, especially in leveraged companies, to pay CEOs in debt rather than equity. What’s more, such compensation is already quite widespread: if a company has promised an executive a defined-benefit pension upon retirement, that’s essentially unsecured debt of the company, and can be substantial.
Edmans is right that there’s the germ of something possibly quite powerful here. If companies started institutionalizing payment-with-debt, rather than having it simply be a necessary byproduct of making promises to pay out money in the future, that could go a good way towards reducing incentives for executives to take on excessive amounts of risk:
The risky project can sometimes create value (e.g. investing in R&D) but sometimes destroy value (e.g. subprime lending). A CEO who holds exclusively equity will take the risky project even when it destroys value (a behaviour known as “risk shifting” or “asset substitution”) because, if he gets lucky and it pays off, his equity will shoot up in value, but if the project is unsuccessful, it is bondholders who suffer the bulk of the losses – as has been clear in the recent global crisis. Equity holders’ losses are capped by limited liability – thus, if the firm is already close to bankruptcy and equity is close to zero, things can’t get any worse and so the manager may “gamble for resurrection,” taking riskier and riskier projects to try to salvage the firm.
The problem, of course, is getting companies to sign up to such a scheme. Compensation committees are created by the board of directors, which is elected by shareholders, not bondholders. So it’s only natural that those compensation committees will structure things in the benefit of shareholders, with bondholders bearing the brunt.
But in extraordinary circumstances, it can be done. AIG (NYSE:AIG) executives’ compensation is in 80% debt and 20% equity, for two unusual reasons. Firstly, the equity is worthless, and the executives know that the equity is worthless. And secondly, the debt is paying an attractive coupon.
Expanding this model from AIG to other leveraged companies will be hard. But increasingly institutional investors place their money across the whole capital structure of a company, rather than just in equity or in debt. If a firm’s big shareholders are also big bondholders, they might be able to persuade the board to do the right thing.