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.
Structural Problems
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.
Hedge Fund Returns: Negatively Skewed, High Kurtosis
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 this aspect 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.
Corporate Managers and Stock Options
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 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.
