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Monthly Archives: September 2007
I’ve had an interest in executive compensation for quite some time. I’m not interested in compensation in and of itself, but in compensation as a form of governance. My interest in compensation revolves around how it can align the interests of shareholders and managers, and how boards (as the representatives of shareholders) can become more effective in designing executive compensation packages. I’ve even blogged a bit about it (see here).
I was therefore very interested to read today’s NY Times article about how Michael Jensen (one of the proponents of stock options as a means of aligning the interests of shareholders and managers) has recently revised his stance toward compensation (see Advocate of Paying Chiefs Well Revises Thinking).
The Times writes:
One of the problems with executive pay was that boards lavished top brass with too many stock options. This resulted in outsized pay and income inequality. Another problem revolves around severance. There are problems with the severance clauses in employment contracts that compensation committees are willing to agree to when hiring executives. Specifically, boards are faulted for allowing huge severance packages. As a result, top executives cannot be fired, even if for cause, without huge payoffs (see Robert Nardelli). Finally, executives got paid without clearly adding value. There was no real down-side risk for CEO’s. If they performed well they made money and if they performed poorly, they still made money. But it’s a little more complex than that. The article explains:
Some of these problems are remediable. For example, if boards were tougher in negotiating with incoming CEO’s, severance packages could be kept in check. Likewise, if we have overshot in granting options in the first place, the most logical thing would be to scale back the number of options we grant. Although we could expect some resistance from executives who have gotten used to current pay levels, it’s not impossible. It might be a little trickier to incorporate cost of capital into option grants. For example, how do you determine the appropriate cost of capital to apply? That’s a difficult thought experiment, but even so, it’s not impossible. Some industry benchmark can surely be found.
My only issue with Jensen’s proposal, and this is raised in part by Jay Lorsch, is that this does not necessarily solve the problem of trying to incentivize long-term performance using short-term metrics (e.g., near-term stock price performance). Again, the standard assumption in accounting is that firms have an infinite lifespan. They are assumed to be around forever. Although the firm is supposed to be around forever, human beings are not. The average lifespan of the homo sapien is around 70 years. And if you consider the lifespan/tenure of a typical CEO (now less than 4 years), the picture looks even bleaker. This creates a severe incentive problem. If I’m a typical CEO, what incentive do I have to look out for the best long-term interests of my firm? After all, I’ll probably only be around here for a few years. In this sense then, CEO’s have an incentive to increase near-term performance sometimes at the expense of long-term performance. This raises an even more basic problem: What is the right measure of long-term performance to use? And how do we design a compensation package to incentivize it?
Not only that, but means-end linkages are difficult to determine for any kind of performance metric. For example, if we are compensating top managers using stock price, how do we know that a particular action taken by the CEO or the top executives actually resulted in the stock outcome. The performance could have been caused by a wonderful decision made by an employee three or four levels down in the organization (despite the effort of top management). Should we therefore disproportionately reward top managers for something they had very little influence in creating?
Finally, the issue of punishing good managers during bear markets and rewarding good managers during bull markets remains. We need to find some way to reward good managers who end up in a bad situation and vice versa. This is not always so easy to do.
Nevertheless, I encourage all of you to read the NY Times article. It is very interesting. That said however, I believe there are a host of unanswered questions that remain.
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Two Thirds of CEOs Say They Are Overpaid (naked capitalism, 10/14/07)
Case Study: The Sopranos and Premium Cable Packages (Canadian Personal Finance Blog, 6/11/07)
Real Stimulus vs. Hand Waving (Venture Chronicles, 1/22/08)
I don’t know what it is about business schools these days, but boy have we ever become the object of increasing attention. What’s the matter, are there not enough other things going on in the economy to write about? Have the credit crunch, subprime fallout, and prospects for a recession become passé? Or are we just easy targets?
I’ve written a bit in past blogs (see here and here) about how the relevance of our research has become a topic of considerable debate among academics and non-academics alike. Now, our curriculum has come into question. I would refer you to an interesting article that appeared in today’s Wall Street Journal questioning whether we’ve failed in achieving our larger, societal mission (Business Schools Forgetting Mission?). The journal writes:
The article goes on to conclude:
I think these are important questions to ask. At its essence, the argument is rooted in decades-old questions about whether stakeholder or shareholder maximization models achieve more desirable social outcomes. I would, however, disagree with the assertion that students no longer yearn to be CEO’s. I’ve had no trouble finding students who long for that role. What I have found, however, is a greater desire among students to lead firms that they themselves have founded (whether an investment, consulting, marketing, or some other kind of firm).
Granted, the WSJ article is mainly meant to summarize the views from a book recently authored by Rakesh Khurana of Harvard. Nevertheless, judging by what’s been written about business schools of late, you’d think that we are facing an outright crisis of confidence. Given all the controversy, I’m just wondering what will they come up with next.
More on this topic (What's this?)
Keeping credit flowing during the credit crunch (Lending Club, 9/1/07)
Credit Markets Still Shaky (And Don’t Think It Doesn’t Matter) (naked capitalism, 9/29/07)
Not Buying It (Condor Options, 8/22/07)
I’m often asked about my views on specific acquisitions. Yes, it’s true that most of them fail, or at the very least, under perform. And while it would be easy to categorically dismiss most as ill-timed and/or poorly thought-out, I believe that would be under appreciating their complexity. It’s much easier to be a Monday-morning quarterback and declare that they were a bad idea after the fact.
When it comes to strategic acquisitions (those made by strategic, industry buyers versus private equity buyers), there are several important parts of the process. First, buyers must identify the appropriate target. This is difficult, but seasoned managers generally have a good sense of the firms with which they would like to combine and those that would make the best fit.
After the target is identified the process becomes more complex because now it must be priced. The intrinsic value of the target must be determined, the synergies that could be generated identified, and a purchase price agreed upon. This is not easy, and this process is more art than exact science. But it can be done, and often done with some precision. I-bankers are pretty good at valuing targets – it’s fairly straightforward to look at comps and historical multiples. Moreover, sage managers know their businesses better than anyone and should be able to come up with some idea for the kinds of synergies that likely exist and a price ceiling that they would be willing to pay. Managers sometimes overpay because they get carried away with a deal as emotions get involved, but a rigorous process to determine a firm price above which managers will walk away can help avoid such emotional attachment.
In my opinion however, the most difficult part of the deal is the integration. How can we effectively bring the two companies together to capture the identified synergies? Although much has been written about how difficult integration can be, we still don’t fully appreciate the process. Deals often go wrong not in the identification of the target, the pricing of the deal, or in the identification of synergies, but in achieving those synergies. Often the synergies are real, yet the cost of realizing them swamps the benefits.
It’s no surprise that integration costs often get underestimated. For one, most acquisitions take place under such time pressure that it’s difficult to spend the appropriate time on pricing-out the integration. We tend to spend the majority of our time pricing the deal and pricing-out synergies. Likewise, even when we have carefully considered the integration, given confidentiality concerns surrounding the due diligence process, access to the appropriate people to help price the integration is limited. Although top managers negotiate the deals, the effectiveness of an integration is determined by the operational, day-to-day managers. These folks often don’t get included into the acquisition process until the deal has already been announced. Finally, we fail to appreciate the human element of the integration process – the resistance to change that is likely to be encountered along the way, and how the process can be deliberately undermined.
Once you put it all together, it’s no wonder that so many of these deals fail. And it’s not solely about integration (although that’s a big part). The real issue is that there are so many places along the way that it can potentially go wrong. First, the target might not be appropriately identified. Second, the intrinsic value calculations might be off, the pricing component might be off, and/or the synergies could be overestimated. Finally of course, the integration costs could be underestimated. But the interesting thing about the whole process is that the mistakes made in one part of the process don’t generally tend to offset the mistakes made in others. Rather, mistakes get amplified along the way. For example, an overly-optimistic intrinsic value might lead to a higher than expected price that an acquirer is willing to pay. Likewise, if the synergies are overestimated, the price an acquirer is willing to pay will mistakenly be pegged. Finally, if synergies are overestimated, this might lead to greater integration costs that the acquirer is willing to tolerate.
All of these things make strategic acquisitions risky, not to mention incredibly difficult to pull off. And true enough, somewhere between 50-85% of them fail. But to underestimate their complexity would be to under appreciate their creativity and the challenges facing managers. Good thing that they’re the ones compensated to take such risks.
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Jack and Vera... The Takeover Team??? (Asset Manager, 8/27/07)
Mergers and Acquisitions(Part 1): Here’s How to Take Advantage of The Takeover Frenzy (Investment U, 11/9/07)
Was Today's Twitter Buyout Hoax An Indication Of An Overvalued Market? (Disciplined Approach to Investing, 7/14/15)