What scandal has been discussed for the past 40 years, in terms of rising disapproval, but has never shown any sign of abating? On the contrary, the scandal has mushroomed year after year to so gigantic a size that the worries of the mid-1960s seem picayune. Even in the giant US economy, $350 billion is a significant number - and that’s the amount collectively collected, you might say, by the top five executives of 1,500 US firms between 1993 and 2003. Million-dollar salaries, once the Everests of business management reward, are today common-or-garden.
They’ve been replaced by billion dollar fortunes for the luckiest mountaineers. The critics of such largesse have always had a highly persuasive case. It ranges from equity - why should top management earn a stupefying 300 times the pay of the average hired hand? - to corporate governance: there’s no countervailing force to the ability of top managers, supported by their boardroom pals, to write their own pay packets. Moreover, these packages have long since left simple salaries far behind. Today’s super-bosses still get salaries, of course, and very large ones at that; but they also receive ‘performance-related’ bonuses of great size, plus even more magnificent stock options and other wonderful rewards, from massive pensions to mighty perks.
WORKING IN REVERSE
These sometimes obscene elements are all supposed to be linked to performance. This is certainly true of one of the most envied perks - the corporate jet. An economic study confirms that there is indeed a linkage, but it works in reverse. Companies whose CEOs get private use of such aircraft under perform those which don’t extend this privilege. But all objections are swept away by the same simple force: the companies can easily find the cash to finance these monster benefits. Even though the cost of stock options can no longer be hidden, shareholders are exceedingly unlike to protest about the packages, unless the management manifestly fails to deliver adequate performance.
That proposition sounds fair enough. Under a little examination, however, it falls apart. First, what is ‘adequate’ performance? The classic answer is a share price that outperforms the sector - to which the retorts are obvious. The sector may be a meaningless concept; outdoing a mediocre bunch of competitors with sub excellent figures is no great achievement; and the share price, anyway, is hardly more under management’s control than the performance of the national and world economies. The only virtue of the share price is that the number is unarguable - for a specific moment in time.
The greatest influence on that price, however, is the multiple applied by the stock market. The price-earnings ratio. This number supposedly reflects the opinion, favourable or unfavourable, held by the stock market at any given time. The market, of course, has no opinions. The rating is really the sum of that day’s decisions to buy, sell, or hold the shares. The factors that tip the balance to ‘buy’ need not be factual: but movements in the ratio over time may well reflect the underlying performance of the company.
A case in point is IBM, which over one whole decade made no progress in its share price, despite consistently good financial figures. The reason was clear. The shares started the decade on a p/e in the 40s - in those days a sky-high figure. Ten years on, a series of erosions had reduced the magic number to 20, wiping out the entire effect of the unceasing advances in earnings per share, which doubled over the decade.
ECONOMIC VALUE
There was no mystery. The later concept of ‘Economic Value Added’ laid IBM’s weakness bare. Year after year, its return on its capital, re-calculated to include the true cost of equity, had been negative. In other words, the funds belonging to shareholders were being eroded.
Those who noticed the deterioration were naturally led to look for more rewarding (or less unrewarding) investments. Those who didn’t notice were probably misled by a corporate reputation second to none (as it still is, despite the devastation of so many IBM businesses in the age of the microprocessor).
Reputations are worth plenty, but the hard question is how much. To get a meaningful measure of management, the fame, like the share price, must be analysed. You’re not interested in the price as established by the market, but in the underlying value of the business. One highly relevant fact is that this value is not achieved by paying top executives inordinate lumps of wealth. According to another economic study, based on 1992-2001, ‘the more a CEO was paid relative to his peers, the more likely his company was to under perform in the stock market’.
That may sound ridiculous at first hearing. If top rewards rise higher than the mean, surely that can only be because the bosses concerned have managed more successfully - a statement for which the share price can stand proxy.
However, if the salaries outperform the shares, the link is broken. In fact, there’s good reason to suppose that overpaying managers makes it less likely that they will be successful. That seems to contradict the basic principle of incentives, from the shop floor upwards: the more you give, in theory, the more you get. The bald statement, however, ignores the way in which effective incentive schemes work. They work by altering behaviour and, in a well designed scheme, by aligning that behaviour with the needs of the organisation.
Incentive schemes can also skew behaviour in the wrong direction, the most famous example being sales incentives tied to turnover, but not to profit. What you get is a great deal of unprofitable business. What you get from a bad CEO scheme, among other nasties, is a bad strategy for mergers and acquisitions. If the result of selling out, for example, is to generate vast personal profits on completion of the takeover, the bosses, as the golden parachutes unfold, will be encouraged to sell out – and never mind the shareholders’ interest.
The question of post-deal attractions also looms large with agreed mergers. The very wonderful synergies that these are always supposed to deliver also offer pleasant rises in reward for those directors who remain in place after the merger - plus large payoffs for those who lose out in the subsequent battles for power. The encouraged behaviours have everything to do with the personal interests of the senior executives, nothing to do with taking the best course in the interests of the firm.
TAKEOVER BENEFITS
In a straight takeover, however, a paradox appears. The medium and long-term benefits accrue almost entirely to the supposed victims, thanks to the hubris and power drives of the apparent victors. The victims get a nice, fat premium for selling their shares. The CEOs pay above market because of the behaviour created by excessive reward, This encourages their belief that they are high-powered wheeler dealers and reinforces that belief by the benefits in pay, perks and power which flow from making big acquisitions – even though the latter more often than not destroy shareholder value.
You need look no further to explain the otherwise inexplicable fact that, having merged unwisely, the super-bosses don’t even bother to check how well or badly their buys have done.
Accountants KPMG discovered that nine out of ten company directors pronounced their buys a success. The sad reality (sad for the investors, that is) is that only three out of ten acquisitions truly paid off by enhancing shareholder value. I’m not happy about KPMG’s definition of this, since it hinges on outperforming the share price performance of the sector.
But purchasers who should have earned 43% of their targeted synergies just to break even not only mostly missed that target; they just didn’t know that they had failed in this elementary task.
As John Kelley of KPMG says, ‘It suggests that companies may not yet be prepared to make an honest assessment of the success or otherwise of their deals’.
You may safely assume that this dishonesty is not confined to M&A. It extends across the whole range of performance indicators. If doubtful numbers are going to boost management’s personal rewards, they have every incentive to gild the lily - or disguise the poison ivy. This pernicious tendency may be no more heinous than turning a blind eye to the dishonest. After all, you have to trust your finance director, don’t you?
That is essentially the legal defence which the top men at Enron will mount as they fight the accusations against them in court. The argument from ignorance, of course, embodies a negation of responsibility. When Enron was being presented as a model of the 21st century corporation, nobody would have accepted this blather had they known that the chairman and CEO were idly sitting by while the finance director created thick profits out of the thinnest air. Yet those who gave Enron their vigorous support included leading gurus and commentators on management.
SUBJECTIVE ANSWERS
Such opinions pay attention to the published figures for financial performance, taking their accuracy on trust, but are mostly not really shaped by all these supposedly objective facts. The fans are influenced by the aura surrounding the strategies and achievements of the business and by their own equally subjective reaction to its principals - and principles. Basically they are seeking an answer to a deceptively simple question: how good is this company? Once again, the answer comes back to performance and its measures.
The enthusiasts should have acted on what they surely knew - that profits can lie and often do. After all, Enron was a wholesaler of energy supplies. How could it coin money in vastly greater quantities than competing firms? These paid much the same sums for energy and sold at much the same prices. The simple answer is that Enron could work no such miracles. In fraud after fraud, common sense should have revealed at once what later took official investigators years to uncover.
The gurus, one hopes, had no financial incentives to form their favourable but false opinions of Enron and the other massive cheats. But what about the financial advisers? Every one of the failed acquisitions spotted by KPMG was nursed along by an investment bank, which may actually have hawked the deal to the management concerned. Their ethical interests should have led these financial experts to make very sure that the deal was fundamentally sound, and that the management was capable of winning the benefits of synergy and executing a well-constructed plan. The enormous banking fees, however, depended on the success of the bid, not that of the mergers.
The impact of these facts on the behaviour of the financiers is evident from their personal rewards. At one investment bank, last year’s lowest salary (and this includes secretaries) was over $500,000. The bank’s leaders received rewards in the tens of millions. Yet again, the culture of overpayment exerts an understandable but pernicious influence on performance. The bankers might be expected by the innocent to provide checks and balances. Instead they help the leaders of the client company to lead where their followers would prefer not to follow.
‘Leadership’, not management, is the flavour of the times. It is, of course, a crucial component in optimising the effectiveness of organisation. But effectiveness – to which management pundits have devoted their teaching and preaching – may no longer be the Holy Grail of the top manager. The change that I see is a switch to maximisation: and what’s being maximised is personal reward.
This shift in values has been seen coming from along way off. CEOs and their cohorts began paying themselves larger and larger sums year by year long ago. At the start of the Seventies I wrote in The Naked Manager as follows: ‘Most managers are badly paid, not in the sense that they get too little (many get far too much), but because they are paid in the wrong way….Come rain or shine, their dinner pail stays full’
‘Over-full’ is a better word. The severe consequences for management are already clear. Fortune recently listed ten CEOs who are ‘facing Herculean challenges’.
All the companies are former super-heroes: Citigroup in banking; Coca-Cola; Gap in clothing; Merck, once easily the best drug company; Microsoft; Morgan Stanley in investment banking; Nike; Sony; Verizon in communications; and even the mighty Wal-Mart.
Most of the Troubled Ten have inherited their anxieties from predecessors who took their enormous rewards into affluent retirement - leaving fateful errors of omission and commission behind them. The more the misuse of corporate funds for private enrichment becomes the rule, the more the long-term health of business must suffer as successful long-term, all-round management is sacrificed for short-term gain. Look at those mighty names again - and despair!
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