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Management Appraisal: Performance should be sustained by appraisal, not incentives

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Chief executives used to be dignified fellows who rarely attracted public criticism and pocketed their substantial (and mushrooming) pay packets with impervious aplomb. Not any more. On the same day in July, Lord Simpson, the CEO of Marconi, and Luc Vandevelde, the head of Marks & Spencer, were roasted right royally by shareholders demanding their heads. Over in the US, Jac Nasser, the CEO of Ford, and Robert Galvin, his vis-a-vis at Motorola, are among many others in the firing line (literally).

In one sense, this is the right and proper reflection of the gigantic pay-packets referred to above. If top managers are made into multi-millionaires by monetary awards from the boards they dominate, they should only expect their ultimate employers, the shareholders, to demand value for money. The worms, anyway, take a long time to turn: it usually takes the sight of large bonuses and options being shelled out after a bad year to get indignation boiling in the investing veins.

But boards very seldom appear to show a similar indignation. Simpson's contract was actually extended for a year despite the catastrophic fall in Marconi's share price. Vandevelde was inanely (or insanely) congratulated for his 'act of leadership' in renouncing an £800,000 bonus (linked to mysterious targets): since he merely exchanged the payment for stock options, it wasn't exactly a noble sacrifice.

DISMISSAL OF CEOS
True, the dismissal of failed or failing CEOs is on the rise. The Economist reported a 40% increase in CEO departures between the first and second halves of 2000. The point had now been reached where the average US CEO only has three years in the job. Martyn Jones, a partner in Deloitte & Touche, regards this tenure as plainly too short, and cites Dutch research into football managers: their frequent replacement apparently did not improve playing results.

If that's true of CEOs, what's the conclusion? That it makes no difference who manages the company at the top? That the disruption of change at the top offsets the benefit of a new broom who might sweep clean (or cleaner)? The two alternatives are contradictory. If the company really runs itself, then frequent changes of top man will be immaterial. So is the organisation self-managed? The answer is by no means obvious. Any company generates a management momentum that has nothing to do with the gyrations at its summit. Simply by doing their jobs, people strongly influence results, even people far down the line. They conform, not only to instructions, but to written and unwritten, spoken and unspoken, rules and codes. That's why ambitious CEOs, boldly driving for change, so often bang their heads against brick walls.

The organisation goes its own way, and the CEO gets left with a sore head, unrealised plans for change and, if he's unlucky with his board and the share price, no job. That last is a personal tragedy, no doubt. But these people, however much wealth they have cost the suffering investors, leave in far from tragic circumstances. Their contracts generate huge payments for loss of office, piled up on top of any option profits that they have previously encashed.

DO INCENTIVES WORK?
The question asked above - do CEOs make any difference to corporate performance? - has an interesting corollary. Does incentive pay have any effect? Motivation consultant John Fisher notes that numerous studies over the years in the US have found virtually no correlation between increasing pay and corporate performance. More specifically, a recent study by management academics drawn from three universities looked at the FTSE 350 companies to see whether 'long-term incentive plans' affected performance - and came up with an astonishing result.

These LTIPs rewarded directors with free shares if they hit specified targets for total return to shareholders (in which the share price is by far the largest component). Companies whose bosses luxuriated in LTIPs increased shareholder returns by 20.71% over the period in question. As for those without LTIPs, the result was 20.74%. In other words, the schemes, costly to administer and a bureaucrat's delight, made not a scintilla of difference.

There's one obvious explanation. Since chief executives play a conspicuous role in fixing the targets, they are not liable to fix objectives that the company is unlikely to meet. The definition of a likely result is one that would be achieved without exceptional performance. So their performance isn't exceptional. That doesn't, however, apply to the rewards. Those top managers without LTIPs or similar rich gifts will no doubt join the party sooner or later, and they, too, will begin to waste their time (from the shareholders' viewpoint) on working out ways to enrich themselves and each other.

It beggared belief to learn of the time that Simpson and his fellows at Marconi spent, while their ship was slowly sinking in the West, on revising the options scheme so that, however low the ship sank, they still had a chance of cashing in Cable & Wireless, another telecommunications company hit by a savage collapse in share price, chose this nadir in its fortunes to propose an incentive scheme with hurdles so low that any remotely competent executive could have vaulted over them blindfold.

The issues go much deeper than greed or morality. If the connection between reward and results is ineffective or worse, top executives are well advised to concentrate less on the business and more on their contract negotiations, and on the bonus, free share and option schemes that accompany the lucrative committee awards. There's a ceiling on the amount by which any management can raise earnings by organic means (as opposed to mergers and acquisitions). The ceiling is set by market conditions, competitor activity and the company's own internal and external constraints. But there's no ceiling to the goodies that the CEO can pull out of the brantub.

TOP HANGERS-ON
Among other defects, that gives men at the top an enormous incentive to hang on to their jobs. With every year that passes, they accumulate more salary, more bonus payments, more options. Once they retire, the brantub will not be replenished. Even the short tenure of failed CEOs, like Doug Ivester at Coca-Cola, leave with incredible fortunes: in his case, as previously reported in Thinking Managers, $84 million. Ivester was only removed so rapidly because two powerful investors, Warren Buffett and Herbert Allen, sat on his board. Otherwise, how long might he have lasted?

How long should CEOs last, anyway? Is three years really so absurd? Back in the days when Litton Industries was the red-hot US conglomerate, and a much cited paragon of management virtue, its top guns, Charles B. Thornton and Roy Ash, used to rotate subordinate managers every three years. The theory expounded by the two ex-Ford whiz-kids was that it took an appointee a year to master the new job: for the next year the person was on top of the job and his firm: then familiarity and routine took over.

Thornton and Ash then moved the incumbent onwards and (if the incumbency had been successful) upwards. As they recounted this policy, a subversive thought struck me. Hadn't they been in their jobs for several times three years? Ah, came the answer, but our jobs are changing all the time. In truth, the duo did outstay their welcome. Ambition over-reached capability, and Litton is ranked as only the 320th largest company in the US - where once it basked amidst the top 50, before its takeover in May. It owes its strength now, as it always did, not to management prowess, but to lucrative defence contracts.

At another, much longer-lost conglomerate, ITT, the same three-year cycle took a different form. In the first year, the new hero salvaged his predecessor's results, and took massive hits as he undid the preceding damage. In the second year the profits duly poured in, and the incumbent glowed in approval. In the third year, he cut every corner in sight to sustain earnings growth, setting the stage for his successor to repeat the cycle.

SUCCESS STORIES
Before deriding this nonsense, mark the resemblance to many chief executive success stories. They similarly knock the previous mismanagement, take the write-offs like a man, and then cash in on the almost inevitable upturn. Their problems arise when the going gets hard. That's when sedate managers start to gamble - like Marconi's Simpson betting the company on a spectacularly ill-timed switch into telecommunications, and engendering a 90% fall in the shares. Yet Lord Weinstock, the creator of the highly profitable, cash-rich GEC (Marconi's predecessor) actually chose Simpson as heir.

Weinstock can't have been unaware of the doubts over Simpson's intellectual capacity. Yet he gave the man unwavering public support - even backing this year's extended contract. Explanations are not easy to find - though one might be that Weinstock himself hung on for too long, staying as chief executive into his 70s, and establishing the legacy (a cash mountain, but a shortage of great new technology enterprises) that drove Simpson to his bet-the-company disaster.

The marvels of these facts are quite clear. First, no leader of any business (unless they are also the proprietor) should be in a position to perpetuate themselves. They should not pick their boards. Second, the boards should take the three-year itch seriously. Every three years, the leader's performance should be reviewed and examined, not against phoney financial criteria, like the performance of the share against their peers in the same industry.

UPWARD APPRAISAL
The comparisons should be of actuals against the operational and strategic targets agreed at the start of the three-year period, as reviewed and revised at yearly intervals. As for the jury, one of Ricardo Semler's iconoclastic ways at the Semco engineering firm in Brazil is certainly worth considering, There, bosses are evaluated by their subordinates. The CEO never has a monopoly of wisdom or knowledge of the business - and subordinates (see above) regularly take the law into their own hands.

I've previously quoted the remarkable experience of Intel's top management when they decided to switch from memories (battered nigh unto death by the Japanese) into microprocessors. It turned out that six out of eight fabricating plants had already switched out of memories because their managers could see no way of earning a profit. The third and final radical suggestion is that a large part of a leader's remuneration should be tied to the successor management's performance. That would force CEOs and others to make better selections and to create better strategies - and would reduce the temptation to hang on to office and to multiply its benefits, not by merit, but by negotiation. Remember, you get what you pay for - and how and why you pay is as important as how much.


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