Sunday, January 14, 2007

Are CEOs paid too little?

In the course of my work I have to analyse the remuneration of corporate executives, mainly in the US. In these circles it is taken for granted that CEOs are massively overpaid, and that this is an outrage. Clearly there are many cases where the relation between a CEO's pay package and the company's performance seems to be totally unhinged. Nonetheless I am not totally sold on the idea that pay packages are immoral simply because they are especially large.
Recently, The American - a new business bimonthly published by the AEI - had a cover story which makes quite a contrarian, but well-reasoned, argument on this subject. The subtitle states:
Sure, some CEOs aren’t worth their outrageous compensation, but a bigger problem is that large public companies, in many cases, don’t pay enough. The best and brightest minds are increasingly drawn from running key businesses to other pursuits that may not be as socially useful—but pay much more.
Such an argument is also supported by some academic research. Professor Steven Kaplan, of the Chicago GSB, illustrates some of it in the HLS Corporate Governance Blog:
I was shocked (but encouraged) to read the New York Times yesterday. Instead of writing another article about how CEOs are massively [over]paid, dishonest, or both, Andrew Sorkin and Eric Dash make a strong argument that U.S. CEOs are underpaid! According to the article, private equity firms are increasingly successful in luring talented public company executives to run private equity-funded firms. A big part of the reason is that private equity firms pay those executives more.
Third, despite much that is written, realized CEO pay is strongly related to firm stock performance. In a recent paper, Josh Rauh and I sorted the firms in the ExecuComp database into ten groups based on realized compensation in 2004. We then looked at how the stocks of each group performed relative to their industry. According to the critics, we should not have found much of a correlation. In fact, we found a strong one. Realized compensation is highly related to performance. CEOs in the top decile of realized compensation saw their firms outperform their industries over the previous three years by more than 50%. CEOs in the bottom decile saw their firms underperform by more than 25%. As you go from the lowest-paid to the highest-paid executives, performance always increases.
Fourth, as Xavier Gabaix and Augustin Landier point out, CEO compensation should be tied to firm size. And firm size has increased markedly in the United States over the last thirty years.
It is a fact that top executives of public U.S. companies are paid a lot today, and a lot more than they have been paid in the past. The high pay combined with questionable behavior by some CEOs and boards has led the press and some academics to conclude that average CEO pay is excessive, driven by dishonest, manipulative top executives and ineffective boards.
The discussion and evidence above calls that conclusion into question. One has to wonder how overpaid public company executives are when private equity investors (who do not have an incentive to overpay) will pay them more. And public company boards appear to have been more active in managing CEOs than they are given credit for.
An interesting case in point is the recent firing of Bob Nardelli, the CEO of Home Depot. Kevin Lacroix at the D & O Diary points out:
There is no particular reason why I should bestir myself to defend ousted Home Depot CEO Robert Nardelli: He certainly bagged sufficient swag to soften the blows of even his most outraged attacker. Yet I think it is important to incorporate into the modern morality play that his departure has become a fair recognition that by some measures his tenure as Home Depot’s CEO was successful. From 2000 (when Nardelli joined the company) to 2005, Home Depot’s revenue nearly doubled, from $45.7 billion to $81.5 billion, and during that same period Home Depot’s profit increased, from $2.6 billion to $5.8 billion. Dividends quintupled. The company's return on capital increased almost 20 percent, a full 10 percentage points above its cost of capital.
Further down in the post Kevin points out that some compensation practices at Home Depot were indeed dubious, but, IMHO, those kinds of problems will be addressed quite effectively by the new disclosure rules that have been put in place by the SEC.
Meanwhile, there is a particularly ironic twist to Bob Nardelli's story: it has been touted as a shareholder victory. Why is this ironic? Well, it is a consistent refrain among shareholder activists that remuneration needs to be tied to performance, and that share price appreciation is not an appropriate performance measure because it is influenced by too many other factors for it to be considered the CEO's merit if the share price goes up. Apparently this logic flies out the window as soon as the share price goes down. Kevin spells it out:
Nevertheless, the consensus view seems to be that his ouster is a victory for shareholders, and that they have shareholder activists to thank. A typical example is the January 5, 2007 New York Times article entitled "Gadflies Get Respect and Not Just at Home Depot" (here), which states that "shareholder activists could claim one of their biggest prizes yet when Home Depot announced the resignation of its chairman and chief executive." The article also notes that since July, activists have also successfully pushed out the CEO's at Pfizer and Sovereign Bank.
In touting Nardelli's ouster as a shareholder activist success story, the Times article note that he had long been "a target of shareholder ire for his large compensation and the company’s flagging share price." It is this latter point – Home Depot's flagging share price – that really seems to be at the heart of Nardelli's problems. A January 3, 2007 article entitled "Nardelli's Downfall: It’s All About the Stock" (here) makes the connection explicit. Gretchen Morgen[son] made the same point in her January 4, 2007 New York Times article entitled "A Warning Shot By Investors to Board and Chiefs" (here, subscription required), in which she says that Nardelli's compensation was "completely at odds with the dismal performance of Home Depot stock on his watch."
One question that needs to be asked is how much of what happened to Home Depot's share price had to do with Nardelli and how much it had to do with where the share price was when Nardelli took over. As points out (here), Home Depot's share price was already at stratospheric levels when Nardelli arrived.
But the more troublesome aspect of the criticisms about Home Depot's share price is the clear implication that Nardelli would still have a job (although he would be $210 million poorer) if he had managed to get the share price to go up. It used to be the conventional wisdom that the market determined a company's share price, not the CEO. Moreover, it has not been that long since corporate America faced a series of crises and scandals because too many CEOs seemed to think it was their job to engineer their company's share price rather than to run their company. Corporate activists may be congratulating themselves for their "victory" at Home Depot, but they should be very careful about the lesson here. The danger, as pointed out on the ContrarianEdge blog (here) is that "the ousting of Bob Nardelli sent a wrong message to America's CEOs : it taught them an incorrect lesson – manage the stock, not the company."
So, the truth is that shareholder activists - if they truly believed what they were saying - should be outraged at the wrong message that Nardelli's ouster is sending the market. If this won't encourage "short-termism" and encourage CEOs to focus on share price, instead of the long-term success of their companies, I don't know what will.

1 comment:

ilanit said...

The record-breaking fundraising by several large buyout/growth equity funds (“mega-funds”) over the past couple of years has

led to heightened demand for people to help invest those

funds. Specifically, the increased competitive pressures for top talent pushed compensation higher at the mega-funds and had

a trickle-down effect throughout the industry pushing compensation up at the mid- to larger-sized funds which had to keep

pace if they wanted to retain and attract top talent.