Thursday, August 20, 2009

Why Corporate Short-Termism Won’t Disappear Anytime Soon

Over the weekend I was reading Gretchen Morgenson’s piece in the New York Times regarding executive pay and I had a completely out of character reaction. I am usually mildly outraged by excessive payouts but unfortunately less so than previously. After watching the banks dole out absurd bonuses and golden parachutes after receiving life-saving taxpayer assistance I have become somewhat desensitized to the subject. These days I see it as par for the course when we live in a country in which big companies have literally captured regulators and members of the executive and legislative branches through their power and generous donations.

Given that background, my initial response to the data presented in Morgenson’s article was much stronger than usual. But not in the direction of outrage. Oddly enough, I felt as though I understood the factors that are motivating of CEOs and corporate boards to not adopt the long term focus when it comes to compensation that we all had been hoping for. Let me discuss the article and then I will explain myself more. Specifically, the basis for the article was a study done regarding executive compensation that came to an all too familiar conclusion:

The study was conducted by James F. Reda & Associates, an independent compensation consultant in New York, and it looked at proxy filings issued by almost 200 companies in the first half of 2009. The firm analyzed changes these companies made to their pay plans that take effect this year.

The biggest shock? Instead of seeing a greater reliance on long-term incentive programs, the Reda report found that changes in these companies’ plans made short-term incentive pay a bigger part of the compensation pie. Let me say that again: The plans — despite the calamities that short-term profiteering has visited on our economy — made short-term incentives a bigger component of compensation.

This led the author of the study to say:

“If you were going to encourage long-term thinking and behavior, you would reduce short-term pay, but companies have in fact reduced the long-term programs,” Mr. Reda said. “This is counter to the direction suggested by the United States Treasury, academics and other expert advisers regarding ways to mitigate risk.”

“When I first got in this business in 1987, a typical C.E.O. would have a short-term incentive opportunity of 60 percent of salary, and for the long-term, a good one would get two times salary,” Mr. Reda said. “If you do the math, the salary was equal to about 30 percent of the total compensation package. Today, it’s about 10 percent. So over the last 20 years or so the leverage of these compensation packages has increased dramatically.”

Now, before you go get out your pitchforks and decide to march yourself onto the White House lawn, hear me out. It struck me that we should not be surprised that companies are more focused on the short term now than ever. And it’s not because of greed necessarily. My devil’s advocate argument is that given the uncertainty in the world right now it is exactly what we should expect. I am certainly not condoning focusing only on the short term but I think I can make the case that doing so is actually quite rational.

Put yourself in the shoes of a CEO. What do you see? The government involved in the private sector. Bankruptcies in every industry, especially those tied to the consumer. Companies with too much debt on their balance sheets unable to refinance or pay off maturities. Top lines down 15-20% and bottom lines down a little less, but only because so many people have been let go. Add to that the possibility of massive inflation and the destruction of the dollar and you can quickly see that executives are incentivized to take as much money in the form of current compensation as possible. When people don’t know if their company will be the same in 6 months or even be in existence, can you really fault them for trying to cash out? It may not be right per se. It certainly isn’t good for shareholders or the long term prospects of the company but before you shower these men and women with criticism I suggest that you think long and hard about what you would do.

In order to illustrate my point further I think it makes sense to use a real world example. Let’s take Warren Buffett. Anyone who knows Buffett knows that he thinks a lot of incapable managers get paid an exorbitant amount of money. The heads of the companies and divisions of Berkshire Hathaway (BRK-A) get paid handsomely but not like Blacksone’s (BX) Stephen Schwarzman who raked in over $700M in 2008 while his stock dropped under $5 or Citigroup’s (C) Andrew Hall who is due about $100M even though Citi had to be saved by a huge government infusion. According to this article, the highest paid Berkshire employee was a CFO in Hamburg who made about $787K while Buffett received $175K in compensation and about $315K for personal and home security. That’s a pretty cheap price to pay for one of the best investors who has ever lived, especially considering the compensation packages that executives who ran their companies into the ground received.

However, the reason I am singling out Buffett is not because of Berkshire’s pay policies. It is clear that he has made an enormous fortune as the head of BRK and he doesn’t need to take a huge salary. He is also very secure in the fact that BRK is going to make it through this cycle and has no reason to try to make as much now as possible. That is one of the advantages of having a ton of cash available at all times (at the annual meeting I believe he said that he wouldn’t like to have less than $20B on the balance sheet) and having a diversified compilation of businesses. But what if you didn’t have BRK’s balance sheet and Buffett’s billions? Even worse, what if your business was highly dependent on the US consumer, had a lot of leverage, and you had the same long term fears about inflation and the dollar as Buffett? Specifically, in his op-ed piece today in the New York Times, Buffett indicated his concern about the course our policy leaders have taken:

Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

As a CEO, if your macro view is that inflation is coming and you are not sure if you will be able to raise prices due to a secular decline in consumer spending, my guess is that you would be inclined to take as much money now as possible. At least then you could put it in TIPS or gold and try to secure the best future for your family. I know this sounds dramatic but if you aren’t sure your business will be viable in the new normal, you have all the incentive in the world to take as much cash out now, especially when the government is stimulating the economy enough to give your company a little bit of a respite. I also think this is one reason why you see so much insider selling. Yes, maybe some executives believe their stocks are bound to come back to earth but I bet there are others who just think they have to diversify. Having all of your eggs in a basket that may not make it through the cycle intact is clearly very dangerous.

In conclusion, I don’t know exactly what companies were investigated in the study highlighted in Morgenson’s article. I also have no idea if these companies have changed their packages for 2009 as a result of all the populist rage against excessive compensation (meaning when things got really bad it was already too late to change 2008 pay schedules). But I can imagine the discussions that went on during the depths of the crisis and are still going on in some board rooms. If the conclusion reached by all parties is that if the world is going to be very different in the future, it makes sense to err on the side of certainty in the form current cash flow. If the world is going to hell, you would rather have a bird in your hand than two in the bush. As I said, this does not exonerate any executive who chooses this path over those that are best in the long run for shareholders. But I do think it illustrates the incentives that lead to short-termism. So, my advice is to not be too surprised if we see corporate managers increasingly willing to pay themselves well and maybe even take more risk to capitalize on near term opportunities even though those are both the opposite of what is probably best for shareholders and society as a whole.

(Picture of Warren Buffett courtesy of