Arguments about executive pay come in two flavours. Economic liberals wary of government intervention reckon that, in spite of some unforgivable transgressions, the system broadly works. Activists seeking a general overhaul of corporate governance have hitched their campaign to pay and tend to say that violations are rife. On the whole, the public agrees with the activists.
This report has, with reservations, sided with the liberals. Most — but not all — of the money that companies have spent on executive pay has represented the price of attracting and motivating the best managers. This has often been obscured by the politics of pay, and by some sensational abuses. Pay has risen largely because of shifts in the market for executive talent, which are part of a more general transfer of rewards to high achievers in many professions.
The strategic decision in America to motivate managers as capitalists, using equity-based long-term incentives, was right in principle and has been widely copied across the world. Too many options were granted during the bull market, mainly thanks to an excess of euphoria and, in America, a misconceived accounting policy that has since been put right. Investors constantly face the risk that boards will make a bad job of looking after their money and fail to stand up to powerful chief executives, and sometimes boards succumb, but this is less of a danger than it was. Over the past 15 years, the managers attracted and kept in place by fat pay packets have led companies through a roller-coaster ride that has been enormously profitable for their investors.
So much for the analysis. When it comes to prescriptions, however, the activists have the stronger case. Where misgovernance has distorted pay, it should be put right. Even though the over-issuance of options was not an abuse perpetrated by the executives themselves, it was a costly mistake all the same. Boards ought to have realised what they were giving away. In addition, better governance is one way to minimise the egregious examples of excessive pay that attract wide attention and spread the belief that all companies pay their top executives too much. If that helps to restore the poor image of business leaders, so much the better.
Reform could also help to fill a vacuum at the heart of the company, especially in America. The big question in the debate about pay remains today what it was when KKR launched its raid on RJR Nabisco all those years ago. How do you get owners to act as stewards so that boards and managers will act in the best interest of owners? A former editor of The Economist defined the problem in a special report 17 years ago:
To shareholders in a typical company in America or Britain — call it Anglo-Saxon Inc — a share is now little more than a betting slip. It is bought at what a shareholder thinks are good odds, to provide winnings that he hopes will be large. The notion that he owns part of Anglo-Saxon Inc makes as much sense to him as it would for the average gambler to imagine that he owns part of Lucky Lady running in the 2.30 tomorrow afternoon. A title deed to a house tells an American or Briton what he knows instinctively: that he owns the place, and must care for it. A share certificate tells him nothing more than that he has the right to a dividend and the chance to make some cash.
Since those days power has shifted in the boardroom, but the vacuum remains. “We have established the idea that the CEO is accountable to the board,” says Mercer’s David Nadler. “But who are the board accountable to?”
In the 1980s raiders like KKR showed up the shortcomings of companies. Private-equity groups — the raiders of today — still do. Private equity has blossomed since those early times. Whereas 20 years ago a handful of private-equity firms (including KKR) managed $1 billion in assets between them, today 2,700 firms manage $500 billion. Indeed, private equity has attracted so much capital that some think it is in the midst of a bubble.
Learning from Leverage
The explanations put forward for the success of private-equity groups include cheap capital, asset stripping, collusion in chasing deals, “financial engineering” and a leveraged bet on rising stockmarkets. No doubt some of these have played a part, but so has what Richard Holden of MIT’s Sloan School calls “governance arbitrage”. The boards of companies owned by private-equity groups are staffed by knowledgeable and highly motivated directors from the fund who have a lot at stake. Managers and directors are all working towards the same medium-term goal of listing or selling a company that will fetch a good price because it is seen to have a long-term future. The arrangement is relatively free of ambiguities about purpose, and there is less temptation either to chase short-term results or to use the very long term as a sentimental excuse for indulgence.
Central to all this is private equity’s way of attracting first-rate executives and then motivating and monitoring them. Pay in private equity can rival or exceed pay in even the largest listed company, but it is also more geared toward success or failure. A manager in a really successful deal might earn $50m-70m. One consultant cites the example of an executive in Norway who earned ten times as much in private equity as he had been getting in his listed company. With incentives like that, it is no wonder that European private-equity managers have the stomach to restructure businesses which executives of listed companies leave alone.
But to earn such sums, private-equity managers have to bear far more risk than their counterparts in public companies do. Each group has its own formula, but at Sentinel Capital Partners in New York, as at almost all such groups, the partners require their managers to put in their own money as a token of their commitment. Up to 15% of a company’s equity is available for the top managers. They get paid a third of that if they last at the company until the fund sells out. Another third comes their way if the fund earns three times its investment, and the remaining third when it earns five times its investment. In addition, Sentinel’s managers earn a basic salary and a bonus structured to reward profit growth and balance-sheet management.
The firms tend to be ruthlessly pragmatic. If something has gone wrong but they retain faith in the manager, they will review the options package, says Sentinel’s David Lobel. In private equity the idea is not to be “fair” but to get the best out of executives. On the other hand if a venture fails then a manager will suffer along with the fund. “You don’t lose your house,” says one consultant. “But you do lose your summer house.”
Private equity not only pays executives more, it also monitors them more carefully. The boards of the companies it invests in are small, with around six directors, compared with 12 or 13 for a typical listed company in America. Directors bring business expertise and are highly motivated because their careers, as well as their own bonuses, depend upon their investments doing well. Public-company managers often say that directors should keep their distance: the board’s job is to govern, not manage. Not so with private-equity boards. Directors are intensely involved and board meetings are generally far more constructive because of that.
The directors of private-equity boards also try to find out as much as possible about the company’s inner workings. One academic who had previously been in private equity recalls how when he sat on boards his task was quietly to befriend the finance director. It was one way of reducing the private-equity firm’s dependence on the chief executive.
Clearly working for private equity is different from managing a quoted company. Everyone is thinking about the sale of the business; the company is in transition; there is a greater appetite for risk, and probably a greater tendency to rate success in purely financial terms. Yet, at some level, private equity is setting out to attract managerial talent and to give it incentives and monitor its performance, just as public companies do. To that extent, private equity holds lessons for public companies.
Risks and Rewards
One concerns the question of how much risk to load on to executives. Private equity strikes a different trade-off between success and failure from that in most public companies. The rewards for success are greater, but so are the consequences of failure. Public companies assume that the sort of people they want to attract as managers need the security of the basic packages they offer. But private-equity firms have successfully bought, taken private and transformed so many quoted companies that the public markets must be missing an opportunity. In Britain Cable & Wireless, a troubled telecoms company, last year overcame investors’ squeamishness and gave its executives private-equity-like pay packages that could make them extremely rich — but only if the company succeeds. More companies should be willing to experiment in this way.
The experience of private equity also suggests that the managerial-power theorists are on to something. Managers do better when they are held to account. Overmighty chief executives who combine the role with the chairmanship would do better if they had to answer to someone. In America, home of the mightiest executives, this is gradually changing. According to the Conference Board, a business-research organisation, some 57% of American chief executives are also chairman of their company, but the share is falling. Almost half of those who fill both roles are watched over by a “lead director”, a sort of non-executive chairman. American managers are imbued with the notion that to concede to directors is to invite meddling, but Josh Lerner, of Harvard Business School, thinks that private equity demonstrates the benefits of involvement. “Intensive oversight is good for companies,” he says. “In an ideal world we would see boards behave more like private equity.”
Punters and Proprietors
That is hard when the board has been assembled with a nod to tokenism and an eye to the star-quality of its directors, not their business acumen; or when the directors do not have a financial interest in the company. It is also hard when board directors have to spend so much time complying with regulations rather than rolling up their sleeves and discussing the details of the business. A consultant recalls how one board in crisis that he was advising had to have three sets of lawyers at each meeting, one for the managers, one for the directors and one for a board committee.
Martin Lipton, a corporate lawyer based in New York, recently questioned whether “the institution of the corporate board of directors, as we know it today, can survive as the governing institution of the public corporation.” Mr Lipton lamented the burden of compliance and the ubiquity of lawyers, auditors and consultants. But his special scorn was reserved for the shareholders, whom he accused of seizing control of the corporation.
Mr Lipton is probably right about compliance, but the working of private-equity boards suggests that he is wrong about shareholder power. Close links between directors and owners make a board stronger. Yet it is only a mild exaggeration to say that relations between American shareholders and their boards are conducted chiefly through lawsuits and proxy fights. Campaigning shareholders, such as the American Federation of State, County and Municipal Employees, represent organised labour and other “special interests” (meaning anti-business interests as far as companies are concerned). Other fund managers tend not to mount campaigns against management. The suspicion is that they fear companies will punish them — by withholding information from their analysts or even, some allege, steering corporate pension-fund money elsewhere.
Direct contact between independent directors and investors is increasing, but it is still too rare, perhaps because boards are worried about breaking the rule that one group of investors must not receive more information than the rest. Rare, too, are the companies that submit executive pay to a vote or allow shareholders to vote down a director (in most companies, all the No votes are “withheld”, meaning that they do not outweigh a single Yes vote).
Fortunately this is beginning to change as a number of big companies such as Intel and Pfizer have switched to a majority-voting system for directors. Charles Elson, a professor at the University of Delaware, thinks that other companies will eventually follow this lead, which could open the way to votes on the membership of the compensation committee and possibly an advisory vote on pay itself.
This cannot happen soon enough. Shareholders of British companies gained such a vote over pay in 2002. Since a showdown in 2003 over the golden farewell of Jean-Pierre Garnier, chief executive of GlaxoSmithKline, the system has worked well, largely drawing the sting of the pay debate. Objections to executives’ pay are mostly sorted out in negotiations with investors’ groups, such as the Association of British Insurers, well before any confrontation at the annual meeting — though that threat is always there. American managers fear that votes will give activists too much say. More likely, institutional investors will at last begin to play their part.
The hope is that legislation can be avoided. Pay is all about detail and matching the package to the company. “Certain practices are universally inappropriate,” says Dan Ryterband of Frederic W. Cook, a pay consultancy, “but not many.” That makes pay singularly ill-suited to broad laws banning this or mandating that. The best legislation would therefore simply close loopholes and straighten out distortions, such as America’s $1m salary cap and France’s bias towards options, and set out standards of transparency.
Companies everywhere urgently need to take steps to ensure that top executives’ pay is seen as fair and deserved. That means opening it up to scrutiny and giving investors votes, rather than erecting barricades as if to hide some guilty secret. The standing of business itself is at stake.