On both sides of the Atlantic, there is widespread disquiet about bankers’ bonuses. Of course, this concern is closely tied up with the financial crisis and the belief that were those bankers in just about any other field they would have been allowed to fail rather than propped up by the state. But it is also part of a wider issue that is perhaps more worrying – the exponential growth in executive pay. Moreover, the remuneration of directors of public companies in Britain, America and elsewhere – unlike that of the employees of the companies they run – seems to defy downturns and other setbacks.
Ever since the recession of the early 1990s set in train various inquiries into corporate governance, there has been much hand-wringing over this issue. And little change. Thanks to the business cycle, it falls out of the public eye when good times return – only to reappear (often uglier than ever) when there is another recession.
Roger Martin, dean of the Rotman School of Management at the University of Toronto, is one who has been worrying over this vexing matter for some time. But, unlike many of the others, he has come up with a convincing explanation of how we got into this mess – and a proposal for getting out of it. The potential ramifications for the future of business are substantial.
Martin and his management school have in recent years acquired something of a reputation for promoting a more “human”, “artistic” approach to business. Martin himself has in his previous book espoused introducing “design thinking” to business as a means of fostering greater innovation. And this approach is echoed in his prescriptions for what is to be done. But the diagnosis and analysis contained in the book “Fixing The Game” (published 3 May by Harvard Business Review Press) is as detailed and closely argued as you are likely to find anywhere.
At the root of the problem, says Martin, is the close coupling of executive pay with shareholder value. At face value, this does not look like a problem. As he explains, linking the interests of managers with those of the owners of the business is “a compelling theory that people find it hard to object to”. Especially when such apparently hugely successful managers as General Electric’s Jack Welch and Coca-Cola’s Robert Goizueta were adopting it. The trouble arises because the concentration on maximising shareholder values causes managers’ attention to shift from what Martin calls the “real market” – making better products, serving customers better etc – to the “expectations market” – the business of trading stocks, options and other market instruments that affects the company’s stock price.
Linking these two markets in the way that executive compensation typically does is like confusing a sports team’s actual victory in a match with winning a bet on the outcome. The dangers associated with this confusion of the two markets has led sports regulators to take tough action against players betting on games – Martin includes a detailed explanation of the steps taken by America’s National Football League in the 1960s – but there have not been similar moves in the capital markets. Instead, executives have in realisation of the role it plays in deciding their total pay become better and better at playing the expectations game. In the 1980s, says Martin, CEOs met corporate guidance about 50 per cent of the time. By the mid-1990s, the figure was 70 per cent. And some companies have been repeatedly uncannily good at meeting market expectations.
Nor is that all. Martin maintains that companies rarely surpass expectations by a significant measure because “if a company beats expectations this quarter, the expectations will be that much higher for the next quarter and that much harder to meet”. Conversely, he says companies rarely miss targets by small margins. Instead, if they are going to miss they ensure they do so by a long way in order to reset expectations at a much lower level, “which allows them to perform wonderfully against that low base of expectations”.
Martin sees the origins for this sorry state of affairs in “a seemingly innocuous paper” published in the “Journal of Financial Economics” in 1976 that would go on to become “the single most frequently cited article in business academia”. In “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”, finance professor Michael Jensen and Dean William Meckling of the Simon School of Business at the University of Rochester first defined the “principal-agent problem” and created “agency theory” as a way of solving it. Essentially, the theory argued that in order for executives to be incentivised to do things for the good of the shareholders rather than themselves the single goal of the company should be to maximise the return to shareholders. In other words, the prevailing theory behind what happens today.
Martin suggests that the authors had little idea at the time that this would be the case. Whatever, it did not take long for the theory to be put into practice. In 1970, says Martin, stock-based incentives accounted for less than 1 per cent of CEO remuneration, but after 1976 executive compensation became increasingly stock-based, “so that when executives produced a stock price increase in the expectations market, their compensation rose dramatically”. By way of example he points to Larry Ellison, the head of the software group Oracle who in 2009 was the highest-paid CEO in the United States. Estimates suggest that 97 per cent of his pay came from realised gains on options.
Just a couple of years after Jensen and Meckling introduced their ideas, a further example of “aligned interests” emerged in the world of investment management – and was to have a similarly far-reaching effects. What became known as the 2&20 Formula started when investment manager Theodore Forstmann felt his track record in earning attractive returns for his clients justified charging a higher fee under a new structure. Forstmann Little and Company announced it would keep a 2 per cent fee on assets under management, as was usual, but would also charge investors 20 per cent of the upside generated on their capital. This surcharge became known as “carried interest” or simply “the carry” and soon spread to all forms of non-public investments (ie those not requiring disclosure prospectuses approved by regulators), including venture capital and hedge funds, and helped make many money managers very wealthy. Indeed, Martin says: “The level of wealth creation driven by 2&20 has been nothing short of awe-inspiring”. Although it is often thought that being an entrepreneur like Bill Gates or Sam Walton is the way to riches in the United States, increasingly managing other people’s money is the way to go. Fifty of the richest 400 hundred Americans on the 2010 Forbes list achieved their places thanks to 2&20, “versus 40 for technology, 39 for media, 38 for oil and gas and 28 for retailing,” adds Martin.
So, what is to be done? Martin says there are “five major things we need to do to heal American capitalism, to fix the game and get real again”. First, companies must shift their focus back to the customer and away from shareholder value. In turning attention back to the real market and away from the expectations market, the theory of the firm should place customers at the centre with the focus on delighting them while earning “an acceptable return for shareholders”. Second, stock-based compensation should be eliminated and models for pay should be created that focus executives on “real and meaningful goals, goals that enable those executives to live and work in a balanced, authentic manner”. Third, the issue of corporate governance, particularly the role of boards, needs reappraising. Recent reforms have added responsibilities to boards with no obvious benefit. Fourth, expectations market players – notably hedge funds – need to be regulated and managed more effectively. Of special importance is making it more difficult for hedge funds to damage real markets by encouraging and exploiting the volatility that is “dangerous for us but lucrative for them”.
Finally, business executives need to take a “more expansive and positive view of the role of for-profit companies in society.” This, he suggests, involves companies and individuals “taking the lead on initiatives that mean more than profits”. What he calls the building of the “civil foundation” has a long history – in 1914 Henry Ford doubled hourly wages so that employees could buy the cars they produced, while in 1976 (roundabout the time the theories that Martin holds largely responsible for the lack of balance in our financial system came about) Anita Roddick founded The Body Shop and showed that cosmetics did not have to rely on animal testing.
These are tough challenges. But not insurmountable. The approach currently followed has only been in vogue for a quarter of a century. Things can change again.
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