Asymmetrical Information

From the desk of Mindles H. Dreck:

Executive Compensation

The only thing that provokes more drooling from business journalists than an Enron-style scandal is executive compensation. Unfortunately, beyond the usual hysterical moaning about how much private companies paid their executives in bad times or times of bad performance, the press offers little clear thinking about performance-based pay. Beyond the potential riches, few have looked at the intrinsic problems with gross stock appreciation as a measure of executive performance.

There is no reason to think that competitive reality and company performance will magically line up so that compensation fluctuates entirely with performance (however you may define it). Furthermore, few analysts examine the deferral intrinsic in options: the time you realize your gain may not be the time you earned it. Regardless of timing, however, the most important question is: should executive compensation fluctuate because of extrinsic factors like market pricing levels?

The press tends to react with outrage when options are repriced lower. Often this is just a free pass for management, but in this environment, management may just be saying that the market went down, and the CEO is not responsible for a cyclical decline in market valuations. The line the press (and, more importantaly, shareholders) ought to take is that market-based repricing is good - and it ought to happen when the market goes up, too. It's absurd that shareholders should pay executives for happening to serve in a bull market.

A theoretically perfect (stock) performance-based pay scheme would offer payments tied directly to the margin of the company's stock outperformance of similar companies over an extended period of time. If you were to pay a new chief executive of Dell, you would want to pay him based on Dell's outperformance of companies like IBM and Gateway. Factors you would not want included would be the aggregate level of the stock market, the effect of the entire PC sector going up or down as the market looks at the sector's prognosis, etc. Why should our new CEO be paid for the effects of the market, or, for that matter, the price of copper, intel CPUs, Silicon, etc.? These things affect the whole industry, and have nothing to do with his performance as CEO.

Secondly, our new CEO's first year or two would enjoy the momentum of his predecessor. The first few quarters do not reflect as much of his contribution to the franchise value as the second and later years. Similarly, the condition in which he leaves the company will benefit or damage his predecessor.

In practical terms, you could deliver this by offering options based on a portfolio holding a long position in Dell and a short position of equal dollar value in the chosen competing companies. The portfolio only increases in value if the spread between Dell and the other companies increases. The market goes up, the market goes down, the PC sector fluctuates and it doesn't matter. The options vest (or the portfolio bets increase in magnitude) on a schedule that begins in earnest at the end of the new CEO's first year and extends beyond the end of his tenure. Payments commence from the portfolio after a year or two.

I believe this is more workable, more market- neutral and less open to manipulation than EVA-based compensation schemes. Furthermore, it requires no huge payments to intense and prickly consultants who have created fancy new terms for old-fashioned present value analysis, and would like you to overhaul your management information systems to calculate their proprietary performance coefficient. But that's just me.

What it does require is a willingness to use derivatives or maintain a short interest, and these, of course, are verboten, because so many people can't be bothered to understand such things. Besides, it's everybody's business how stockholders pay management, whether you have a stake in the company or not! Seriously, for some reason, a lot of people think this is a public (government regulatory/tax) issue, when it's really between shareholders, directors and management.

I heard on the radio today that New York City has ordered all decorative fountains shut off due to the water shortage. The Four Seasons Restaurant wanted to substitute champagne or wine for water at their own expense, but the city told them that would "send the wrong message". I guess there really are no such things as private transactions or private property if someone in power deems them conspicuous or wasteful.

Oh, and don't give me that crap about foreign CEO's being so willing to work for less. You ain't seen an expense account until you've seen a Japanese or German executive's perks.

Posted by Mindles H. Dreck at April 15, 2002 10:43 PM | Technorati inbound links