In January, the Economist magazine ran a survey of executive compensation which was quite interesting. I really liked the survey, and if you would like to visit it for background, please click here. The survey presented some really interesting data and provided valuable insight. I applaud the authors for making an attempt to explain a truly complex phenomenon. The Economist recently revisited this survey when discussing proposed legislation that will give shareholders the right to vote on executive compensation (click here for article).

I agree that allowing shareholders to vote may improve, and reign in, a system that has seen executive compensation rise from about 30 times the average employee’s salary in the 1970’s to over 100 times the average employee’s salary today (see chart below). However, I take issue with one assertion that the Economist makes in its discussion of executive compensation. Moreover, I believe that the problems with executive pay are endemic to a market, and institutional, system which has radically changed over the last half century.

First, if you read the Economist articles, they argue that poor performing boards (and poor governance) are not to blame for inflated executive pay because boards are more independent than ever today and executives continue to receive large paydays. However, I believe that the authors are fundamentally confusing cause and effect. While I agree that boards are not solely to blame and that the reasons for the spectacular rise in executive compensation are complex, I do believe that boards are partially to blame - if of nothing else - for being asleep at the wheel. Moreover, some of the recent (last 5-10 years or so) improvement in independence was a direct result of over-inflated pay. We are only now beginning to witness the full response to such bloat.

Activist shareholders have recently made inroads toward making boards more independent with monitoring of the CEO an explicit agenda. Therefore, although it is factually correct that boards are more independent now than ever, this stylized fact is a consequence of bloat in CEO pay. In fact, the requirement to have independent directors serve on the compensation committee is evidence that greater independence is a result of the meteoric rise in executive pay in an effort to reign in such pay (or at least to make it more equitable - i.e., to better correlate pay with performance). And although I believe that allowing shareholders to vote on executive compensation represents an important first step in keeping executive compensation in check, there are more fundamental questions we should be asking.

For example, we need to ask ourselves, "Who are shareholders?" Although seemingly a silly question, the answer has important implications for corporate governance and executive pay.

Historically, shareholders were individual company owners (often dispersed) who held stock for long periods of time. Today, the picture is quite different. Shareholders are represented less and less by individuals holding stocks for the long-term, but by institutions looking to make a quick buck - buying and selling with incredible frequency. The rise of such "traders" (those who seek to profit from near-term volatility in stock prices) has changed the nature of the system. Whether they be institutional or individual, it seems that there is a large class of traders (not investors) today who are looking to profit from the tiniest movement in share price. These traders are inconsistent with the spirit of the view of the shareholder as owner. They are not really "owners", and often do not even necessarily care about the survival of the firm. They only care about micro-movements in share price.

Why does this matter? Well first, let’s not forget about the accounting assumptions about the firm. The standard assumption in accounting is that firms have an infinite lifespan. They are assumed to be around forever. Moreover, in finance we assume that firms should maximize the net present value of all future cash flows. However, there is a fundamental disconnect between some of these assumptions and the state of the world. Although the firm is supposed to be around forever, human beings are not. The average lifespan of the homo sapien is around 70 years. And if you consider the lifespan/tenure of a typical CEO (now less than 4 years), the picture looks even bleaker. This creates a severe incentive problem. If I’m a typical CEO, what incentive do I have to look out for the best long-term interests of my firm? After all, I’ll probably only be around here for a few years. In this sense then, CEO’s have an incentive to increase near-term performance sometimes at the expense of long-term performance. You may argue however that the stock markets should keep these CEO’s in check because the market will penalize CEO’s (and a firm’s share price) for making short-sighted near-term decisions. Unfortunately, the field of behavioral economics has been showing us that market participants are not very good at valuing the long-term consequences (with more than a 5 years horizon) of managerial decisions.

What’s more, owners are not effectively keeping CEO’s in check. In fact, with institutions in control of many shares, the incentives of the institutions align with those of the CEO’s. That is, with institutions looking to make a quick buck, short-termism on the part of the CEO is not only condoned, but sometimes encouraged. This is one additional factor that has led to increased CEO pay - the advent of a short-termism, consume now pay the consequences later, system.

How do we solve these problems? That’s a good question. I have some ideas, as I’m sure do others. But an important first step is to recognize the problem. I will address these issues in future posts; however, one thing is clear - these issues raise concerns about stock options as compensation instruments. In fact, stock options may reward behaviors that we do not want to encourage and thereby increase short-termisism. Instead, we should find a way to tie CEO compensation to some metric that allows us to assess whether the CEO leaves the firm in a better position than s/he found it. Easier said than done. In the meantime, until we solve the dilemma endemic to our current system, an increase in the independence of directors and measures that improve governance are a step in the right direction.    

It is interesting to me that Daimler has now decided that it is open to considering suitors for its Chrysler unit. It’s not so much interesting to me that an acquirer would sell an underperforming target. This happens all the time. Again, most acquisitions fail, so why shouldn’t we expect a parent firm to dispose of an underperforming subunit? Rather, what’s most interesting to me about DaimlerChrysler is that the deal performed as poorly as it did.

If you would have told me on May 8th, 1998 (one day after the merger announcement) that this would be the end result, I certainly would have granted you that it could have been a possibility. However, I would have pegged that possibility at lower than 50%, much lower than 50% …maybe somewhere in the 10-20% range. I thought the combined DaimlerChrysler might have underperformed the individual units had each been left to its own devices – probably a 50% chance of this happening. I even thought that they had a 30-40% chance to make this thing work (creating true synergies and a whole more valuable than the sum of its parts). But I never envisioned total failure.

This deal had a lot going for it. The equity markets liked it. Shares of both companies increased dramatically in the months following the announcement. Moreover, there were some real complementarities between Daimler and Chrysler. Chrysler complemented Daimler on the product side by adding a line of small vehicles, minivans, and SUV’s to Daimler’s traditional up-market saloons. Daimler complemented Chrysler’s geographic reach and vice versa. Daimler had a strong footprint in Europe and Chrysler’s strength lie in the U.S. In addition, Chrysler had a very efficient production organization based on a platform-team structure, while Daimler had high production costs, in part because of its manufacturing base in Germany and its associated labor costs, but also in part because of its single platform per model approach. In that sense then, Chrysler could help Daimler lower its costs to more effectively compete with Japanese marks that had lower production costs like Lexus and Infiniti.

We certainly can’t blame this deal’s failure on Daimler overpaying (the premium Chrysler shareholders received was modest – 26% by most calculations). We can’t even blame this deal’s failure on the absence of synergies necessary to make the deal pay off. What scuttled this deal at the end of the day was the failure to realize those synergies. As a result, this merger stands as an example of one of the poorest integrations in the history of deal making.

I will not go over all the failures of execution here because I believe they have been fairly well covered in the popular press. However, I will acknowledge several issues that made this deal unbelievably complex from an integration perspective. First, this was a large deal. Large deals of this sort are always difficult to integrate due to their inherent complexities and sheer scale. But add on top of that the fact that it was a cross-border deal, and now we’re not only talking about corporate culture that needs to be integrated, but the need to achieve that in a context complicated by national culture. Stories of conflict between Americans at Chrysler and their German counterparts abound. There was also one unique issue of corporate culture in this deal – the marrying up marrying down problem. In this merger, Daimler (as the high status partner) viewed Chrysler not as an equal, but inferior in both quality and image. As a result, Daimler was resistant to any ideas and/or process improvements suggested by its American subunit. For example, Daimler could have saved a substantial amount of money had it moved to a platform-based system and shared platforms with Chrysler. Fearing brand dilution, Daimler decided against it. In addition, Daimler decided that it could not share a significant amount of parts with Chrysler for fear of diluting its brand in the eyes of the consumer. For these reasons (and others related) the merger never achieved the cost savings that might have been realized. Instead, the merger simply added layers of administrative and operating costs from which the deal never recovered. For instance, at the outset, Daimler’s top brass realized that they were underpaid compared to their American counterparts, in part due to the differences in business practices between the U.S. and Germany. Top managers at Chrysler earned in the neighborhood of $160 million per year whereas their counterparts at Daimler earned $16 million per year. Therefore, it was decided that Daimler managers should be “marked-to-market” to earn an amount in line with Chrysler’s management. This added $150 million to costs right off the bat. Not only that, but managing both entities required an extensive amount of travel between the U.S. and Germany. German executives made many trips to the U.S. (not Auburn Hills but New York City) to meet with their counterparts from Chrysler. After incurring large hotel bills in New York, Daimler executives decided to open an office there and acquire some corporate apartments. Again, this added to DaimlerChrysler’s overall costs.

In addition to an increase in costs, the combined entity lost a significant amount of managerial talent in the form of defections to other car makers. Talented managers and engineers (from both the Daimler and Chrysler sides) walked away because they were overwhelmed and/or marginalized. Daimler managers left because they were overwhelmed trying to integrate the two companies while at the same time they were expected to accomplish their day-to-day tasks. This is a classic case of managerial attention diverted away from the activities that they are supposed to be doing – running the business! Many talented Chrysler employees raced for the exits as it became increasingly clear that the deal was not truly a merger of equals but an acquisition of Chrysler by Daimler. As a result, their ideas were not implemented and they felt disenfranchised.

We can analyze this deal six ways to Sunday. Was this deal a merger or an acquisition? Might the integration efforts had gone better had it been billed as an acquisition instead of a merger with Daimler clearly taking the lead from the start? Would the U.S. government have even allowed Chrysler to have been purchased had it been billed as an outright acquisition? We can ask many questions about why the deal failed. We can also generate a bevy of alternatives to have made the merger work. But it’s easy to play Monday morning quarterback once you know the final score. Nevertheless, there are some cautionary tales in here. Was this deal a failure of due diligence? Probably not. In all fairness to Daimler, it’s true that Chrysler’s product line consisted of gas guzzling SUV’s and an ageing Minivan portfolio. Moreover, the sharp increase in gasoline prices from 2003-2006 could scarcely have been predicted. But Daimler knew what it was getting in Chrysler. And even so, real synergies existed. Was this then failure to realize ex ante the costs imposed by culture – both corporate and national? This is part of the story, as explained above. Was this the failure to execute and implement an effective integration plan? Absolutely!

On the face of it, with no prior information, we should expect this merger to fail. The  fact is, most mergers do. Statistics show (depending upon which ones you believe) that somewhere between 50-80% of mergers and acquisitions result in failure. However, there are reasons to believe that the Sirius-XM deal may buck that trend, …provided that the FCC, FTC, and DOJ allow it to go through.

Typically, if firms have not overpaid for acquisitions to begin with, integration costs often swamp the potential synergies that exist. But I believe, for many reasons, that this merger may be different.

First, the best way to achieve consistent profitability is through the creation of a monopoly. Monopolies allow firms control over pricing. This would, more or less, be the case with Sirius-XM. With no other competitor in the satellite radio space, the merger gives them considerably more pricing power than they have currently. Not surprisingly, this will also be the toughest hurdle to overcome in convincing the U.S. government to bless the union. Likely, the position taken by Sirius-XM will be that they do face substantial competition, not in the form of competitors in their existing space, but in the form of substitutes. They face threats from HD radio, traditional radio, iPod connectivity, internet streaming, etc. So this, they will argue, will put a ceiling on their pricing power. However, the nice thing (from the Sirius/XM standpoint) is that they already have a significant install base - something like 14 million customers combined - and most auto manufacturers install satellite radio enabled head units standard. To the extent that auto manufacturers continue to install satellite-enabled radios in new cars, that will insure a steady stream of potential customers over which Sirius-XM will have a fair amount of pricing power. The combined entity will therefore enjoy some level of pricing power through at least one distribution channel - the new car market.

Second, there are some real cost saving opportunities to this merger. The synergies are real and tangible. Not only do the firms have the ability to economize on administrative costs (e.g., why do we need two sets of management to run these firms), but there are some obvious synergies in production (e.g., why do we need two sets of alternative rock stations when one will suffice).

Third, this merger adds consumer willingness to pay. That is to say, it adds value for customers. Exclusivity contracts negotiated by these separate firms locked-in consumers. For example, fans of Major League Baseball were forced to choose XM while fans of Howard Stern only had Sirius as an option. Combining the firms allows fans of both to resolve issues of which service to choose. Should the merger go through, consumers who have chosen to wait for the uncertainty to resolve over which service would become the standard because they did not like having to choose between two options that are second-best (e.g., I want both Howard Stern and MLB, but I won’t choose until things get resolved) will no longer have to agonize over the decision of which service to select. With Sirius and XM merged, it becomes a no-brainer. More consumers will likely opt for satellite radio. Moreover, to the extent that individual employees of the firm (e.g., radio show hosts) can be re-deployed on channels with differing formats, the consumer experience should be enhanced. Rather than firing one of the alternative rock radio show hosts, for example, we may increase the number of channel offerings by re-deploying that employee as a host on a channel of a different genre (e.g., the punk and rockabilly station) thereby adding value to consumers by increasing variety.

Fourth, the equity markets approved. On the day of the announcement, XM’s (the target firm) shares soared by nearly 10% while Sirius’ (the acquiring firm) shares increased by greater than 5%. Traditionally, because an acquisition represents a re-distribution of wealth from the acquiring firm’s shareholders to the target firm’s shareholders, the acquiring firm’s shares decline, often proportionately to the amount by which it dilutes the value of the acquiring firm. However, equity markets acknowledged the presence of synergies and sent the shares of both companies higher. Although the fact that the equity markets liked the deal is no guarantee of success, it is an indicator that bodes well for its prospects.

Granted, even should the U.S. government allow the merger, it will not be easy to put the firms together. Certainly, organizational impediments to the integration will arise. The firms must execute a joint plan and integrate effectively in order to achieve the synergies present. Can the organizational cultures come together? Will employees at XM resent that their smaller, lower-status brethren is taking "control", resulting in conflict that jeopardizes the integration? Will the costs of integrating the back-end software and the front-end radio head units be greater than expected? Is Mel Karmazin the right person to run the combined entity?

Many of these issues need to be resolved in order for this merger to succeed; however, compared with most others I see that don’t make sense on first glance, this one has potential. We shall see…

Welcome to this blog. It was developed to discuss issues related to Business, Corporate, and International Strategy. In this forum I will address the management of individual businesses as well as the management of the multi-business and multi-nation firm.

From a business strategy perspective, this blog will address how firms generate and sustain competitive advantage, market positioning vis-à-vis competitors, and competitive dynamics. Broadly, issues of Corporate Strategy revolve around whether firms should enter a range of businesses, how those businesses
should be entered, how businesses can be synergistically combined
to create value, and how diversified firms can and should be managed. With respect to International strategy, the blog will consider globalization, why firms expand abroad, how firms expand abroad, how managing a
multinational corporation (MNC) differs from managing a domestic
corporation, and how macro economic events in the institutional and political environments impact firms.

Specific topics will include mergers and acquisitions, joint ventures and alliances, corporate governance, executive pay, foreign entry strategies, foreign entry modes, location decisions, and globalization. Of course, I may have missed a few things here and there, so I obviously reserve the right to broaden the scope of the blog to address items that may or may not be listed herein…

In any event, I’ve noticed a dearth of blogs on Strategy topics, and I hope this blog fills that gap. Moreover, I hope you enjoy reading it as much as I do writing it!