I’ve had an interest in executive compensation for quite some time. I’m not interested in compensation in and of itself, but in compensation as a form of governance. My interest in compensation revolves around how it can align the interests of shareholders and managers, and how boards (as the representatives of shareholders) can become more effective in designing executive compensation packages. I’ve even blogged a bit about it (see here).

I was therefore very interested to read today’s NY Times article about how Michael Jensen (one of the proponents of stock options as a means of aligning the interests of shareholders and managers) has recently revised his stance toward compensation (see Advocate of Paying Chiefs Well Revises Thinking).

The Times writes:

Michael C. Jensen was an early inventor of bigger-than-life compensation packages for corporate chief executives, and nearly 20 years later, he still believes passionately in the concept of “pay for performance” that he championed…But along the way more than a few things went wrong…

One of the problems with executive pay was that boards lavished top brass with too many stock options. This resulted in outsized pay and income inequality. Another problem revolves around severance. There are problems with the severance clauses in employment contracts that compensation committees are willing to agree to when hiring executives. Specifically, boards are faulted for allowing huge severance packages. As a result, top executives cannot be fired, even if for cause, without huge payoffs (see Robert Nardelli). Finally, executives got paid without clearly adding value. There was no real down-side risk for CEO’s. If they performed well they made money and if they performed poorly, they still made money. But it’s a little more complex than that. The article explains:

…most such [executive] contracts fail to take into account the cost of capital [when granting options]…Say the cost of capital is 10 percent and a chief executive holds a bundle of options acquired when a share was worth $100. The share goes to $108, allowing the executive to exercise his options, earning $8 a share. But he has not created any real value, Mr. Jensen argues; he has shortchanged the shareholder, who would have come away with $110 if he had put $100 into a reasonable alternative.

Some of these problems are remediable. For example, if boards were tougher in negotiating with incoming CEO’s, severance packages could be kept in check. Likewise, if we have overshot in granting options in the first place, the most logical thing would be to scale back the number of options we grant. Although we could expect some resistance from executives who have gotten used to current pay levels, it’s not impossible. It might be a little trickier to incorporate cost of capital into option grants. For example, how do you determine the appropriate cost of capital to apply? That’s a difficult thought experiment, but even so, it’s not impossible. Some industry benchmark can surely be found.

My only issue with Jensen’s proposal, and this is raised in part by Jay Lorsch, is that this does not necessarily solve the problem of trying to incentivize long-term performance using short-term metrics (e.g., near-term stock price performance). Again, the standard assumption in accounting is that firms have an infinite lifespan. They are assumed to be around forever. 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. This raises an even more basic problem: What is the right measure of long-term performance to use? And how do we design a compensation package to incentivize it?

Not only that, but means-end linkages are difficult to determine for any kind of performance metric. For example, if we are compensating top managers using stock price, how do we know that a particular action taken by the CEO or the top executives actually resulted in the stock outcome. The performance could have been caused by a wonderful decision made by an employee three or four levels down in the organization (despite the effort of top management). Should we therefore disproportionately reward top managers for something they had very little influence in creating?

Finally, the issue of punishing good managers during bear markets and rewarding good managers during bull markets remains. We need to find some way to reward good managers who end up in a bad situation and vice versa. This is not always so easy to do.

Nevertheless, I encourage all of you to read the NY Times article. It is very interesting. That said however, I believe there are a host of unanswered questions that remain.

I don’t know what it is about business schools these days, but boy have we ever become the object of increasing attention. What’s the matter, are there not enough other things going on in the economy to write about? Have the credit crunch, subprime fallout, and prospects for a recession become passé? Or are we just easy targets?

I’ve written a bit in past blogs (see here and here) about how the relevance of our research has become a topic of considerable debate among academics and non-academics alike. Now, our curriculum has come into question. I would refer you to an interesting article that appeared in today’s Wall Street Journal questioning whether we’ve failed in achieving our larger, societal mission (Business Schools Forgetting Mission?). The journal writes:

B-schools…have lost track of their original mission to produce far-sighted leaders who can help the economy run better…M.B.A. training has deteriorated into a race to steer students into high-paying finance and consulting jobs without caring about the graduates’ broader roles in society…Panoramic, long-term thinking has given way to an almost grotesque obsession with maximizing shareholder value over increasingly brief spans…As a result…getting an advanced degree in business no longer amounts to entry into a full-fledged profession, like law or medicine. It’s just a badge that lets graduates latch onto situations where they can jostle the actual managers of companies and make a lot of money for themselves in the process.

The article goes on to conclude:

In the current environment, many brilliant young M.B.A.s don’t aspire to be corporate chief executive officers, who struggle to uphold their agendas against pressure from all sides. These students would rather be consultants who earn big money fomenting change. Better yet, they want to be the powerful investors who hire and fire CEOs. Until those dynamics change, it will be hard for top business schools to resume their traditional — and vital — role as training grounds for the next generation of corporate leaders.

I think these are important questions to ask. At its essence, the argument is rooted in decades-old questions about whether stakeholder or shareholder maximization models achieve more desirable social outcomes. I would, however, disagree with the assertion that students no longer yearn to be CEO’s. I’ve had no trouble finding students who long for that role. What I have found, however, is a greater desire among students to lead firms that they themselves have founded (whether an investment, consulting, marketing, or some other kind of firm).

Granted, the WSJ article is mainly meant to summarize the views from a book recently authored by Rakesh Khurana of Harvard. Nevertheless, judging by what’s been written about business schools of late, you’d think that we are facing an outright crisis of confidence. Given all the controversy, I’m just wondering what will they come up with next.

I’m often asked about my views on specific acquisitions. Yes, it’s true that most of them fail, or at the very least, under perform. And while it would be easy to categorically dismiss most as ill-timed and/or poorly thought-out, I believe that would be under appreciating their complexity. It’s much easier to be a Monday-morning quarterback and declare that they were a bad idea after the fact.

When it comes to strategic acquisitions (those made by strategic, industry buyers versus private equity buyers), there are several important parts of the process. First, buyers must identify the appropriate target. This is difficult, but seasoned managers generally have a good sense of the firms with which they would like to combine and those that would make the best fit.

After the target is identified the process becomes more complex because now it must be priced. The intrinsic value of the target must be determined, the synergies that could be generated identified, and a purchase price agreed upon. This is not easy, and this process is more art than exact science. But it can be done, and often done with some precision. I-bankers are pretty good at valuing targets - it’s fairly straightforward to look at comps and historical multiples. Moreover, sage managers know their businesses better than anyone and should be able to come up with some idea for the kinds of synergies that likely exist and a price ceiling that they would be willing to pay. Managers sometimes overpay because they get carried away with a deal as emotions get involved, but a rigorous process to determine a firm price above which managers will walk away can help avoid such emotional attachment.

In my opinion however, the most difficult part of the deal is the integration. How can we effectively bring the two companies together to capture the identified synergies? Although much has been written about how difficult integration can be, we still don’t fully appreciate the process. Deals often go wrong not in the identification of the target, the pricing of the deal, or in the identification of synergies, but in achieving those synergies. Often the synergies are real, yet the cost of realizing them swamps the benefits.

It’s no surprise that integration costs often get underestimated. For one, most acquisitions take place under such time pressure that it’s difficult to spend the appropriate time on pricing-out the integration. We tend to spend the majority of our time pricing the deal and pricing-out synergies. Likewise, even when we have carefully considered the integration, given confidentiality concerns surrounding the due diligence process, access to the appropriate people to help price the integration is limited. Although top managers negotiate the deals, the effectiveness of an integration is determined by the operational, day-to-day managers. These folks often don’t get included into the acquisition process until the deal has already been announced. Finally, we fail to appreciate the human element of the integration process - the resistance to change that is likely to be encountered along the way, and how the process can be deliberately undermined.

Once you put it all together, it’s no wonder that so many of these deals fail. And it’s not solely about integration (although that’s a big part). The real issue is that there are so many places along the way that it can potentially go wrong. First, the target might not be appropriately identified. Second, the intrinsic value calculations might be off, the pricing component might be off, and/or the synergies could be overestimated. Finally of course, the integration costs could be underestimated. But the interesting thing about the whole process is that the mistakes made in one part of the process don’t generally tend to offset the mistakes made in others. Rather, mistakes get amplified along the way. For example, an overly-optimistic intrinsic value might lead to a higher than expected price that an acquirer is willing to pay. Likewise, if the synergies are overestimated, the price an acquirer is willing to pay will mistakenly be pegged. Finally, if synergies are overestimated, this might lead to greater integration costs that the acquirer is willing to tolerate.

All of these things make strategic acquisitions risky, not to mention incredibly difficult to pull off. And true enough, somewhere between 50-85% of them fail. But to underestimate their complexity would be to under appreciate their creativity and the challenges facing managers. Good thing that they’re the ones compensated to take such risks.

There was an interesting article that I caught on marketwatch yesterday about how Moody’s expects corporate defaults to double in the next year to 4% (see article here). This more or less expresses the sentiment from my previous blog (see here), and is consistent with what I’ve been writing over the past few months.

Alistair Barr (from marketwatch) writes:

Few companies have struggled to repay debt in recent
years, mainly because booming credit markets allowed weak businesses to
get rescue financing to avoid bankruptcy. However, this summer’s credit
crunch has changed all that, Moody’s said.

“Going forward … many
more weak companies will be unable to obtain new financing and will
default either when debt maturities come due or when they run out of
cash,” the agency said.

As I’ve mentioned previously, the next leg down should be increased bankruptcy activity as firms that
were saddled with too much debt become unable to service that debt and unable to refinance. The intensity of this effect depends critically upon the slowdown of the U.S. economy and the severity of the credit crunch.

There was an interesting article that I caught on marketwatch yesterday about how Moody’s expects corporate defaults to double in the next year to 4% (see article here). This more or less expresses the sentiment from my previous blog (see here), and is consistent with what I’ve been writing over the past few months.

Alistair Barr (from marketwatch) writes:

Few companies have struggled to repay debt in recent years, mainly because booming credit markets allowed weak businesses to get rescue financing to avoid bankruptcy. However, this summer’s credit crunch has changed all that, Moody’s said.

“Going forward … many more weak companies will be unable to obtain new financing and will default either when debt maturities come due or when they run out of cash,” the agency said.

As I’ve mentioned previously, the next leg down should be increased bankruptcy activity as firms that
were saddled with too much debt become unable to service that debt and unable to refinance. The intensity of this effect depends critically upon the slowdown of the U.S. economy and the severity of the credit crunch.

I have been blogging for several months now about how money has been too cheap and how ill-advised acquisitions (by both private equity and strategic buyers) have been fueled by such cheap money (see here and here and here). Therefore, I was not surprised to see a recent article in the Wall Street Joural entitled “Deal Boom Fizzles as Cheap Credit Fades” summarizing the current state of the market for acquisitions.

The article is well written and pretty accurately captures what happened…

The global mergers-and-acquisition boom that began in 2003, the greatest deal frenzy in history, is winding down…within weeks, the market began to run out of steam. In August, there were about $222 billion worth of deals around the globe…the lowest monthly total since July 2005, and a far cry from the $695 billion figure struck in April and the $579 billion in July.

What fueled it [the M&A boom] was cheaply priced credit — bank loans and high-yield bonds were readily available. The biggest beneficiaries were private-equity funds, which took advantage of low interest rates and lax terms from lenders to make acquisitions more cheaply and with lower risks than corporations could. In 2000, leveraged buyouts accounted for only $14 of every $100 spent on deals in the U.S. This year, through July, they accounted for $37 of every $100. Earlier this year, investors were suggesting huge companies such as Home Depot Inc., then worth about $100 billion, as candidates for leveraged buyouts.

While I would encourage everyone to take a read of this interesting article, for those of you who have been following the markets (as I suspect many have), the content should strike you as patently obvious. Many have argued that credit was too cheap for too long - and not simply in the acquisition market - but across myriad credit markets, especially housing. This is nothing new.

Moreover, the article is retrospective. It simply recounts recent events. It does not provide any insight into what we can expect given such stylized facts.

So, what should we expect next?

Of course, we should expect deal flow to slow. We simply cannot continue the breakneck rate of the past few years. However, as I’ve also alluded to in previous posts, the next leg down should be increased bankruptcy activity as firms that were saddled with too much debt become unable to service that debt (not unlike many homeowners). Acquiring firms (whether private equity firms or strategic buyers) had been borrowing at between 5 and 7 times earnings (on average) over the last few years and burdening firms with that debt. Historically, such borrowing has taken place at around 4 times earnings. As a result of cheap and abundant credit, the default rate has been running around 1.4% over the past few years, an artificially low level, and well above their long-term average of 3%. Therefore, look for default rates to converge to, and in the near-term exceed, their long-run averages.

We’ve heard so much recently about how Jeremy Grantham has predicted that 50% of hedge funds will fail in the next few years (see here). I’d also venture that as a result of assembling portfolios of firms with excessive debt, some private equity firms won’t be far behind. And while 50% of private equity firms failing would clearly be a stretch, I would be shocked if it were only a handful.

Depending upon the severity of the slowdown of the U.S. economy, this scenario may end up slightly better, or potentially, a whole heck of a lot worse. I’m hoping for the former.

Months ago I commented about the relevance of academic research to practicing managers (see post here). This has been a topic of considerable interest among scholars over the past few years. It is now apparently of interest to members of the popular press. The Economist raises some interesting questions about the relevance of our research in an article that appears in the latest issue (Practically Irrelevant?). It certainly is worth a read.

To summarize some main points, they write:

LIKE other academic institutions, business schools are judged by the quality of the research carried out by their faculties. At the same time they mean to equip their students for the real world, however that is defined. Whether academic research actually produces anything that is useful to the practice of business, or even whether it is its job to do so, are questions that can provoke vigorous arguments on campus…

One of the main complaints is that the research is inaccessible to managers:

A paper in a 2006 issue of Strategy & Leadership commented that “research is not designed with managers’ needs in mind, nor is it communicated in the journals they read…For the most part it has become a self-referential closed system [irrelevant to] corporate performance.”

These are fair criticisms of the field and they are important issues to consider. However, the article goes on to make the following point:

The argument most often used by defenders of the traditional approach is that research tends to be “translated” into the business world, either by consultants or by teaching in MBA and non-degree executive programmes. But Kai Peters, the chief executive officer of Ashridge Business School in Britain, believes this argument doesn’t stack up. He says that research rarely surfaces in the classroom. Most professors, he says, teach standard practice—from a generic marketing book, for example—while spending their research time on something esoteric. “So how is it filtering into schools’ programmes?” he asks. “By osmosis?”

With this last point I must strongly disagree. I believe that we, as professors, do play an important role in bringing current research into the classroom. It is up to us to expose students to state-of-the art research, to discuss the important questions of the field, to synthesize the existing findings, to explain those findings in an accessible way, to impart received wisdom, to identify remaining gaps and unanswered questions, and to honestly acknowledge the shortcomings of our work. If we can do all these things, we (and our students) gain a better appreciation for the complexities of the real world. In fact, I believe so strongly in this charge that I feel that if we are not bringing research into the classroom, then we are failing our students. We owe them the best education possible, and it doesn’t mean spoon-feeding them “the answers”, but rather, engaging them in intellectually stimulating discourse and debate so that they can come to their own (informed) conclusions.

As I mentioned in my earlier post, I absolutely believe that research ought to be rigorous. I also believe that business schools, and the research that comes out of them, ought to be relevant too managers. However, I think it’s too early to conclude that we are failing in our goals to be relevant.

Take a read of the Economist article and see what you think. I’d be interested to hear your opinion.