A friend pointed me in the direction of a recent Financial Times article regarding executive compensation (We are overpaid, say executives, hat tip Mike Barnett). I’m officially blown away! You mean to tell me that there’s a constituency out there that actually admits to being overpaid? I don’t remember the last time I had a conversation amongst friends (or with anyone else for that matter) where the conclusion was that any of us were overpaid. And senior executives admitted to this no less?? Wow! Have I just been struck by lightening?

The article explains:

Most US corporate leaders believe chief executives are overpaid, according to a study. The findings - to be published today by the National Association of Corporate Directors - are likely to strengthen calls…for curbs on executive pay.

Four out of six chief executives or company presidents polled by the NACD in July and August said the compensation of top executives was high, relative to their performance.

Fully 66% of executives think executive compensation is too high? C’mon now, is there really such a thing as a house that’s too big, or too many homes? Is there such a thing as owning a boat that’s too big, or too many boats? And don’t even get me started about airplanes.

To this point I still just couldn’t believe what I was reading.

Only 2.2 per cent of the nearly 70 chief executives and presidents involved in the survey said compensation was too low, while a third deemed it “just right”.

That’s it? Only 2.2% say that executive compensation is too low? I’d like to find those two executives (or one depending upon how many precisely completed the survey) to ask them why they think so. That would be a fun conversation.

There’s also a subtle difference between asking whether “executives” (in general) are getting paid too much or whether “I” (specifically) am getting paid to much. If I had to bet, the farm would be riding on the former.

That said however, I was not surprised by the responses of directors. They nearly uniformly agreed that senior executives are overpaid. This is consistent with conversations that I’ve had with directors at various corporations. The funny thing though is that it is one thing to recognize and/or admit that executives are getting paid too much. It’s quite another to do something about it. And as directors, they’re the ones in the best position to do something about it.

Their views were backed up by outside directors, with more than 80 per cent of them saying chief executives were overpaid.

In all fairness to directors however, it is true that measuring executive performance is no easy task (see my blogs here and here and here). We are probably guilty of having lavished far too many options on executives at a time when we didn’t have a solid understanding of their ex post impact on executive behavior. As the article explains:

Nearly 60 per cent of the directors polled by the NACD said the reason for excessive pay packages was the absence of objective ways to measure an executive’s performance. Nearly half criticised the use of options and equity awards that reward executives when the company’s share price goes up, rather than when its operations improve.

There are some other good nuggets in this article about exorbitant exit pay and widening income gaps in the U.S., so I encourage you all to take a look. Nevertheless, after having read it, I’m left with only a couple of lingering, yet unanswered, questions. Precisely how long ago did executives come to the realization that they are overpaid? And now that they have finally recognized that a problem might exist, where do we go from here?

Floyd Norris of The New York Times wrote an interesting piece about executive compensation the other day (see Maybe It’s Time to Restructure Executive Stock Options). In the article he summarized findings from a recent academic study about variable compensation (e.g., stock options) and risky behavior. The study finds that executives whose compensation relies more heavily on stock options are more prone to take greater, and more often than not, unwarranted, risks. I believe that this finding, in and of itself, is fairly interesting. The article then goes on to discuss implications for restructuring stock option plans to incentivize the kinds of behavior that shareholders want to see from management. Namely, shareholders should be incentivizing long-term performance instead of short-term performance.

I have blogged on several occasions about the difficulty of incentivizing managers to maximize long-term, versus near-term, performance (see here and here). In my opinion this is one of the most difficult problems we face with respect to executive compensation.

In this article, Norris (and the study’s authors) suggests two potential fixes:

1. Grant in-the-money options - The idea behind this alternative is that if managers hold options that are in the money, they already have "skin in the game" and will therefore have an incentive not take inappropriate risks. This is because if the stock price goes down, managers actually stand to lose something.

2. Grant restricted shares instead of options - Likewise, the thinking here goes that if managers hold actual shares, if those shares go down, they are destroying the value of their shares and reducing their own compensation.

There is one not-so-subtle assumption associated with these alternatives. Specifically, these are viable alternatives only to the extent that managers think about, and treat, stock options granted at current market prices differently than restricted shares or in-the-money stock options. Otherwise stated, they must think of options granted at current market prices as found money - money that they didn’t expect to receive that more or less falls into their lap if their bets pay off. By contrast, managers must think (and act) as if restricted shares or in-the-money options were already theirs (which in a way they are). If managers do not think about (and treat in practice) these types of variable compensation mechanisms differently, we should expect no observable change in risk behavior.

I have to say up front that I am generally a fan of restricted shares over stock options. I’m not necessarily opposed to granting in-the-money options either. However, neither of these solutions, in principle, solves the long-term vs. short-term agency problem.

The key lies in how such compensation programs are implemented and the specifics of the restrictions attached to the shares. In general, the longer the term managers must hold their shares/options, the better aligned their interests will be with shareholders. In addition, irrespective of the alternative chosen, we again must be careful not to lavish top brass with too many shares, …or options that are too far in-the-money.

Businessweek recently published a really interesting article about why many merger and acquisition deals fail (see When Big Deals Go Bad - and Why). As I have pointed out on this blog (see here and here and here), it’s not simply about the price paid. Other factors are involved - managerial egos, the involvement of interested parties (e.g., lawyers and bankers), and cultural fit between firms in the integration process.

Businessweek writes:

when…grand thinking is applied to the mergers-and-acquisitions arena, disaster often ensues. Multibillion-dollar deals are based on personal relationships and egos, grandiose plans for so-called transformational changes to an industry, and a sense that the new sum will be far greater than all the previous parts…

In previous posts I focused especially on integration difficulties - i.e., how synergies fail to materialize in the integration process. I still believe that most deals fail in integration. However, Steve Rosenbush (the author of this article) recognizes, and rightly so, that there is a human element to deal-making that can lead to their suboptimal formation in the first place.

This is where behavioral economics comes into play.

What we’ve learned from the burgeoning field of behavioral economics is that managers often do not make entirely “rational” decisions. There are certain heuristics that humans use in decision-making and certain biases that seem hardwired into our psyche. These biases are likely to affect the deals managers enact. For example, managers get caught up in the “emotion” of a deal and can end up overpaying in fear of losing out on the target. After all, acquisitions are exciting transactions. Adrenaline kicks in causing managers to get attached to a deal when it might be better to simply walk away. In addition, for good and bad, managers are not lacking in confidence. Sometimes their (over)confidence leads them to put deals together that don’t quite belong.

We’ve known about these issues for some time, and as the article explains:

M&A tends to go awry when well-run orderly deal machines are thrown off kilter by volatility or emotion…”Psychology is a big part of M&A. It’s not all of it, but it’s a big part,” says veteran banker Hal Ritch…

But my kudos to the author for subtly recognizing one oft-overlooked reason why deals go awry - the participation of certain interested parties.

And, of course, the path for much of the wheeling and dealing is well lubricated by fee-hunting bankers and lawyers…It may not hurt that buyers such as Cisco tend to work on their own, without much outside influence from investment bankers.

So let’s use I-bankers as an example (and nothing against I-bankers, I think they perform a valuable societal good, especially when it comes to underwriting and financing deals). But let’s face it, I-bankers generally get paid on a contingency basis (not too much different than real estate brokers). They don’t get paid unless the deal gets done. It is therefore in the best interest of the I-banker to get the deal done, …even if this means putting together a sub-par deal.

I’ve been meaning to write about the influence of I-bankers on the M&A process in more detail. In fact, the sentiment expressed in the Businessweek article has been echoed by more than a few top managers with whom I’ve spoken. But that will have to wait for another day and another post. In the meantime, the lesson for managers is to be cautious when doing deals, especially if interested third parties are involved. Be careful not to pay too much attention to outside parties whispering “sweet little nothings” into your ears. And of course, enjoy the Businessweek article…