How to Fix Corporate Governance and Executive Compensation

Size: px

Start display at page:

Download "How to Fix Corporate Governance and Executive Compensation"

Joanna Andrews
5 years ago
Views:

1 How to Fix Corporate Governance and Executive Compensation Boards of directors need to reconsider their approach to corporate governance. This means measuring corporate performance, allocating capital and, most important of all, writing the chief executive s contract, including pay-for-performance. Unfortunately, each of these tasks is working poorly, often destroying shareholder value. Even more surprising, in almost all cases where corporate governance is failing, bottom-line profits and earnings per share (EPS) growth have been performing remarkably well, even as revenue growth targets are achieved. Yet, relative value, such as the price-to-earnings (P/E) ratio or the market-to-book (M/B) ratio, have collapsed. Markets have spoken. The question is are boards getting the message? What happened and why, and how to fix it is the principal purpose here. In addition, it is important to differentiate that the solution to corporate governance proposed here is very different from the direction taken by most critics of corporate governance practices. Theirs is a laundry list of compliance issues, most of which are simple and are based on common sense. Examples include having only non-executive directors on the audit, finance and nominating committees to achieve independence and objectivity in serving shareholder interests. We refer to the compliance focus as external governance. The real problems, however, are concerned with internal governance, which is independent of the business cycle. It links the role of the board to operations management. It is not a technical issue, one of performing calculations, but rather it is strategic in nature because it focuses on the evaluation of prospective investments relative to the risks inherent in those investments. In short, governance is not simply financial calculations, but as will become clear, it focuses on the kinds of behaviors in which management should engage that makes decisions inside the firm congruent with shareholder and other stakeholder needs. Furthermore, whereas in the past the principal task of the board was to write the chief executive s contract, including variable compensation, in these times the responsibility has been extended to include other members of the management team. What happened is easy to identify, but difficult to comprehend. The problem is that the board s principal performance measure, bottom-line profit, the net earnings, simply is flawed. The accounting framework from which it is calculated is based on a liquidation model of the firm, rather than seeing the firm as a going concern. In practical terms this means almost all investments in intangible assets -- in people, in brands and in research and development -- are immediately expensed on the profit and loss statement, as if they provide no value after the current fiscal year ends. This makes no economic sense. Who would invest in training and developing people if such worthwhile expenditures would have to earn their full returns during the current fiscal year. To assume there is no value from such investments after the end of the current fiscal year is simply wrong. The same is true for building long-term brand value, or investing in research and development. One argument presented by the accounting fraternity is that they would have to make subjective estimates of the value of these intangible investments and use a notion of impairment when writing them down in much the same way that accounting goodwill is recorded and adjusted over time. The accountants are simply missing the point. The corporate governance problem is not about the Page 1

2 valuation of such items as intangibles, but rather about following the trail of cash, so that management can be held accountable in future years for investments made today. Once written off, who will remember the outlays? The same argument can be used for restructuring charges. The accountants write them off immediately, but if these are worthwhile investments, they should be placed on the balance sheet where they belong, again so the board can hold management accountable for earning a return on the investment in the future. Boards must keep in mind the dictum, Out-of-sight, out-of-mind, or What gets measured, gets managed. In short, by writing such investments off immediately, current year profits are understated, and by having the investments not appear on the balance sheet, they are easily forgotten both by management and the board. Such governance is unacceptable. A particularly noteworthy case study was that of Mr. Roberto Goizueta, the late Chairman and Chief Executive of Coca-Cola, an early proponent of these corporate governance suggestions. He said that failing to capitalize intangibles on to the balance sheet where they belong cast great doubt on the measure and significance of profitability. He said, Without the suggested adjustments, management really has no idea how well they are truly performing. He decided to use these suggestions in measuring performance, which he termed Economic Profit. In fact, beginning in the late 1980s his Letter To Shareholders discussed the progress made in improving Economic Profit each year, the problems incurred, and then he presented a simple graph showing the almost perfect correlation between changes in Economic Profit and the price of his firm s shares. The accounting framework possesses a second major shortcoming. It permits shareholder funds, the equity capital, to ride free on the profit and loss statement. Thus, in calculating profit accountants subtract costs from revenues, including the cost of debt capital, which is the interest expense on debt. This is good. However, there is no corresponding cost extracted for equity. The consequences of this omission have been dire. Charge too little for capital, and management will use too much of it. Charge enough for it, and management will be motivated to economize on its use. Although there are numerous other, but less important adjustments, that can be made to the accountants version of profitability and assets, once the aforementioned key adjustments are made, the board and management have a reasonably accurate measure of economic performance for the firm. The board should use this measure to keep score, both for the firm as a whole as well as for units down through the organization, possibly even down to the shop floor. At Stern Stewart, Mr. Goizueta s Economic Profit is called Economic Value Added (EVA ). The specific calculation is shown below as being equal to the amount of Net Assets (NA) multiplied by the spread between the Return on Net Assets (RONA) and an estimate of the firm s required return for risk, also known as the cost of debt and equity capital (C): EVA = NA (RONA C) Page 2

3 The overriding operating goal of a firm, therefore, is to grow EVA, which can be accomplished in three ways: 1 1) Grow the net assets (NA), but only if the return on net assets (RONA) exceeds the hurdle rate, (C) 2) Improve the return on net assets (RONA) on existing capital 3) Harvest losers where RONA is less than C and where there is little possibility for improvement 2 Shareholder value automatically increases whenever EVA improves, and the reverse is also true: when EVA falls, shareholder value falls. One of the most important responsibilities for the board is to convince the dominant price setting investors on the share markets, the Lead Steers, that EVA growth is the principal operating measure for management. If the board can convince the Lead Steers, it is even possible that tomorrow s higher share price can be moved forward to be reflected in today s share price. The reason is that if the board can convince the Lead Steers that future performance will focus on the determinants of value, namely EVA, the Lead Steers will have increased confidence that EVA growth will be much more likely. Thus, the firm will not have to wait for tomorrow s value. This can be appreciated if we examine the principal determinants of a firm s enterprise value. It is equal to its adjusted book value (adjusted for the aforementioned intangibles and the cost of equity capital) plus the present value of the expected future EVAs. This is why the Lead Steers want EVA to grow, because the faster and the greater EVA is delivered, the greater will be the enterprise value. The Lead Steers want the board to encourage investments only in worthwhile projects, where EVA is positive, while increasing the human capital in the firm to support these projects. Furthermore, the Lead Steers are most concerned about the temptation that faces management to grow the firm for its own sake, forgetting about value, which means not focusing on EVA. You might ask, Why would management build the size of the firm, without consideration for creating shareholder value? Unfortunately, the answer is that management s direct remuneration -- wages plus pension -- is directly tied to the size of their responsibility, not the value-add they create. It is much easier to go for size without working the extra effort to create value simultaneously. In short, it is a rational choice on the part of management to go for size 1 Some practitioners have added a fourth way to improve EVA, namely to reduce C, the required return for risk. Since C is the weighted average cost of debt and equity capital, they suggest that the debt-to-equity ratio be increased thereby reducing C, since debt is less expensive than equity. The problem we have with this suggestion is the temptation on the part of management to raise the debt ratio at the very time the return on net assets is falling, for example, because of an economic recession. Nothing could be worse corporate governance than that. Raising the debt ratio as the recession gets underway and then raising it more as the recession gets worse could throw the firm into insolvency. The board should set the long-term average ratio of debt-to-equity that the firm should maintain on average and over time. So, this responsibility should never be placed in the hands of management. 2 Perhaps even more important regarding item number 3 above, is that capital should be harvested when there is greater value for an operating unit in the hands of some other firm. This means that part of the planning process should always consider the alternative to expanding existing units, the calculation of value to somebody else. Page 3

4 rather than value. By size, we are referring to revenues, assets under management or the number of people working in the firm, the headcount. The principal police action protecting shareholder interests in a free market system is an active market for corporate control, which means the threat of unfriendly takeover. This model, however, does not work as efficiently as classical economics would have us believe. The reason is that premiums in takeover attempts normally exceed 25% of the current value. Often premiums are in excess of 50%. This means a good deal of operating inefficiencies can exist in firms even with the threat of unfriendly takeovers. For example, if a firm has a market value of $100 million, a takeover premium of at least $25 million must be paid to gain control, and if the firm s required return for risk, is say, 10%, then $2.5 million of operating inefficiencies are necessary in order to justify paying the 25% premium (10 times the amount of inefficiency). That is, inefficiencies must be great enough to justify at least the takeover premium, which means plenty of inefficiency can exist under that amount. Far more effective in achieving operating efficiencies is the third principal corporate governance function for the board of directors, namely designing incentive contracts that are based on sustainable improvements in value. As mentioned earlier, the first two major tasks for the board regarding corporate governance are getting the measure right and then using the measure to prioritize on all new capital expenditures, including the pricing of potential mergers and acquisitions. In all cases, the priority should be based on the magnitude of EVA to be generated: the larger the amount, the more valuable the project. On mergers and acquisitions, the objective is to set the upper limit price that can be offered beyond which payments destroy value, which means EVA is negative. The board must keep in mind that overpaying on acquisitions means that the acquisition will never be worth while no matter how long it is a part of the firm s asset portfolio. Finally, the third task of designing variable compensation needs to recognize that the Lead Steers focus their attention on expected improvements in EVA. In short, this means that project returns must exceed the cost of both debt and equity capital. This is precisely where governance broke down during the economic crisis, especially amongst financial institutions. Boards of directors were measuring performance on the basis of ROE and on the rate of growth in EPS. Both of these measures increase as long as the rate of return on net assets exceeds only the after-tax borrowing rate. This means that projects can be undertaken, including loans granted, well below the cost of debt and equity capital. The equity cost is simply omitted. It does not enter the decision process. Thus, as competition intensified in the banking industry and profit margins narrowed because of competition and the beginning of the economic meltdown, managements increased the ratio of debt-to-equity simply to maintain the return on equity and the prescribed EPS growth objective. For example, at both Bear Stearns and Lehman Brothers the debt-to-equity ratio rose above 40 to 1. Had the boards known that the cost of equity capital, the required return for shareholders, which includes capital structure risk, is directly proportional to the ratio of debt to equity, they would have realized that the required return on equity had reached and even exceeded 30% after tax. In short, the board would have had an early warning system that both EPS growth and ROE were Page 4

5 being achieved but would likely result in firm failure, bankruptcy and ultimately liquidation. They would not have missed this message if an EVA framework had been used in the corporate governance process. The same occurred at Enron back in the late 1990s when EPS growth and ROE continued to increase until the very end. It is even plausible to believe that the drive for ROE and EPS growth ultimately pushed an honest management team over the line. Again, this would not have been the likely outcome under an EVA framework. The board would have received the message early and continuously that the firm was venturing into very dangerous territory. The Lead Steers want action. Specifically, they want economic action that makes sense and that reinforces managements behaviors that lead to value maximization. This can only be provided if the board of directors ties incentives to sustainable improvements in EVA. Boards need to declare bonuses based on actual EVA improvement, but they must have a set-aside mechanism that only pays out a portion of the current year s declaration, with the remainder held at risk and subject to loss in a bonus bank. Thus, if improvements are followed by deterioration, the bonus bank can be lost. This is what makes employees behave like owners, having real money at risk that can be lost. They do not need share certificates and legal title in order to perform like owners. It is long-term EVA improvement that propels value upwards. It is the failure to deliver sustainable gains that keeps the value of the firm low. If boards need to focus on a ratio when measuring performance, they should focus on the enterprise value divided by EVA or, better still, changes in EVA year on year divided by the beginning of year net assets. Then they will have ratios that mean something to management, to shareholders and to stakeholders at large. In the next issue, we will present a specific solution for incentive design that will show how EVA needs to be driven down at least to middle management and how EVA drivers must ultimately become the measure of success. We will show that based on the latest research middle management is the secret weapon for creating substantial long-term value, because without their interests being made congruent with those of senior management and the shareholders, too much value can be lost because of a high risk of retention. The research on this subject will also be discussed in detail. Furthermore, the role of stock options and restricted shares will be introduced, but in a more systematic manner that focuses on the risks involved in designing compensation systems. The issue of risk in the design of incentives will be presented from a shareholder viewpoint, which means focusing on both risks and rewards for the management team. Page 5

Maximizing the value of the firm is the goal of managing capital structure.

Maximizing the value of the firm is the goal of managing capital structure. Key Concepts and Skills Understand the effect of financial leverage on cash flows and the cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components