The Fragile Notion of Shareholder Value

Once upon a time when Capitalism was in full bloom corporations cared about their investors, and deferred to their shareholders as the owners of the enterprises.  At least that is the way it is supposed to work.  Now, the best shareholders can manage is to catch a quick gleam from an executive’s eye, a wave of the hand, and some trite catch phrases about promoting “Shareholder Value.”   Unfortunately, what we’ve been looking at in this wondrous age of deregulation and dogma is a portrait of Capitalism under attack from the very people who purport to espouse it uxoriously.

If pleasing the shareholders were a prime consideration, then it would be self-evident that every dime that goes into executive compensation is ten cents out of the pockets of the people expecting dividend checks.  For example, some of this nation’s largest banks had a rough 2011, Goldman Sachs reported a decline of 67& in profits from 2010.  Morgan Stanley dropped 40%  But what happened while shareholders were getting bashed? The executives were merely getting bruised.

“Despite the difficult environment, New York firms paid roughly $20 billion in year-end cash compensation to their employees. The average bonus was $121,150, down just 13 percent from the year before as the head count shrank. In 2006, the year before the financial crisis, the average investment bank employee took home a bonus of $191,360.”  [NYT]

These figures don’t include non-cash compensation.   If a person is thinking that restricted stock options don’t affect shareholders — please, do think again.  There are at least two problems with stock option compensation.

The first problem is the dilution of shares.  WatsonWyatt defines this: “As options are exercised, the shares are issued and counted as outstanding. More shares at the same level of earnings mean lower earnings per share, thus the “dilution” effect.”   Lovely, just what I want to hear from my broker, my per share value is diluted by the guys and gals at the top.

A second issue encompasses the ramifications when a corporation decides to compensate executives at the expense of the shareholders instead of “the corporation.”  One primary concern is that the executives, hoping beyond hope that the price of shares will be vastly higher than when the options were awarded, will leverage (pile up debt) to the gunwales and when the ship starts to sink as happens often in business cycles, it’s the creditors, the ordinary investors, and the employees who take the biggest hits. [Tavakoli]

Another concern is predicated upon a very human weakness — i.e. Whatever Can Be Manipulated Will Be Manipulated.  With stock options came backdating.   The concept was simplicity itself: If the stock option was for a $20 per share price — why not back-date it to when the share price was $10? and — badda boom! — cash in.  This practice was usually perfectly legal, falling neatly into the Lawful But Awful category of human activities.  [NYT] What was NOT legal was failing to tell the shareholders how all of this pen-pushing was going to work when the investors approved compensation packages.  It wasn’t until FASB required stock options to be expensed that the practice and the surrounding furor died down.   Those Sarbanes-Oxley haters of “onerous regulatory burdens” should also note that back-dating is no longer an issue because under the terms of that statute all stock option issuances have to be reported within two days.

However, the manipulation of corporate assets and revenues is still an issue so long as such short-term executive compensation tricks of the trade, like stock option grants, are a significant part of executive management pay packages.  So, last month Goldman Sachs awarded $7 million in stock option grants to two top executives, [NYT] and last year several executives waltzed out of their corner offices with significant amounts of compensation.   Burger King’s profits might be down 13% but CEO John Chidsey left with $49.9 million for his services.  [WSJ] Carol Bartz, fired as CEO of Yahoo, parted with a tidy $23.1 million severance package. [NYT]

This is not to say that the whinging and whining about declining bonus pools has abated all that much, it hasn’t.  However, that is probably as it should be. If revenues are down, then the bonus pools should obviously decline.  Shareholders should watch for new gimmicks like the convertible bond.  Let’s say that an executive’s compensation is $1 million, with $500,000 in cash and instead of stock options the exec is given a bond paying about 8% to make up the remaining $500,000.  [DealBook video] Stock options, convertible bonds, whatever … this is still money that isn’t headed toward shareholder dividend checks or employees paychecks, or for that matter, being reinvested in the company.

Is asking about the level of executive compensation a matter of miserly shareholders, creditors, and employees not wishing to part with pennies, or is there a correlation between executive compensation and corporate performance? [HBR]

There is, but it’s not the one the executives want to hear.  A Purdue/Utah University study released in December 2009 reported (pdf):

“We find evidence that industry and size adjusted CEO pay is negatively related to future shareholder wealth changes for periods up to five years after sorting on pay. For example, firms that pay their CEOs in the top ten percent of pay earn negative abnormal returns over the next five years of approximately -13%. The effect is stronger for CEOs who receive higher incentive pay relative to their peers. Our results are consistent with high-pay induced CEO overconfidence and investor overreaction towards firms with high paid CEOs.”

Bloomberg News reported similar results:

Although there is no standard method for analyzing compensation, Crystal, 76, developed the formulas he uses over the course of 30 years advising companies such as CBS (CBS), Coca-Cola (KO), and American Express (AXP) on their pay practices. In an ideal world, Crystal and many investors agree, stock performance and CEO pay would be closely aligned. But no matter how he parsed the numbers, Crystal discovered no relationship between shareholder returns and CEO compensation. “

A quick observation about causation and correlation is required.  Some studies of specific industries, public utilities where executive compensation is usually lower, or a small study of local banks, do indicate a correlation between compensation and a corporations general performance. [Bentham] [Alabama] Nor should we overlook the short tenure of some executives, or the differences in the types of businesses in which they function.  What we can conclude with some certainty is that there doesn’t appear to be a direct correlation between executive compensation and share value over time, and there definitely isn’t an causal relationship that can be documented which would include all types of corporations in all manner of commercial pursuits.

Another factor which deserves more study is the relationship between investors and executives in terms of compensation. Are potential investors “turned off” by companies with lavish executive compensation packages?  Would there be more “buy orders” and hence higher share values if the compensation packages were not so extravagant?

There are resources for investors who want to evaluate the performance of CEOs in regard to share prices.  And, there is hope on the horizon that corporations will be more transparent on the subject:

“There have been many new laws passed to help satisfy investor concerns over executive compensation. Changes in SEC reporting requirements have forced companies to include an “Executive Compensation Discussion & Analysis” section to accompany all future pay documentation in all SEC forms. This section requires a “readable” explanation of how the compensation was determined and what it encompasses.” [Investopedia]

It isn’t all that comforting to find that many corporations weren’t fully reporting compensation to the SEC, or weren’t putting it in readable form.  However, there have been some improvements and for these we probably ought to be grateful if not exactly thrilled.

Executive compensation is one facet of the more general issue of shareholder control. Spokespersons representing the management side often argue that shareholders should not exercise control because  (1) they may be misinformed, (2) they may have “agendas,” or (3) they lack the technical expertise to make informed decisions.  An interesting, if highly technical study, published by economists from Northwestern University and the University of Chicago came to some intriguing conclusions: (pdf)

• “Shareholders should always control decisions about which they have no private information.
• Shareholders should not control some decisions about which they have private information.
• Misinformed shareholders should control some decisions.
• Shareholders with social/political/environmental agendas should control some decisions.”

While the bullet points may be confusing, what is clear is that the standard talking points from the executive offices do not mesh neatly with the realities of corporate management.

If publicly traded companies are fraught with issues of executive compensation, and more general questions about management/shareholder powers, are we better off with having private equity firms take over major companies?   Depends.  Should we simply invest in the hedge funds and let them buyout companies? Probably not.  A study from the University of Chicago (pdf) underwritten by conservative foundations ended by saying:

“Finally, what will happen to funds and transactions completed in the recent private equity boom of 2005 to mid-2007? It seems plausible that the ultimate returns to private equity funds raised during these years will prove disappointing because firms are unlikely to be able to exit the deals from this period at valuations as high as the private equity firms paid to buy the firms. It is also plausible that some of the transactions undertaken during the boom were less driven by the potential of operating and governance improvements, and more driven by the availability of debt financing, which also implies that the returns on these deals will be disappointing.”

One way to translate this would be to say — don’t get your hopes up because the deals may have been the result of market timing and cheap money.  Or even more simply — the hedge funds and private equity firms borrowed too much money to buy companies at prices that were too high.  A recipe for disappointing returns if there ever was one.

As more and more money from the 1%’ers flows into the accounts of private equity firms and hedge funds, what are we likely to see in terms of value for investors?  Again, there’s a mixed picture.  These are not for the faint of heart, as this description explains:

Determining whether this asset class is appropriate for clients begins with a clear understanding of these funds. The word “hedge” might invoke images of investors prudently covering their bets.  But hedge funds can be highly risky and super-volatile. In fact, dozens of hedge funds have suffered serious losses, shut down or filed for bankruptcy in recent years.  Being relatively unconstrained by SEC regulations that apply to mutual funds, hedge fund managers can and do use leverage, take short positions and invest in derivatives. Overall, hedge fund managers employ an estimated 15 to 20 different types of strategy, which Hedge Fund Research, the largest industry data tracker, groups into four broad categories, [...]  For their vaunted expertise, hedge fund managers typically charge high fees, which industry critics cite as a value detractor.  The industry average is the so-called “two and 20,” 2% of AUM and 20% of the profits. In practice, management fees range from 1% to 3% and performance fees can be as high as 40% of the fund’s upside. [Securities America FA]

Right off the bat the investor should know that the “strategy” is proprietary information some of which may or may not be imparted, mostly may not.  So, for 2/20 or 3/40 the hedge fund management will take your money, invest it in something, with some mathematical (or not) formula for trading and portfolio management, using money you can’t get back for a specified period of time,  and then may or may not give you a satisfying result, or might give you what you could have gotten by putting the money in Treasury paper.  We can all hope that the investments by major players like pension funds with plenty of good old fashioned clout will make hedge fund managers more cooperative in terms of reduced fees and shorter “lock up” periods.

What would NOT be helpful for Capitalist America is to have more money flowing into more private hands with a paucity of transparency, less accountability, and practically no oversight. It is, indeed, an invitation to manufacture more  “creative” products cranked out for sale in the financial markets with esoteric alphabetic nomenclature and fizzling results.   We tried this — it didn’t work so well, as we found out to our horror in 2007-08.

Shareholders, the backbone of American Capitalism, have every right to expect to invest in a financial market that is as transparent as possible — after all isn’t the cornerstone of pricing the notion that both sides in a transaction have as much information as possible?  Investors also have the right to expect management to make decisions which improve the company’s revenue, promote growth, and insure that the company can pay off its debts — if a firm can’t do this it’s not worth the time it takes to put the prospectus in the shredder.  In order for these to be accomplished we need:
  • Laws and regulations which require full and complete corporate information regarding financing and operations, which is in readable and comprehensible form.
  • Enhanced shareholder control of corporate decisions.
  • Executive compensation which is adequately monitored and terms which include claw-back provisions to recoup losses resulting from poor management.
  • Increased oversight of private equity and hedge fund transactions to protect investors from outrageous fee structures and incompetent fund management.
  • Improved transparency from private equity and hedge firms when handling pension funds and other public investments.

Then we can talk about “shareholder value.”

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