In today’s New York Times, an article on the lofty sums some private equity firms are paying to former CEOs seems tosupport the thesis that their compensation is market driven:
Flush with hundreds of billions of dollars, private equity firms are beginning to offer compensation on a previously unimaginable scale to the chief executives who run the once-public companies that the firms have bought out. At the privately held firms, the executives still get salaries and bonuses, but a crucial difference lies in the ownership positions they can secure, which can turn into particularly bountiful riches when these businesses are sold or go public again….
This willingness to pay big money may bolster the argument of defenders of corporate pay practices who have contended that companies have simply been paying the going rate in the market to attract top talent. At the same time, however, private equity may be quicker than a public company to fire an executive if he is not getting results. “There’s also huge risk,” said Mr. Paulin, whose firm advised on some of the richest pay packages for executives at a number of big public companies. “It’s the classic pay-for-performance model.”
Huge risk? Since when? These executives are not at risk of losing money, as their investors are (some may forget that private equity funds once in a while hemmorage money, as did many venture capital firms in the dot-com bust, and even soem storied names, like Clayton, Dubilier & Rice, which lost $500 million on some failed deals).
But journalists are only as good as their sources, and the sources for these CEO comp stories always include the executive pay consultants and the executives themselves, who have every reason to present the pay as warranted because it is the result of “market” forces.
Nothing could be further from the truth, yet the press has seemed unwilling or unable to examine the thesis that fits the facts better (or as the analytically minded woudl say, has better explanatory power), namely, that skyrocketing pay points to a huge agency problem.
In lay terms, the principal-agent problem comes into play whenever we hire someone to do a job on our behalf. The more discretion we give our agent, the more of our resources at his disposal, the greater the exposure we have to the possibility that he may be feathering his nest at our expense.
In a 2003 paper in the Journal of Economic Perspectives, Lucian Bebchuk Professor of Law, Economics and Finance at Harvard Law School and Research Associate of the National Bureau of Economic Research) and Jessie Fried (Professor of Law at the University of California, Berkeley) argue that some aspects of executive compensation are better explained by the “managerial power approach,” which says that “some features of pay arrangements reflect managerial rent-seeking rather than the provision of effective incentives,” than by the “optimal contracting approach,” which assumes that boards design compensation schemes to maximize shareholder value.
Bebchuk and Fried cite a number of obstacles to efforts to limit senior executive “rent collecting.” First, the directors themselves are agents, and subject to their own desire to do well for themselves. Being a director is well paid and prestigeous; since management puts forward a slate of directors for election, rocking the boat is not in their interest. Second, market mechanisms to restrict CEO pay have limited reach. Companies have substantial defenses against takeovers, and golden parachutes protect CEOs from their impact. And Bebchuk’s and Fried’s analysis shows that,”CEOs of firms with stronger takeover protection get pay packages that are both larger and less sensitive to performance.”
The writers also dismiss the idea that arm’s length bargaining takes place when CEO are hired:
Among other things, directors negotiating with an outside CEO candidate know that after the candidate becomes CEO, she will have influence over their renomination to the board and over their compensation and perks. The directors will also wish to have good personal and working relationships with the person who is expected to become the firm’s leader and a fellow board member. And while agreeing to a pay package that favors the outside CEO hire imposes little financial cost on the directors, any breakdown in the hiring negotiations, which might embarrass the directors and in any event force them to reopen the CEO selection process, would
be personally costly to them. Finally, directors’ limited time forces them to rely on information shaped and presented by the company’s human resources staff and compensation consultants, all of whom have incentives to please the incoming CEO.
Another constraint on CEO pay is outrage, the fear that the board will be embarrassed by criticism, precisely the issue that brough down Hank McKinnell and Bob Nardelli. But again, the response isn’t necessarily to keep pay at a reasoanble level:
To avoid or minimize the outrage that results from outsiders’ recognition of rent extraction, managers have a substantial incentive to obscure and try to legitimize—or, more generally, to camouflage—their extraction of rents.
Remember the Grasso case? The board claimed it didn’t understand how much his package was worth. If that isn’t effective camouflage, I don’t know what is.
And of course, we have the compensation consultants:
Compensation consultants have strong incentives to use their discretion to benefit the CEO. Even if the CEO is not formally involved in the selection of the compensation consultant, the consultant is usually hired by the firm’s human resources department, which is subordinate to the CEO. Providing advice that hurts the CEO’s pocketbook is hardly a way to enhance the consultant’s chances of being hired in the future by this firm or, indeed, by any other firms. Moreover, executive pay specialists often work for consulting firms that have other, larger assignments with the hiring company, which further distorts their incentives.
Pay consultants can favor the CEO by providing the compensation data that are most useful for justifying a high level of pay. For example, when firms do well, consultants argue that pay should reflect performance and should be higher than the average in the industry—and certainly higher than that of CEOs who are doing poorly. In contrast, when firms do poorly, the consultants focus not on performance data but rather on peer group pay to argue that CEO compensation should be higher to reflect prevailing industry levels (Gillan, 2001).
After the compensation consultant has collected and presented the “relevant” comparative data, the board generally sets pay equal to or higher than the median CEO pay in the comparison group. Reviewing the reports of compensation committees in 100 large companies, Bizjack, Lemmon and Naveen (2000) report that 96 used peer groups in determining management compensation and that a large majority of firms that use peer groups set compensation at or above the fiftieth percentile of the peer group. The combination of helpful compensation consultants and sympathetic boards is partly responsible for the widely recognized “ratcheting up” of executive salaries (Murphy, 1999, p. 2525)
Why go into such detail? Because none of the factors in the Bebchuk/Fried paper are novel. They are well understood by most people who have a reasonable understanding of how large organizations work, including the journalists that cover them. Yet the myth of “market pay” persists, most likely because the constituency that benefits from it – the executives, boards, consultants, and HR professionals – are better organized and more vocal than their opponents.
And why would private equity firms be willing to overpay CEOs? They suffer from similar agency problems. The partners of the firms themselves receive princely sums. Paying CEOs handsomely makes their compensation (which is a function of the fees they charge their investors) seem less questionable. And the CEO’s salary and options are not paid by the manaagement company (the private equity firm itself) but by the investee company. Even though any equity linked compensation will impact the private equity firm’s upside fee, the effect is marginal. So private equity firms have no strong financial incentive to discipline CEO pay and in some respects benefit from it.