Today, Financial Rounds posted this entertaining cartoon about executive pay (one assumes the target is CEOs of public companies). Notice, however, that the Professor doesn't necessarily advocate the position taken by the cartoon. At the risk of being branded a republican (trust me, I'm not), and though I think the cartoon is actually quite funny, I don't actually see the issue. I cannot for the moment think of a market for talent with more transparency, liquidity, or velocity than the market for CEO of publicly held corporations in the United States. They can bolt at any moment to competition. Foreign firms are always looking to supplement their access to and knowledge of lucrative American markets. Private equity firms are prowling around for anyone who wants to come over to "the Dark Side."
In addition, the United States has substantially boosted the risk, intrusiveness and liability surrounding a decision to take the top jobs through mechanisms as varied as the potential piercing of the corporate veil, increased personal liability (civil and criminal) for the senior executive teams, and a microscopic analysis of the personal lives of candidates, in some cases beyond even that endured by presidential candidates.
One Fortune 1000 CEO quipped to me, "It is to the point where you become convinced that you don't yet know it but you actually are a criminal, and you're just waiting for someone to slap the handcuffs on and tell you. I feel like a character in Terry Gilliam's Brazil or something." We are negotiating with said CEO to quit his burdensome, public job and head up one of our portfolio firms. The negotiations are quite easy, so far.
Of course, many critics of executive pay like to ignore a few
points that put big holes in their arguments. My favorite is the assumption that because stock options
worth, say $10 million, were sold in 2005, that executive's compensation for 2005
should include $10 million in cash. This, of course, ignores the fact
that vesting schedules mean those options were earned over several
years. Prior years with few, if any, vested options are either ignored,
potentially tripling or quadrupling actual annual compensation, or counted also in the year of granting by
Time and Business Week some of the less detail-attentive publications in the media today.
Convenient omissions, these, and omissions generally resulting in leading paragraphs of press releases and articles that sound something like, "In a year when LargeCo's profits are down 18% LargeCo's larger than life CEO Phil Bigwig cashed out $28 million in options." Unsaid is the fact that profits for the firm over the 5 year period he slowly collected those options are up 139% even after counting this year's poor showing. Is it any surprise the AFL-CIO is the worst offender here?
Then there is the whining about backdating of options. From my perspective the issue here is one of disclosure. Backdating options is actually a good tool to use to avoid large cash outlays from the company to compensate executives. Remember also, options themselves align the interests of executives with the firm insofar as stock gains are a prerequisite for options to be valuable. So long as this practice is disclosed, I don't consider it an issue. If it isn't, well it could be a 10b-5 violation. (Securities Fraud).
But most annoying to me, executive pay alarmists seem to be a little short on fact. The Wall Street Journal and Mercer do a rather comprehensive study on executive pay each year. The 2004 results illustrate some quite interesting points.
The most interesting to me is shown in this chart. It is the significant dip from 2001 to 2002 and the tiny gain in 2003 in total direct compensation. Even 2004 has barely recovered from 2001. Can we really believe that risk adjusted returns for CEOs facing Sarbanes Oxley, which could damn them, destroy their career and trash any future earnings potential for the acts of a few rogue subordinates, could show a net gain during the interim before and after SarOx's passage? Don't get me wrong, I like SarOx on many levels, but in conjunction with reduced CEO compensation, it is a disaster.
Not only that, but CEOs in the United States have had the beta of their compensation substantially increased insofar as it has been shifted heavily into contingent bonuses and long-term compensation, which is often tied to stock performance. The odd terrorist event could eliminate massive portions of CEO compensation even if they were the best manager the known universe had yet seen.
The character of the long-term potion itself has changed dramatically as well. In 2004 43% of it is either restricted stock or performance related. Up from 24% in 2002. All having, again, an impact on the risk to CEOs.
So let's review. Longer term, riskier and more contingent compensation. Lower salaries as a portion of total compensation. Substantially increased legal risk, both civil and criminal. Short-term focus on returns by the short-term focused markets. Add to this a private equity sector that, in terms of total investments in 2005, could buy up nearly 10% of the Dow Jones Industrials, and it becomes clear that the market (in this case composed mostly of "smart" institutional money) is increasingly counting on private equity as the more efficient deployment of capital over the highly regulated public markets.
Keep it up, America. Right or wrong, we private equity folks love the massive flood of senior management talent currently being driven our way out of public companies.