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Reputability LLP are pioneers and leaders globally in the field of reputational risk and its root causes, behavioural risk and organisational risk. We help business leaders to find these widespread but hidden risks that regularly cause reputational disasters. We also teach leaders and risk teams about these risks. Here are our thoughts, and the thoughts of our guest bloggers, on some recent stories which have captured our attention. We are always interested to know what you think too.

Friday, 28 March 2014

Big bonuses lead to poorer performance, says new research

Groundbreaking new research, based on the study of hundreds of firms over almost 15 years, has challenged the widely held belief that pay packages including large bonuses translate into better performance and enhanced shareholder returns.

Almost ten years ago, Dan Ariely and colleagues reported some unexpected findings. Big bonuses produced worse performance. As the authors concluded, in their report for the Reserve Bank of Boston, “Our results challenge the assumption that increases in incentives necessarily lead to improvements in Performance”.

Commenting on the findings in 2010, we questioned whether these results, obtained from experiments on poor Indian villagers and broke MIT students, would translate to real life.

New research has answered that question “Yes” at least as regards the most generously paid business leaders.

Researchers Cooper, Gulen and Rau, respectively at the Universities of Utah, Purdue and Cambridge (England) took data on CEO earnings and corporate performance for all NYSE, AMEX and NASDAQ companies from 1994 to 2011. They looked for relationships between pay and performance.

The disparity of company types and sizes meant that some adjustments were needed to make meaningful comparisons, so they measured what I will call generosity of pay after adjusting for the company size and the industry type.

The results are stark. For the top 10% of CEOs by generosity of pay relative to their peers, who typically receive more than 80% of their pay in incentives for performance, CEOs earned negative returns of about 5% over one year and 9% over three years, again relative to their peers. To put values on these percentages, $21million of extra generosity in CEO pay translated into a typical annual loss of $1.4billion in stock market valuation. These CEOs also led their businesses to a fall in Return on Assets.

The researchers dug deep for correlations between different elements of CEO pay and the effect on the stock market valuation. They found that for generously-paid CEOs, incentive pay was closely - and negatively - correlated with stock market valuation and ROA, with stock options being the key predictor. Fixed pay was not found to be a predictor of stock price rises and falls.

The team went on to investigate various theories. They began by identifying “over-confident” CEOs which they defined as those who retained un-exercised but exercisable in-the-money stock options.

There was evidence that CEOs with the most generous pay are typically “overconfident”, at least by this definition, and are more frequently involved in acquisitions than their less confident peers. It is a dismal truth that acquisitions are an exceptionally good incinerator of shareholder value for the acquiring company. As Michael Porter of the Harvard Business School put it years ago:
“The weight of research evidence indicates that the majority of corporately sponsored acquisitions, alliances, new ventures and business re-definitions fail to create value.”
Markets understand this: they react more negatively to mergers announced by highly paid CEOs.

The researchers eventually settled on the suggestion that overconfident CEOs accept large amounts of incentive pay and then try to realise the incentives by embarking on value-destroying activities that reduce future firm performance.

This may well be the case but there are other possible explanations. It is not improbable that many of these ‘overconfident’ CEOs were also dominant. ‘Roads to Ruin’, the Cass Business School report for Airmic and Reputability’s follow-up study ‘Deconstructing failure found that the behaviour of dominant CEOs was a regular cause of severe trouble. An important mechanism, amongst others, is that a dominant CEO’s dominant behaviour can easily make the firm dysfunctional, leaving its leaders unknowingly operating in the dark as regards important information and blind to alternative views that may be better than their own.

The lesson for risk professionals and remuneration committees is however simple. Employing a CEO who demands a very generous pay package can be dangerous to shareholders’ wealth, especially if incentives such as stock options form a large proportion of pay and even more so if he has a history of not exercising exercisable in-the-money options.  Those risks need to be identified and actively managed.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

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