Alfred Rappaport's important new book, Saving Capitalism From Short-Termism: How to Build Long-Term Value and Take Back Our Financial Future, has a penetrating diagnosis of the disruptive forces in our markets and powerful prescriptions for addressing them. He generously took time to answer my questions.
How does the current structure of incentive compensation at the CEO level affect the obsession with short-term performance? How can it be changed?
Ideally, incentive compensation should motivate executives to maximize long-term shareholder value while avoiding either excessively risky behavior or excessively risk-averse behavior.
Most companies offer CEOs and other senior executives annual incentive plans featuring earnings, revenue, cash flow, and return on investment performance targets. None of these short-term financial measures is reliably linked to long-term value creation. On the contrary, these incentives can encourage reckless risk taking leading to massive value destruction because the long-term consequences of today’s operating and investment decisions are ignored. Executives of major financial institutions demonstrated precisely this type of behavior, with its disastrous consequences, during the housing-price bubble.
At other companies, executives may choose to delay or forgo value-creating investments in order to achieve their bonus targets. These vital investments include research, new product development, brand building, and product and market extensions. By refusing to take reasonable risks, executives boost the company’s short-term results at the expense of its long-term value-creation potential. The bottom line is that annual bonuses fail to achieve any of the three essential objectives of incentive compensation. They do not provide executives with an incentive to maximize long-term value, they can encourage excessively risky behavior, and they can encourage excessively risk-averse behavior.
Multiyear plans employ many of the same performance measures as annual bonuses. Extending the period over which unsuitable targets are measured from one year to three years doesn’t do the job. A company can report three or more years of earnings growth or improving capital-efficiency ratios without creating any value.
Standard stock option plans have limited ability to motivate superior long-term value creation because performance targets are too low (any increase in grant-date stock price) and holding periods are typically too short (3-4 years). One potential solution is an indexed option plan that requires executives to retain a meaningful fraction of the equity they obtain well after the vesting date. Unlike standard options, which have a fixed exercise price, indexed options have an exercise price that rises or falls with an index of the company’s competitors.
For companies that are unable to develop a reasonable peer index, there is an attractive alternative which I call an equity-premium option plan (EPOP). EPOPs require a higher level of threshold performance than standard fixed-price options, but, unlike indexed options, they do not require the construction of an index. Specifically, the exercise price of the option rises by the yield to maturity on the 10-year U.S. Treasury note plus an equity-risk premium minus the dividends that the company pays. Suppose a company’s shares are trading at $50 at the option grant date, the yield on the Treasury note is 2%, and the equity risk premium is estimated at 4%. The exercise price would rise by 6% over the next year to $53. Assuming a dividend of $1 per share the exercise price would be adjusted to $52.
The post-Enron backlash against options encouraged many companies over the past decade to move from stock options to restricted stock. Restricted stock grants vest after an executive has remained with the company for a specified length of time. At the end of the vesting period, executives own the stock and are free to do whatever they want with it. Restricted stock grants are equivalent to options with an exercise price of zero. They are largely guaranteed pay, have no commensurate performance requirement, and are aptly referred to as “pay for pulse.” Stock grants encourage risk-averse executives to play it safe, protect the current share price, and avoid getting fired.
In an effort to blunt the criticism that restricted stock plans are a giveaway, some companies offer performance shares that require executives not only to remain on the payroll, but also to meet performance targets for metrics such as earnings per share, revenue, and return on capital employed. Executives may pursue these short-term targets, which are typically set at undemanding levels, at the expense of the company’s longer-term value-creation potential. Unlike restricted stock grants, performance share plans do demand some performance. Unfortunately, it’s not the right performance.
Companies typically have annual and long-term (most often three-year) incentive plans that reward operating managers for beating financial targets, including revenue, operating income, cash flow, and return on capital. Many companies include nonfinancial targets as well. In most cases these measures are not reliably linked to the cash flows that produce superior long-term value.
One way to set incentive pay for operating unit managers is to reward them for the shareholder value added (SVA) they produce. To add value over time, operating cash inflows must increase at a rate that more than compensates for the investment cash outflows that the business needs in order to grow as well as for the cost of capital.
To ensure that the incentive captures long-term performance, the performance evaluation period should be lengthened to at least a rolling three-year cycle with a provision that allows the program to retain a portion of the incentive payouts to cover possible future underperformance.
A company needs appropriate incentive pay measures at every level to maximize its potential for superior long-term value creation. The final piece of the puzzle is establishing measures that properly guide hands-on decision making by front-line employees. Although sales growth, operating margins, and capital expenditures are useful for tracking value, they are far too broad to provide much day-to-day guidance for middle managers and front-line employees, who need to know what specific actions they need to take to increase value.
Measuring performance using leading indicators of value fills this gap. Leading indicators of value are current accomplishments that have a significant positive impact on the long-term value of the business. These are indicators that the company can measure, that it can easily communicate, and, most important, that employees can meaningfully influence. Examples include customer retention rates, number of new customers, timely opening of new stores or manufacturing facilities, on-time new product launches, employee retention rates, and average cycle time from order date to shipping date. Think of the leading-indicators approach as a system of “management by objectives” tied directly to long-term value creation. Leading indicators look to the long term but demand accountability in the short term.
What about the incentive compensation for fund managers?
By far the most common fee structure pays managers a fixed percentage of the market value of assets under management. But asset-based fees contain an inherent conflict of interest, in that they reward fund managers for focusing on asset gathering often at the expense of long-term performance. Because flows into and out of mutual funds are strongly correlated with recent performance, managers try to avoid underperforming their peers and benchmarks over the short term. This, in turn, can lead to behavior that compromises long-term performance, including herding and closet indexing preferring the safety of delivering short-term results that are acceptably close to the index to the riskier strategy of building portfolios that are meaningfully different from their benchmark. This is not the way to achieve superior long-term returns for shareholders and beneficiaries.
Another problem with asset-based fee structures is that shareholders pay for outperformance, whether or not that outperformance materializes. A fund with a 1.00 percent expense ratio, for example, charges a premium of more than 0.80 relative to index funds, which typically have expense ratios of less than 0.20 percent. Paying investment managers a fee based on the amount of assets that they manage is comparable to paying corporate executives based on the size of the company they run. Neither structure properly considers value creation, and therefore both structures fall short of the pay-for-performance standard.
There is an alternative—long-term performance fees that align managers’ interests with those of the shareholders and attract talented managers who believe that they can deliver superior returns and, as a result, earn superior pay for themselves. If performance fees lead to competition that lowers asset-based fees, actively managed funds will improve their aggregate results relative to their passive benchmark indexes. Price competition aside, we know that if funds used performance-based fees, total expenses would decline purely as a function of the fact that the majority of funds must underperform.
The proper design of performance fees entails a number of important decisions, including choosing an appropriate benchmark index, determining the rewards for outperforming and penalties for underperforming the benchmark, and consideration of the length of the performance period.
Selecting an appropriate time period over which managers calculate the performance fees is critical to the plan’s success. If the measurement period is too short, short-term volatility could overwhelm the fees. Longer measurement periods of rolling 36 to 60 months moderate volatility, lengthen the manager’s investment horizon, and reduce the chance that managers will assume excessive risk in the hope of increasing their short-term compensation. Importantly, managers who have their own money invested alongside their shareholders’ are less likely to drift from their investment mandate.
Incentive compensation is a devilishly complex matter, and getting it right is difficult. It’s always helpful to recognize that investment outcomes and compensation, whether asset-based or performance-based, are a largely unknown blend of skill and luck. It’s hard to get a handle on the relative contribution of skill and luck in a competitive activity like investing, where we must rely largely on outcomes. That different investment styles tend to rotate in outperforming the broader market only compounds this difficulty. Therefore, the success of small-cap managers during a period in which small-cap stocks outperform large-cap stocks is more about style than about skill. Some may question the wisdom of performance fees when there is no objective way to untangle skill from luck. What’s important is that fund managers and shareholders share a more equitable stake in the outcome, no matter what the mix of skill and luck.
How do current financial reporting conventions contribute to the problem?
The principal objective of financial reporting is to supply capital providers and other financial statement users with information that is useful for estimating the magnitude, timing, and riskiness of future cash flows.
As the centerpiece of corporate financial reporting, the income statement falls far short of the accounting profession’s objective of supplying information that is useful for decision making. First, the dollar amounts of revenue and expenses that a company presents in the income statement are an amalgam of observable facts (cash flows) and uncertain estimates (accruals) that suppress information. This commingling produces an incomprehensible bottom line.
The other major impediment to the usefulness of the income statement is the way in which financial statements bundle uncertainty into a single-point accrual estimate. Presenting a single answer for a broad range of possible outcomes creates an illusion of certainty that does not serve investors, companies, or the overall economy well.
To deal with these shortcomings I have developed the Corporate Performance Statement which separates fact-based cash flows from forecast-based accounting accruals. It also sheds light on the dark corners of uncertainty by reporting multiple outcomes rather than just one. More complete and transparent information enables capital markets to produce better price signals for allocating scarce resources to their most productive uses. Also, the better the information they have, the better investors can manage the risks that they face. When well-informed equity investors and creditors are confident that they can manage their risks, they lower the minimum acceptable rate of return on their investments. This lowers the cost of capital and expands the portfolio of projects in which companies can profitably invest. More value-creating investment, in turn, leads to higher growth in the overall economy.