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Using Executive Compensation to Chase Stars

 November 14, 2012 11:52 AM

(By Robert Salomon) I recently read an article at the Baseline Scenario about CEO stars, CEO compensation, and firm performance (see One Hit Wonder). It is no secret that compensation packages for CEO's are often quite lucrative. However, there is a common belief that CEO's, as "star" executives, merit such compensation packages because they possess inalienable management skills that create value for shareholders. Moreover, the belief is that the managerial skills that "star" executives possess are transferable from one organization to another. For this reason, companies poaching CEO's from one organization to another often lavish that individual with sweetheart deals. Such an outcome is rational if we believe that executive (CEO) compensation is the natural result of a competitive market for "talent," and that the CEO will bring his or her talents to the new company, thereby increasing shareholder value.

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However, James Kwak of the Baseline Scenario points out that there might not be such a tight coupling between pay and performance when star executives move from one company to another. According to a review of the academic literature on the topic by Charles Elson and Craig Ferrere (as summarized by Kwak),

Elson and Ferrere cite multiple empirical studies finding no relationship between a CEO's performance at one company and his performance at the next company that massively overpaid to hire him. They conclude: "the empirical evidence suggests a negative expected benefit from going outside rather than pursuing an internal succession strategy, despite the ability to access an enhanced talent pool. In the aggregate, CEOs appear to be at their most effective only when they have made significant investments in firm-specific human capital."

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The argument is that "star" CEO's lured from one company to another – i.e., the ones that everyone believes will succeed because they have succeeded in the past – don't create value for the hiring company. Rather, it is likely that they appropriate most of the value that they generate by commanding higher pay packages than what should have been granted them. It is also quite possible that their "inalienable" management talent is not as "inalienable" as many believe. Otherwise stated, they are not as good as their pay suggests.

Although not in the context of CEO's, Boris Groysberg (of Harvard) has a similar study of star analysts (see Chasing Stars: The Myth of Talent and the Portability of Performance). Like the CEO study, he finds that when star analysts move from one company to another, they usually under-perform  and are overpaid for the privilege. They appropriate more value than they bring to the new company. In essence, they are likely not as good as most believe them to be, their prior performance depends upon the resources available to them at their former employer, and the teams they had in place while working for that company. In short, it's less about individual, portable talent and more about a team of people working together.

I've written about executive compensation extensively in the past (see The Credit Crunch and Executive Pay, Revisiting Executive Pay, A New Approach to Executive Compensation and Are Managers Really Rational). I've previously pointed out other factors contributing to the complex issue of excessive compensation packages:

  1. The nature of the shift over time in shareholder profiles (from a traditional long-term individual investors to more short-term institutional traders).
  2. The fundamental misalignment in incentives created by the differences between the accounting view of the firm (infinite lifespan) and the tenure of the average CEO (less than 5 year lifespan), and the inability of stock options to alleviate the short-term versus long-term incentive problem (see especially my post A New Approach to Executive Compensation).
  3. Poor (or at the very least disinterested) governance on the part of the board members in general (and the compensation committee specifically).
  4. The role of compensation consultants in bench-marking against "peer" companies and then subsequently ratcheting up executive compensation.

We can now add to that the "chasing stars" phenomenon.

Overall then, there are various reasons why executive compensation might not reflect such a "rational" process. And unfortunately, it is shareholders who end up bearing the real costs associated with any perversion in the compensation system.



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