Warren Buffett is a famous critic of executive compensation, which he
suggests is, as John Kenneth Galbraith once put it, "Frequently in the
nature of a warm personal gesture from the CEO to himself." A
shareholder from the Phillipines (people travel a long way to ask
Warren and Charlie questions) asks him how he thinks one should
structure a good compensation package for managers at a
capital-intensive subsidiary. The implication is that if the banks
hadn't had such poorly structured compensation, they wouldn't have
taken such outsized risks.Photo from Flickr User AMagill
The responses from Warren Buffet and Charlie Munger are worth repeating at length. They don't actually explain whatever magic metric Berkshire Hathaway has found for aligning the incentives of managers and shareholders, but they're a nice statement of their views on the Principal-Agent problem:
We think we have a good system.
Your question implies that the board sets these things. In the recent forty years, basically the board has had little effect on these things. The CEO has had an important role determining their compensation. These people pick their own compensation committee. I've been on one compensation committee out of nineteen boards because these people aren't looking for Dobermans; they're looking for cocker spaniels. It's been a system that the Ceo has dominated. In my experience, boards have done little in the way of thinking through as an owner what they ought to pay these people.
Here in town, Pete Kiewit figured out a very logical way to pay people in his business. It's not rocket science--you would be able to figure it out, I can figure it out, but you have to understand that not every CEO wants a rational compensation committee.
I don't think there should be a compensation committee. . .
It can be done. It's very difficult to have a system where the board, thinking as owners, care as much as the guy on the other side of the negotiating table. But it's very important how you compensate the CEO, and it can be done.
Charlie Munger added:
Liberally paid boards of directors can be counterproductive. There's a sort of reciprocation--you keep raising me, and I keep raising you, and it's very clublike.
This brought on applause from the value-minded audience.
But as Ed Carr argued in the pages of my former employer a few years ago, there's a problem with the "cosy boards" story. It's widely agreed upon by almost everyone, including yours truly until Carr got to me. Here's the problem, though: private companies pay their managers even more. It's riskier compensation, of course, and it's plausible to argue that all of the extra pay is a risk premium. But if CEOs were only getting paid so much because they'd captured the boards, you'd expect to see private companies paying less. You'd also expect to see incumbents making more than CEOs recruited from outside, but you don't.
It's hard--nay, impossible--to believe that cosy board relationships don't inflate CEO pay. But the effect doesn't actually seem to be that large.
Buffett and Munger addressed this in Berkshire's 2006 annual shareholder letter, as I noted elsewhere recently. The impetus for addressing this at the time was their selection of a new board member, Susan Decker:
As for executive comp in private versus public companies: I don't think most shareholders in publicly traded firms care what executives of private companies get paid. Generally though, excessive comp seems to be an issue mainly with the largest publicly traded companies, and less so with smaller ones. This could be partly because large companies have more money to throw around, but I think it's also because smaller companies are less likely to select board members for non-business reasons (e.g., the Noah's ark mentality Buffett mentions above). Perhaps an even more important reason is that executives in smaller public companies often hold much larger stakes in their companies (which, in many cases, they founded), so their interests are more closely aligned with those of their shareholders.
Forbes has a list of the largest private companies in the US.
http://www.forbes.com/2008/11/03/largest-private-companies-biz-privates08-cx_sr_1103private_land.html
I'd be interested to see a study of their compensation levels vs. that of their public competitors.
I wonder how many of them even make their comp info public.
Dave,
Maybe more than you might think. I once worked for a privately held company that had an ESOP and as a result they had to file a 10k with the SEC. You could find out, not only how much the executives made in salary and bonus, but as they also owned 40% of the company you could see how much their dividends were each quarter.
Interesting. I didn't realize private companies with ESOPs were required to file 10-ks. I wonder if that discourages many firms from establishing ESOPs.
Also, if the company has gone private in an LBO transaction, the company may have to file financial reports with the SEC by reason of its publicly traded debt.
Your point about private company compensation is an interesting one, but I don't think it really affects argument about excessive CEO pay.
Let's suppose that Galbraith is correct: CEO pay is inflated by the nature of boards of directors and compensation committees. Now suppose that you are a private company trying to figure out how to pay your manager. For all the reasons you suggest, it's not likely that you will pay them less than the executive of a comparable public company: the private firm manager has a greater stake in the company, takes more risk, and is probably even more personally involved in the setting of his or her own pay. The pay inflation of large public companies will thus naturally leak into private companies - otherwise why would a talented entrepreneur bother to take a supposedly riskier job at a private company?
It still seems very plausible that clubby relationships among these corporate titans (public or private) could have a big effect on their pay.
Am I getting this right? You are arguing that some public-company CEO-agents have exceeded their labor's market-clearing rate by "capturing" a process designed to help the public company employer discover the market rate for CEO labor. In short, these CEOs rig the machine and produce an above-market rate. They are able to maintain this over their own tenure. And when you face the fact that successive CEOs continue receiving similarly large packages over multiple CEO turnovers (I believe that most CEOs last on average four years), this shows that the "capture" is a heritable power, shared by incumbents and successors without interuption.
Then you argue that the private company market rates for CEO labor are impacted by this rigged machine operating in public companies, causing the private-company CEO labor rates to go up beyond the market-clearing level it otherwise would.
To use an analogy, if Hardee's managers find a way to routinely siphon from their employer's respective tills, all the Burger King and Wendy's managers can expect to receive higher compensation as a result, because the siphoned money over at the local Hardee's franchises will bid up the price for other managers? And in fact, if you find that Burger Kind and Wendy's managers are paid *higher* than Hardee's this is actually evidence for this effect you describe?
I think your model is in serious need of data; it is a very non-intuitive model. Especially that last part where the higher wages at Wendy's proves your point. I also think the fact that successive CEOs obtain the higher compensation without having the benefit of incumbency (i.e., supposedly selecting the compensation committee) undercuts your view.
One other fact you must wrestle with, I think, is when another firm bids away one of these supposedly overpaid public company CEOs by OFFERING THEM EVEN MORE money than the public-company CEO currently receives. The new emplpoyer's compensation process is not captured in any way by the incoming CEO, yet the compensation is more than that person received at the old joint. How is he extracting an even higher above-market wage rate from a new board and compensation committee where he not only had no interaction with before getting the job, but also already obtains an above-market rate from his current employer? That would seem a very unstable pricing situation, and I would expect that the price would collapse at some point. Maybe that is what is happening now. But again, I think this is something numbers can clear up.
The biggest problem I have with CEO compensation is the way they back-load everything. A guy gets hired to run a company that's doing all right for a seemingly reasonable amount, the company tanks, he gets fired... and walks away with a lump sum worth ten times what he made in the previous year. Do shareholders have access to those kinds of contract details? Seems like they ought to.
Yes, the provisions of the CEO's contract are of course public.
Is there a public source for the claim that private companies pay more?
Buffet says that directors should think like owners.
How about owners think like owners? I know if I was to get some funding for what I do, nothing on the scale Berkshire does, but local, and acquaintance probably, with a shrewd eye on the risk and returns, they would be interested in what I would be getting out of it.
There is this magic. Give your money to some guy in a storefront or bank. Lots of it. He promises a good return, with some charts and graphs on returns and risk. The money buys something that a sales guy offered, again with charts. Up the chain it goes until some trader buys and sells, a fund works it, everyone taking their slice. And in good times everyone makes money. Right now the poor sod at the bottom saw his capital deplete by 30-50%.
Where is the CEO compensation in this equation? Where is what the stock issuer actually does? Who cares about CEO compensation when you are buying the cash flow on a CDS on a worthless bond?
I read a book on super sales a number of years ago, and the gist of it was to show up looking prosperous, even if you had to borrow or steal to do so.
Of course, if owners acted like owners, then there would be far fewer owners. And far less money paid to CEO's and fund managers and Wall Street bankers and traders.
Derek
One reason why a lot of owners don't act like owners is that they don't own shares in companies directly, they own them through mutual funds (whether actively managed funds or index funds). Fund managers tend to vote inline with corporate boards. One way to strengthen the voice of retail shareholders on executive compensation might be to require mutual funds to aggregate the votes of their retail shareholders on, say, the funds' top 5 or 10 holdings, and then vote their proxies accordingly.
I should also add that a lot of folks who own stock directly don't vote their proxies, which is lazy. You can vote most online in matter of minutes via ProxyVote.com. And you don't need to read the proxy statement cover to cover to vote intelligently. Read the bios of the director candidates, and vote against anyone who looks like: 1) they add little relevant experience to the board; 2) owns only a small number of shares in the company; 3) probably earns more from directorships than from his or her day job. Then you just have to read the other proposals, of which there are usually few, and vote accordingly. Many large company proxies today have "say on pay" shareholder proposals calling for at least an advisory vote on executive comp. Anyone who doesn't vote their proxies has no reason to complain about these proposals not passing.
Top executives get paid a lot because their decisions determine the success or failure of the entire company. They are analogous to navigators on ships in the Age of Sail. If the navigator on the ship screwed up, it didn't matter how competent the sailors were.
Executives as a group get paid a great deal because it takes a lot of money to lure them away from running their own companies. If someone has what it takes to run a large public company, they have what it takes to run a smaller private one. If they have what it takes to convince a board to hire them, then they have what it takes to convince investors to invest in their private company. You've got to offer someone a significant chunk of change to work for your benefit instead of their own.
The idea that high executive pay represents some kind of breakdown in market forces is silly. Investors won't spend literally hundreds of millions (if not billions) on the executive compensation for the companies they own if they don't have to. The best way to understand the real drivers of high pay is to look at the choices that the executives can make not the choices that owners can make. Once you understand the executives full range of options, the cause of their high pay becomes obvious.
"If they have what it takes to convince a board to hire them, then they have what it takes to convince investors to invest in their private company."
Convincing a corporate director to spend shareholders' money is a little different from convincing an investor to reach into his own pocket. If more corporate directors fit Buffett's criteria above (e.g., they thought and acted like intelligent owners of the business) it might not be, but in big companies that's often not the case. As Buffett noted, some "independent" directors make more money from their directorships than they do from their day jobs. Why would they risk their sinecures by rocking the boat on executive pay?
"Investors won't spend literally hundreds of millions (if not billions) on the executive compensation for the companies they own if they don't have to."
Investors don't set executive comp directly, as I'm sure you know. They vote for a board of directors (from a list nominated by the company) that does. Many retail investors that own shares directly don't even vote, and most mutual fund managers vote their shares in accordance the board's wishes.
"Here's the problem, though: private companies pay their managers even more"
Whether other employers pay "even more" misses the point. People don't get mad when executive pay is too high - they get mad when it's too high (or ridiculously, insanly high) relative to performance. I don't care if Lee Raymond gets half a billion dollars if his company had the highest profit of any company in history (even if he had nothing to do with it). What makes my blood boil is the guy who gets paid $750K who ran the company into the ground because he was stupid and incompetent.
I've got no problem paying top dollar for top talent, but too many compensation committees give millions to people who made lots of friends at the right schools, but aren't worth minimum wage when it comes to running a business. Private companies may well pay more, but I'll bet CEOs at private firms get the boot a lot quicker when they screw up.
I strongly suspect that there's an almost insurmountable tendency to pay a CEO relative to the size of their company, and companies now are much, much bigger than they used to be. You can say that running a hundred billion dollar company is not much harder than running a billion dollar company, and I'd tend to agree with you, but I think almost everyone (i.e. stock holders and owners) will *feel* it's somehow intrinsically wrong for the two to be paid the same and the owners of the hundred billion dollar company will feel very very nervous about why they're not paying top dollar for someone that important.
I think paying a lot of money for the CEO is a security blanket for a lot of owners and board members. After all, who wants to be accused of skimping on the most important position in the company.
The private company comparison assumes all other things are equal, which isn't really the case. In private equity situations, executives are often expected to radically restructure, grow, or otherwise improve the company. There are often specific strategic initiatives in place before the CEO comes in. And pay is highly equity-based and pegged to the private equity owners' time-table. In addition, PE owners are much more hands-on and demanding.
I'm not sure whether private company executives really are paid more in general. However, in the PE case, which I think you might be referring to, there's much less information assymetry and much clearer expectations. There's also much more value to be created than in the cases of many public company CEO's who are in some sense keeping the seat warm.
Bottom line, it's probably not a valid comparison. It would be interesting to see how public and private trends have moved over time, though.