I can readily understand why people who are not executives of large businesses can be bewildered and outraged by the compensation of some CEOs, especially when it is given in big chunks of severance to CEOs who have failed at their companies.  The obvious question is: why would boards of directors have approved these packages in the first place?

There is a market for CEOs, just like there is a market for houses, internet stocks, or baseball players.  Just as these other markets fail from time to time, with housing bubbles, stock bubbles, or overpaid baseball players, sometimes we see market failures for executive compensation, too.

One very insightful book on this subject was actually written six years ago.  It is entitled Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs, by Rakesh Khurana.  What is unimaginable today is the degree to which shareholders, boards of directors, rating agencies, the media, and even the public believed in the notion that there were a handful of exceptionally talented CEO candidates that companies in trouble, or, for that matter, companies not in trouble, but desirous of improving their results, should spare no expense in recruiting.

General Electric provides some examples of this “Corporate Savior” phenomenon.  During the Jack Welch era, several of his top lieutenants were recruited away to become the CEOs of other companies.  Many of these executives received lavish pay packages, on the belief held at the time by directors and executive recruiters that a single highly-talented individual could create enormous economic value through executive leadership.  As events unfolded, some of the businesses led by these GE alumni did not perform well, and, in some cases, the pay packages came under heavy criticism.  These were all very talented executives, who received exceptional training and mentoring at GE under Jack Welch, as did Jeff Immelt, who is truly one of the world’s greatest business leaders.  However, what went wrong for those who were less successful was not how they performed, but the huge gap between their considerable talents and the unrealistic expectations for their performance.

Today, we understand better that CEOs, like any other people, are limited in what they can accomplish.  When they succeed, they may be catalysts for an organization’s success, but there needs to be a good business model, a critical mass of talent, and the right external environmental conditions.  Relative to the business model, that is, the value proposition of the company and its way of delivering that value profitably to customers, Warren Buffett once said something to the effect that when a highly-talented leadership team collides with a flawed business model, the business model generally wins.

Beyond the flawed belief in the “corporate savior,” the pressure on a board to recruit the best and the brightest, and the time pressure under which many boards operate when they are recruiting an external CEO, there are other subtle factors that drive up compensation in these negotiated contract arrangements.

While the executive search firms are retained by the company and are accountable to the board, they also succumb to the subtle pressure to justify their very lucrative fee by securing the “corporate savior.” They put additional pressure on the board by pointing out that the “corporate savior” is being hotly recruited by other companies and boards, and that the board needs to accommodate his or her compensation demands.

This is no different from what happened in professional sports with some of the outsized contracts over the last decade.  One difference today in professional sports negotiations is that salary caps in sports like football, basketball, and ice hockey, and the “luxury tax” in baseball act as a brake on runaway compensation.  The other difference is that professional sports teams and the agents who represent players have a better-developed methodology for valuing a superstar against other alternatives.  Baseball even has a valuation methodology called “value over replacement player” to help determine how many incremental victories a player has contributed to his team.  From that calculation, the financial value of that player for that team can be determined.  Many of these valuation methodologies were not developed by the teams, the agents, or even by the official statistician of Major League Baseball, the Elias Sports Bureau, but by outside sports statistics aficionados like Bill James, Pete Palmer, and John Thorn.

Business today lacks the kind of sophisticated tools that can truly isolate the economic contributions that a CEO uniquely creates.  Some companies have developed methods that move in the right direction, but in fact it is a very complex problem given how many factors influence company performance, including factors over which the CEO has no control.

Right now, we are in an exceptionally populist environment, so we may see excessive controls put on executive pay that will be determined through emotions and political calculations.  We must acknowledge that neither the free market nor government regulation offer a perfect solution to the perception or reality of excessive pay.  We need to draw upon tools developed for other purposes than compensation and to modify them as needed for executive compensation analysis.

This entry was posted on Monday, November 10th, 2008 at 4:12 pm and is filed under Current Events, Financial Crisis. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.