22 June 2006
Executive pay and incentives in capital markets
On 20th June the Financial Times published a letter from David Haarmeyer which emphasised the role of activist shareholders with large stakes as an important constraint on executive pay. Whilst Mr Haarmeyer clearly has a point, the significance of the point is overstated. It is in fact completely unrealistic to assume that the incentives of the capital markets will ensure responsible practice on executive pay. I wrote to the Financial Times on this subject. The letter was not published, but is set out below.
(To see Mr Haarmeyer's letter or any of the relevant FT articles follow the links below. Level 1 subscription to FT.com may be required.)
My letter:
Sir, David Haarmeyer's letter ("Active investors are critical for controlling management"), 20th June) was too hasty to suggest that your article "What Price talent?" (Comment and Analysis, 16th June) was "high on moralistic indignation but less so on substance".
Mr Haarrmeyer quite rightly points out that independent directors are not in a position to properly hold management to account. His gives good reasons for this, the most crucial of which is the lack of proper incentives faced by the independent directors. Independent directors usually hold little or no equity stake.
However Mr Haarmeyer then rushes ahead to suggest that active investors with significant stakes do have proper incentives to control executive pay. If only it were that simple! Sadly however there are very important mismatches between the incentives faced by active investors and the behaviours which would be optimal for the underlying owners of the funds that they control.
Firstly, the hedge fund style active investor gets paid a big bonus in a year in which investments do well, but suffers no penalty in a year when investments do badly. As John Plender points out ("The games investors play", 18th June, ft.com) such investors therefore have a big incentive to provide the equivalent of catastrophe insurance.
Secondly, a person in the role of active investor has a disproportionate need to present strong recent performance because this is the basis on which that person is assessed, measured and given new opportunities. Long term performance is therefore compromised.
Thirdly, many large active fund managers are owned and controlled by FTSE 100 companies. This completely compromises their ability to comment critically on the corporate governance or executive pay of such companies.
Fourthly, and specifically on the subject of executive pay, activist fund managers are themselves notoriously well paid. In many cases, through their own pay they take far more from the underlying owners of their funds than company chief executives could ever justify. Activist fund managers are therefore in no position to critique the pay of chief executives. In fact their incentive is to support excessive executive pay to make their own position appear more credible.
For these four reasons it is not realistic to depend on the incentives of the capital markets to control executive pay. Rather we are quite right to demand that chief executives put the shareholder interest before their own, and provide evidence of this by exercising restraint on their own pay.
Yours faithfully, Patrick Gerard
(To see Mr Haarmeyer's letter or any of the relevant FT articles follow the links below. Level 1 subscription to FT.com may be required.)
My letter:
Sir, David Haarmeyer's letter ("Active investors are critical for controlling management"), 20th June) was too hasty to suggest that your article "What Price talent?" (Comment and Analysis, 16th June) was "high on moralistic indignation but less so on substance".
Mr Haarrmeyer quite rightly points out that independent directors are not in a position to properly hold management to account. His gives good reasons for this, the most crucial of which is the lack of proper incentives faced by the independent directors. Independent directors usually hold little or no equity stake.
However Mr Haarmeyer then rushes ahead to suggest that active investors with significant stakes do have proper incentives to control executive pay. If only it were that simple! Sadly however there are very important mismatches between the incentives faced by active investors and the behaviours which would be optimal for the underlying owners of the funds that they control.
Firstly, the hedge fund style active investor gets paid a big bonus in a year in which investments do well, but suffers no penalty in a year when investments do badly. As John Plender points out ("The games investors play", 18th June, ft.com) such investors therefore have a big incentive to provide the equivalent of catastrophe insurance.
Secondly, a person in the role of active investor has a disproportionate need to present strong recent performance because this is the basis on which that person is assessed, measured and given new opportunities. Long term performance is therefore compromised.
Thirdly, many large active fund managers are owned and controlled by FTSE 100 companies. This completely compromises their ability to comment critically on the corporate governance or executive pay of such companies.
Fourthly, and specifically on the subject of executive pay, activist fund managers are themselves notoriously well paid. In many cases, through their own pay they take far more from the underlying owners of their funds than company chief executives could ever justify. Activist fund managers are therefore in no position to critique the pay of chief executives. In fact their incentive is to support excessive executive pay to make their own position appear more credible.
For these four reasons it is not realistic to depend on the incentives of the capital markets to control executive pay. Rather we are quite right to demand that chief executives put the shareholder interest before their own, and provide evidence of this by exercising restraint on their own pay.
Yours faithfully, Patrick Gerard
Comments:
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Patrick,
I think you make a number of good points in critiquing my letter. That said I would like to clarify an important point. As there are constraints in writing a letter to the editor, my points about active investors were somewhat generalized. This is indeed a diverse group, which includes private equity groups, hedge fund investors, as well as financial entrepreneurs such as Warren Buffett and Wilbur Ross. What they have in common is taking large concentrated stakes in public companies and having their own capital at risk. Compared to many money managers who hold small positions and trade in and out of 100s of companies, many active investors are much longer term investors. Certainly Buffett, but also a number of hedge fund activists such as Jeff Ubben of ValueAct Capital take a much longer view to value creation. Like Buffett, they do take board seats and monitor mgmt.
Finally, I think the point you make at the end of your letter about expecting managers to subvert their interests to shareholders is not realistic and indeed likely to lead to bad outcomes. This was the same idea that the Soviet state was model under -- that human nature is malleable. This is after all the point of corporate governance -- to use internal and external forces to align management's interests with those of shareholders.
Regards,
David Haarmeyer
dhaarmeyer@gmail.com
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I think you make a number of good points in critiquing my letter. That said I would like to clarify an important point. As there are constraints in writing a letter to the editor, my points about active investors were somewhat generalized. This is indeed a diverse group, which includes private equity groups, hedge fund investors, as well as financial entrepreneurs such as Warren Buffett and Wilbur Ross. What they have in common is taking large concentrated stakes in public companies and having their own capital at risk. Compared to many money managers who hold small positions and trade in and out of 100s of companies, many active investors are much longer term investors. Certainly Buffett, but also a number of hedge fund activists such as Jeff Ubben of ValueAct Capital take a much longer view to value creation. Like Buffett, they do take board seats and monitor mgmt.
Finally, I think the point you make at the end of your letter about expecting managers to subvert their interests to shareholders is not realistic and indeed likely to lead to bad outcomes. This was the same idea that the Soviet state was model under -- that human nature is malleable. This is after all the point of corporate governance -- to use internal and external forces to align management's interests with those of shareholders.
Regards,
David Haarmeyer
dhaarmeyer@gmail.com
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: 04 August, 2006 23:00
: 04 August, 2006 23:00 
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