What’s your CEO really worth?

INSEAD’s Corporate Governance Initiative creates a model

By Shellie Karabell

IF there is a culprit behind the dismal state of corporate governance today, INSEAD Professor Ludo Van der Heyden blames Wall Street capitalism.

“Wall Street capitalism is ‘unfair capitalism,’” claims Van der Heyden, who is The Solvay Chaired Professor of Technological Innovation and Academic Director of INSEAD’s new Corporate Governance Initiative.

“Corporate governance – and beyond that governance by the state – has failed in the USA. That is a major lesson of the recent financial crisis. Of course, it has failed in other countries as well, as the UBS debacle attests. But the absence of adequate corporate governance in the US financial sector has certainly been shown. And the response is now being worked out between the US government and the banks right now.”

“Throughout the last 20 years there was this myth of substantial value creation by US financial corporations. Now we understand better that a substantial part of the value increase was fuelled by the US government throwing money into the economy (via tax cuts under the Bush administration) that led to a demand for stocks … and that increased corporate ‘value’ through demand effects, without these companies actually creating real value,” Van der Heyden claims.

“The US compensation system rests excessively on market valuation – and here we got the direction wrong: we concluded that if these stocks went up, there must have been substantial value generation. The additional factor that made the US go so far in excess is that US boards are largely controlled by their CEOs – who had no problem with the continuous stock rally … so corporate governance was locked up by CEOs who also were chairmen, who were running the show for their own benefit and that of their friends, with insufficient regard of underlying value principles, ” he concludes.

Van der Heyden claims there was no downside risk to underperforming CEOs. “This was allowed by the corporate governance practice of the ‘golden handshake’”, he says. “The CEOs knew they were under the gun so they signed very good exit packages, which I would say most managers in the US wouldn’t ask for and wouldn’t get.”

Topping the list of INSEAD’s Corporate Governance Initiative issues is – not surprisingly – CEO pay. “We have to look much more seriously at CEO compensation and have a principle-based approach rather than a strictly financial market-based approach,” he says. “I believe the value-added of the CEO is not just their own value, but the value-added of the whole team; so why would all the pay go to the CEO? And why should he get much more than his colleagues in the management?”

But if you don’t use market mechanisms to determine CEO pay, what do you use? Enter INSEAD Professor of Accounting and Control S. David Young, who with compensation consultant Stephen O’Byrne, has created a metric to do the math.

“We call it ‘Executive Wealth Leverage,’” explains Young. “And it takes into account all the components that are reflected in the compensation contract, such as salary, short-term bonus, long-term incentives, pensions, stock options, shares that managers may already have, and it creates a summary measure that reflects the sensitivity of an executive’s wealth to changes in shareholder wealth. Most senior executives have their personal wealth more closely associated with sales and sales growth than they do with value -- which means that most companies are creating stronger incentives for their CEOs to grow the business than to actually create value.”

The higher the Executive Wealth Leverage, the stronger the tie between executive compensation and shareholder wealth. “A wealth lever factor of ‘zero’ would mean that a manager’s personal wealth is effectively insensitive to changes in shareholder wealth,” explains Young.

“So shareholder wealth can go up (or) go down, but the impact on executive wealth is basically nothing. On the other hand, an executive wealth factor of ‘one’ would mean that there’s a very tight link between shareholder value and executive wealth. As shareholder value goes up, executive wealth goes up more or less proportionately. ”  In other words, when the shareholders lose money, so does the CEO; he doesn’t get to leave the job with a huge severance package in his pocket. “If you’re the CEO of a large publicly-traded company, given the level of compensation that you’re being paid, there should be some willingness to take a hit in an economic recession, because your shareholders certainly are,” he says. Young’s research has so far focused on US firms “because the data (on executive pay) are more readily available there; (they are) in accessible databases.” He says the average Executive Wealth Leverage in US firms is around 0.4. Anecdotal evidence from Europe suggests that Wealth Leverage figures are likely to be similar to those in the US.

“It’s not a question of how much money you make; it’s not a question of your market share or sales,” Young opines. “It’s a question of the value of the firm by reference to expected cash flows, discounted at the opportunity cost of capital. This is the intrinsic value of any firm. So what we want to do is create incentives for top managers to maximise this intrinsic value.”

Young says boards have tried to provide incentives in the past, such as putting CEO pay at risk by tying compensation to sales or financial metrics. “Boards of directors have a tendency to try to fiddle and tweak the compensation package each year. And often boards aren’t even aware they’re doing this.”

Young believes the financial crisis provides an opportunity for boards to scrutinise their compensation practices more carefully, spurred on in no small part by public outrage over executive pay packets and bonuses.

This public outrage “is going to continue for a while longer,” he says, “and the only dependable way I think for boards of directors to diffuse the crisis in the long run is by scrutinising their compensation practices more carefully and to have a better idea of exactly what kinds of incentives, what kinds of behaviours are being encouraged.”