Deutsche Bank has released the results of analysis that indicates the financial performance of Australian companies can be reasonably predicted from the CEO’s share of the pay for a company’s top five executives.

 

The study replicated as closely as possible a US study by Bebchuck and others showing that that the CEO ‘pay slice’ is negatively correlated with accounting profitability and that firms with a high CEO pay slice tend to make worse acquisition decisions and are more likely to make opportunistically timed option grants to their CEOs. In addition, the probability of CEO turnover after poor performance is lower in those companies.

 

Deutsche found that for a sample of 173 ASX200 companies for which top five remuneration data was available for FY2010, the financial performance (measured by Deutsche as industry-adjusted total shareholder return and industry-adjusted return on equity) of those with a CEO pay slice greater than 50% in FY2010 underperformed the market in FY2011, while those with a CEO pay slice less than 20% significantly outperformed.

 

We note that there has to be something unusual going on in a company where the CEO’s pay slice is less than 20% of the total pay for the top five executives – such an arrangement is simply not sustainable for a company that needs to offer market-competitive CEO remuneration, and is most likely to occur when the CEO is the founder of the business.  Indeed, Deutsche indicates that the lowest CEO slice of 2.9% went to Andrew Forrest at Fortescue Metals Group.

 

Deutsche suggest the CEO pay slice is easy to calculate, but acknowledge that in some years the CEO slice is affected by ‘one-off short or long-term incentive payments or payments related to acquisitions or divestitures’.  They quite properly exclude retirement payments but their methodology may compound the impact of one-off equity grants made on appointment to compensate for grants forfeited from a previous employer, as annualising the numbers for a part-year CEO would exacerbate the impact of these one-off equity grants.

 

More generally, equity disclosures may bear no relation to the ultimate value the equity awards generate for the executive – the fair value of equity grants will often be accrued and disclosed before performance can reasonably be expected to improve, especially where a new CEO has the task of improving performance.

 

We have noted before that executive pay imbalances are indicators of company risk (see HERE and HERE).  CEOs taking a high share of executive pay can indicate that the company lacks successors.  It may also indicate a company board “captured” to an extent by a powerful CEO.

 

But too little difference may also be a problem.  While higher pay sharpens incentives in the contest for promotion, the larger the difference in pay between higher-paid and lower-paid executives, the greater the risk that such a pay structure will lead to unproductive (or even destructive) competition between colleagues. But too much salary compression can lead to lower productivity, especially if executives have weaker incentives to compete for promotion.

 

The Deutsche paper suggests investors (and presumably boards) consider the following questions:

 

·          What is the firm’s CEO pay slice?

·          Has the firm’s CEO pay slice changed over time?

·          What is the average CEO pay slice in the firm’s industry?

·          Does the CEO pay slice establish the right incentives among the executive team?

·          Does the CEO pay slice promote a team-based decision-making style or is the CEO the dominant decision-maker?

·          Does the CEO pay slice create productive (or unproductive) competition among the senior management team?

·          Does an abnormal or excessive CEO pay slice reflect agency or corporate governance problems?

·          Does a high CEO pay slice make it more difficult to dismiss a CEO after poor performance?

·          Have the firm’s acquisition decisions been well received by the market?

 

The Deutsche Bank paper is available for a few weeks HERE

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