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Just What is Your CEO really Worth?
Shelly Karabell, Executive Editor, INSEAD Knowledge Writes on a new Metric to Judge CEO pay
Issue Date - 12/05/2011
 
“W all 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.

“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 () 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: 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, ” 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.

INSEAD Professor of Accounting and Control S. David Young, has created a metric with compensation consultant Stephen O’ Byrne,. “We call it ‘Executive Wealth Leverage’,” explains Young. “It takes into account all components reflected in the compensation contract, such as salary, short-term bonus, long-term incentives, pensions, stock options, shares that managers may already have. 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 & sales growth than they do with value.”

“A wealth lever factor of ‘zero’ would mean that a manager’s personal wealth is effectively insensitive to changes in shareholder wealth,” explains Young. “An executive wealth factor of ‘one’ would mean a very tight link between shareholder value and executive wealth. ”

 
In other words, when 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 data (on executive pay) is more readily available there; (they are) in accessible databases.” He says average Executive Wealth Leverage in US firms is around 0.4. Anecdotal evidence from Europe suggests that figures are likely similar to US.

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. 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.

Young believes the financial crisis provides an opportunity for boards to scrutinise their compensation practices more carefully, spurred on in no small part by current public outrage over huge executive pay packets and bonuses. He says that “the only dependable way 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."

Shellie Karabell is currently Executive Editor, INSEAD Knowledge, and has prior experience of over 20 years in Europe as a TV journalist, which includes working as CNBC’s bureau chief in Paris
          

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