New Approach Links Exec Compensation to Corporate Debt
Risks taken by leaders to build up corporate equity (along
with their compensation packages) has been tied to the financial industry’s
house of cards that came crashing down in 2008. The time may have come, according
to a Knowledge@Wharton (K@W)
article, to reconsider adjusting those packages, not based on how much a company
appears to be worth on paper but how solvent it is in real terms.
In a new paper, Inside
Debt, written by Wharton finance professor Alex
Edmans and doctoral student Qi Liu, to be published in the Review of Finance,
the authors contend that in companies run by executives with packages based
largely on equity, there is a natural inclination to take risks.
for tying executive compensation to a company’s equity has been the defacto
standard for three decades. The idea is that shareholders and execs share a
common purpose — increasing the value of a company’s stock. The issue is that
the pursuit of that goal (as well as other factors) does not always lead to
an ever upward path for share values.
“If the risk pays off, the value of the equity shoots up,” said
Prof. Edmans. “If the risk doesn’t pay off, the worst their (executives’)
equity can be is zero.” Bondholders and other creditors, however, are
not as fortunate.
Prof. Edmans pointed to Bear Stearns, Enron and Lehman Brothers
as three companies that took the “gamble for resurrection” and failed.
the case of Enron, Prof. Edmans told K@W, the company should have
been upfront about what it was facing. “Instead, they tried to conceal
the problems, hoping that one of their gambles would pay off before the problems
became noticed. But they only became worse.”
AIG, another poster child
for the financial industry’s collapse, might offer a picture of compensation
packages that balance equity and debt. Executives at the company are now paid
bonuses based on “long-term performance units.” Roughly
20 percent of these units are tied to the company’s common stock while 80 percent
is based on AIG’s junior debt.
Discussion Questions: Is it time for a lower percentage of executive compensation
to be tied to share prices? Does tying more executive compensation to performance
of a company’s bondholders work for successful companies as well as those in
a turnaround mode?
- Why It Pays to Link Executive Compensation with Corporate Debt – Knowledge@Wharton
- Inside Debt – Social Science Research Network