New research points to a “managerial myopia” caused by bosses putting short-term prosperity before long-term value. John Walker takes a closer look.
This article is provided by the Deloitte Institute of Innovation and Entrepreneurship.
Firms have long wrestled with the challenge of motivating executives to act in the best interest of their shareholders. Granting stock or share options to the boss is the accepted solution. Until recently, little information existed to help researchers examine the effect these incentives have on management behaviour and business performance. London Business School Finance Professor Alex Edmans and his colleagues use new legislation, hard data and scientific analysis to shed fresh light on their impact. The results offer company boards practical insight to tackle material damage to sources of competitive advantage.
In the 18th century, Adam Smith cautioned that a company’s managers cannot be expected to exercise the “same anxious vigilance” as its owners. The manager’s financial self-interest is simply too great. By the Great Depression of the 1930s, economic concern with the separation of ownership and control (known later as agency theory) had given way to full-blown political angst.
American academic Adolf Berle warned of investors surrendering wealth and power to those that run the modern corporation. Berle’s ideas saw him invited to join Roosevelt’s Brains Trust, a group tasked with shaping the New Deal. Resultant proposals that government should keep corporations and executives in check rankled with free marketeers. They feared that such intervention would harm the ongoing innovative process of opening up new markets, developing new goods and designing new ways of manufacture: the “creative destruction” that Joseph Schumpeter saw at the time as essential to the heart of the capitalist engine.
The last 50 years has seen greater understanding of the principal-agent problem from the agency theory work of noted economists Eugene Fama and Michael Jensen. Firms have responded with executive share plans and equity options; an element of remuneration designed to converge all interests to long-term wealth creation. Such an outcome would be good for wider society, but do these incentives work?
The researchers uncover the wide extent that bosses are manipulating earnings to ensure they personally prosper from their stock and share options. Their ground-breaking study finds bosses cutting back on crucial drivers of lasting value, such as innovation, at times that suit the boss’s own priorities. The aim: to boost the short-term share price (an act of “managerial myopia”). But as the research reveals, they are unsuccessful, as their actions don’t go unnoticed by the market. Armed with these findings, boards can mitigate harmful behaviour by guiding management or restructuring equity incentives.
Mounting disquiet in a sea of noise
Executive pay has been a particularly divisive topic since the 2008 financial crisis, as boards combat a hostile political and media landscape calling for restraint. Designing a compensation package that navigates executives away from value destroying short-termism and on to the company’s strategic vision requires the right blend of pay, perks, bonuses and equity. Edmans says stock and options are the popular choice to overcome managerial myopia, but “it’s not just about their size; we believe the timeframe is just as important”.
Equity options grant the CEO the right to buy stock at a predetermined price and ‘vesting’ date in the future. If the company’s share price has risen when the option comes to vest, the executive stands to make an immediate profit. However, if the share price has fallen since the grant, the option is worthless.
Over recent years, concern has grown that even equity incentives are skewing executive behaviour towards the here and now. Executives and boards are acutely aware that missing quarterly earnings targets can erode market confidence and result in a sharp fall in the company’s share price. If this coincides with the vesting period of executive stock and options, then the boss is out of pocket. Siren voices struggling to be heard have warned that executives with impending vesting equity will inevitably load the cards in their favour by cutting discretionary spending such as research and development (R&D). This boosts short-term profits, but harms a firm’s innovative capacity and long-term chance of success. London Business School’s Costas Markides says there is no strategy without such innovation. He finds that if firms don’t permanently strive to discover new positions in their market, then it encourages their competition to do precisely that.
Transparency leading to transparency
Until recently, evidence of these myopic concerns was simply impossible to determine as firms were inconsistent in reporting executive stock and option arrangements. That changed in 2006 with federally mandated disclosure in the US, a situation seized upon by Edmans and his colleagues. Edmans notes that while their research is “over a relatively short fve-year time series, this is more than countered by good
quality data on over 2,000 firms”.
Their paper, ‘Equity Vesting and Managerial Myopia’, examined executive behaviour in the year before stock or options vest. They found myopic activity; bosses were reacting to the upcoming vest by ensuring their firms met or exceeded the market’s consensus estimate for earnings. To achieve this, bosses were not only cutting back on R&D, but also cutting advertising and capital investments.
The researchers find the association between vesting equity and investment cuts statistically significant – too large to be explainable by pure chance. When the amount of vesting equity increases from the 25th percentile to the 75th percentile, the growth rate in R&D (as a proportion of total assets) falls by 37 per cent. This translates into a fall in R&D of $1m per year.
The three researchers believe the data and study approach can also open the door to other examples of managerial myopia. Indeed, a fledgling paper by Edmans and other co-authors shows that executives release more news stories in months in which their equity vests. No doubt an effort by the boss to distract attention away from cutbacks and further pump up the short-term share price.
A game of cat and mouse
Even though bosses try to pump up earnings to fool investors, the researchers found that the market anticipates their self-interest and discounts the upbeat earnings. So why do it? The researchers suggest that CEOs may find themselves trapped into manipulating their earnings, as all the other CEOs do it. If they didn’t, and broke free from the pack, their earnings would be comparatively weaker, harming the share price for investors and the CEO.
All of which begs the question, if the market knows what’s going on, surely the board does too? Anything less and the board is asleep at the wheel, but to suggest they’re complicit in this counterproductive activity, questions why they haven’t tried harder to improve the status quo. Not least, as they’re adding to already sizeable uninvested corporate cash pots. Indeed, the effort it takes the boss to shave costs and cover his or her tracks in so many areas of the business, takes critical time away from productive tasks, such as executing strategy.
Options do exist
The researchers say that proving the long-term damage from the boss’s behaviour is much harder. Whether any of the cut drivers of growth would have delivered strategic value, is almost impossible to determine. Michael Porter, one of the world’s most significant business writers, contends that a firm’s R&D capability is a core ongoing differentiation needed to survive competitive forces over time.
Edmans suggests alternatives do exist to overcome myopia. “Boards are starting to lengthen stock and option vesting periods, which helps,” he says. “Although if it’s pushed too far out, the executive is likely to discount its future value and demand a risk premium from the employer. Alternatively, boards may simply choose to monitor executives’ investment decisions more closely during the years in which they have significant equity vesting.”
Changing the politics of pay
Edmans concludes that he wishes to see the remuneration debate depoliticised and shifted away from argument on the size of the CEO’s pay relative to the average worker’s, and on to the horizon of the CEO’s incentives – paying according to long-term, rather than short-term, performance. “An executive motivated to meet next month’s earnings target may cut wages and employee training, damaging long-term value and fuelling political hostilities. The better way to reform pay is to increase vesting periods. With a long-term perspective, executives will treat workers like long-term assets. Pay caps may appeal to political populism, but it’s the structure of pay, not the level, that will have the biggest impact on society”. If Edmans and his colleagues’ research is the catalyst for awakening the board to the scale of this problem, then political change may just be possible, and Edmans could get his wish.