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Finance Executive Comp - a New Solution

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The whole question of executive compensation, moral hazard, and agency conflict has been getting a lot of press, as well it should.
Executives at a range of firms were (until recently) compensated with equity, which has limited risk and unlimited return.
Equity return itself is generally premised on incremental increased earnings - if you made $1 this year, you better make $1.10 next, or we will bludgeon your share price into "value" territory.
So all executives, since they were paid in restricted stock, were heavily incentivized to increase gross returns to the bottom line, even if the marginal returns for each dollar of activity was declining or in some cases negative.
Example - your firm made $100mm of $1bn in sales. Pretty good. Suppose now you borrow Another $900mm to double sales - will earnings be $200? No. There are interest expenses, among others. But earnings will jump. This is a simplistic example, but it illustrates the point.
In 2007, GS and MS had ~30x leverage. Their unlevered ROEs were 12-15%. Decent. Their levered ROEs were >30%. But what does this imply? In the case of MS, they earned 0.33% in additional earnings every time they borrowed the amount of their equity base (US$33bn). So every time they borrowed another $33bn (CDOs, repos, regular bonds, etc.), they earned about $100mm. However, this $100mm was a nice kick to earnings. It would be irrational to follow any other course. So as long as the market rewarded them, they borrowed.

Now, if the guys at the top were compensated in a different way, such that their payoff profile resembled a bond (a short put) rather than equity (a long call), everybody would be happy. The senior guys are not too happy, but they are the latest chew-toy of the press and public, so lets have at them.

An alternative would be junior high yield debt (maybe with some tax incentives). You are paid $10mm in bonus. Thanks very much, great job on last year, don't spend it all in one place. Well, you can't anyway. Its held as a maturing loan at the bottom of the liabilities column. Interest is paid to you, and the principal vests after a period (3-5yrs?). But it is clearly in your interests to keep the company solvent for that long, and avoid risks that might jeopardize this payout. If the company goes under in that period, you are absolutely dead last in line. The only people behind you are equity holders. If things work out, the equity flies. However for you, Mr. Senior MD, you get what you were told you would be getting.

Problem solved? No. But its an idea that gets regulators closer to a "market solution" than other that have been proposed.

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Guest Monday, 25 May 2020