Tuesday, 20 April 2010

Buffett (1994): "In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls.

Warren Buffett wrote on how corporate managers destroy shareholder value by resorting to unwanted acquisitions through his 1994 letter to shareholders. Let us proceed further in the same letter and see what other investment wisdom the master has to offer.

The current mortgage crisis in the US has put the global economy on the brink of a recession and has made big dents in the balance sheets of some of world's top financial institutions. Thus, with damages of such a magnitude, it is only natural to assume that the heads of these institutions during whose tenure the crisis took place should face financial penalties of some kind. However, if the pay packets of some of these executives are any indication, people harboring such notions are doing nothing but wallowing in outright fantasy. As per reports, CEOs of some of these institutions who have posted billions of dollars of losses due to the sub prime crisis will continue to rake in millions of dollars. All that shareholders get by way of solace is their ouster by the board or voluntary resignation. So much for alignment of shareholders' interest with that of the CEO or the management!

This is not a standalone case and there have been many such instances in the past where despite bringing companies down to their knees, CEOs and top management have gone on to earn fat salaries. Certainly, boots that all of us would love to get into! After all who would not want to lead a company where while salaries are tied to profits on the upside, there is no financial punishment to speak of when losses happen by the billions.

Yet, practices like these are commonplace in the corporate world and year after year, shareholders of troubled companies have to bear the egregious costs of the animal like aggressive instincts of its management. Thus, in order to avoid traps like these, it becomes important that when we as investors invest, we should have a close look at the compensations that the management gets in times both good as well as bad and see whether the company has a proper compensation system in place. A lot can be learnt if we have a look at how the master plans compensation for executives in the companies Berkshire own and his views on the issue. This is what he has to say on fair compensation practices.

"In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls. When capital invested in an operation is significant, we also both charge managers a high rate for incremental capital they employ and credit them at an equally high rate for capital they release.

It has become fashionable at public companies to describe almost every compensation plan as aligning the interests of management with those of shareholders. In our book, alignment means being a partner in both directions, not just on the upside. Many "alignment" plans flunk this basic test, being artful forms of "heads I win, tails you lose."

In all instances, we pursue rationality. Arrangements that pay off in capricious ways, unrelated to a manager's personal accomplishments, may well be welcomed by certain managers. Who, after all, refuses a free lottery ticket? But such arrangements are wasteful to the company and cause the manager to lose focus on what should be his real areas of concern. Additionally, irrational behavior at the parent may well encourage imitative behavior at subsidiaries."


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