Finance: Fat Cats can be key to success

EACH YEAR, as the annual reports begin to roll in, the "Fat Cat" compensation debate starts again. At PA Consulting, we believe this issue suffers from confusion between two questions:

Is there an optimal form of compensation scheme for top management that will maximise value for shareholders? (An "efficiency" question.)

If top management receives enormous payouts as a result of the compensation scheme, is that necessarily a bad thing? (A "justice" question.)

We believe - based on client experience and extensive research - that shareholders should ensure their companies operate a top management compensation scheme that is efficient and just.

The Efficiency Question

What is the optimal top management compensation plan? Over the past year, PA has conducted surveys in 11 countries to uncover the characteristics of companies which create top levels of shareholder value.

The first finding was that our surveyed companies had widely different levels of shareholder returns over several years. We reached an unexpected conclusion. The most important factor associated with superior shareholder returns, was whether the company adopted a "Managing for Shareholder Value" (MSV) approach to its top management compensation policies. The chart (above) shows that the average company which follows an MSV approach to its top management compensation has more than 6 percentage points of additional shareholder return, compared to the company that does not.

The chart also reveals that fewer than 1 in 10 companies follow such an approach. This finding is consistent across all our surveyed countries - with the exception of the US, where it is still less than one in four.

The impact of the correct compensation approach - across our surveyed countries - is enormous. The average annual shareholder returns of the company that embraces best practice in this area is almost 20 per cent a year, versus less than 14 per cent a year for companies who reject that. Over 10 years, an investor putting pounds 10,000 into a basket of companies following the right approach would see a return of pounds 60,000. An investor who put a similar amount into companies following the opposite approach would get pounds 34,000.

Managers of institutional investment funds are considered superstars if they can beat the market annually by two or three percentage points a year.Institutional investors need to build a "Code of Compensation Conduct" that ensures their company follows that approach. For example:

n Ensure the company pays high variable compensation. A bonus scheme that allows managers to earn substantial bonuses - potentially rising to many times base salary - has an even larger impact on shareholder value.

n Ensure the company paysbelow-average salaries in senior positions, relative to what is paid in the industry. We found the impact on share price of paying high versus low salaries was three percentage points of shareholder return per year - an enormous amount.

n Ensure bonuses are contingent on shareholder results. The more top management interests can be aligned with those of shareholders, the more likely it is that shareholder returns will be maximised. Incentive programmes should focus on factors directly under the individual's control (value drivers), rather than on the overall share price. But the company should identify what management actions lead to share-price maximisation.

The recent wave of companies which reward managers on a measure of "profits minus a charge for capital" has led to enormous improvements in shareholder value, optimising profits and use of capital.

n Ensure the company reviews its salaries against an annual industry- specific pay survey. Investors should know whether this step is taken and what is done with the output.

n Ensure a percentage of annual bonus is paid in long-term handcuffed shares. This will build a class of managers who have a large shareholding in the company, and strongly motivated to ensure the share price increases.

n Ensure the company encourages top management and other staff - to have an ownership rather than an employee mentality. The most important thing is not the way in which you get people to be shareholders - it is just the fact that you do it.

n Ensure the company pays non-executive directors in shares. Companies with many large shareholders on the board are more likely to increase shareholder value. The board will then focus more aggressively on its number one objective - to maximise share price over the long term.

The Justice Question

Is it fair when top managers earn enormous sums from compensation programmes?

Our research implies that companies which place no limit on what managers can earn do far better by their shareholders than organisations that limit the annual compensation package.

Top managers of high-bonus companies draw anger when newspapers run stories decrying the large amounts earned.We should care if a manager earns a large package whenshareholders see a poor return.

But if shareholders have done well (and the national economic "cake" has expanded), is it wrong if managers also receive spectacularly large compensation packages? Capitalism's underpinning of companies owned via shares traded on stock exchanges, is a successful mechanism for increasing economic value and benefit, for the benefit of a country.

If a company does not put in a compensation programme that has a strong potential upside for its executives, it is less likely to create value for shareholders. The reason is probably that insufficient incentives exist for managers to take the difficult but valuable decisions that increase share price. "Fat Cat" executives of large companies are not in need of particular protection. Most probably they will continue to earn large remuneration packages for some time, whatever the degree of outrage.

But some aspects of these compensation packages are important if we are to have flourishing publicly owned companies, even if other aspects, such as high fixed salaries, are counterproductive.

Jon Moynihan is executive chairman of PA Consulting, the management and technology consultancy.

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