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Jul 15

The value of tying exec comp to debt

Posted by Karen1 in pensionsexecutive compensationcompensationAIG


For years, the prevailing wisdom has held that executive compensation should be tied to a firm's equity. That way, the theory goes, management's goals are aligned with shareholders' interests.  

This thinking is fine if you're a shareholder. However, what about bondholders? "If you're compensated only with equity, you're not worried about creditors losing money," points out Alex Edmans, a professor of finance at Wharton who has researched executive compensation. He also is the author of a recent study, "Inside Debt." 

A chief executive whose variable compensation is tied just to the firm's equity, rather than both debt and equity, may be tempted to pursue highly risky projects. Here's why: say a firm is running into trouble and bankruptcy is a real possibility. The CEO may launch a "Hail Mary" initiative, figuring it's pretty much all or nothing at that point. From an equity point of view, that thinking is accurate - either the firm survives or it heads into bankruptcy. The CEO either makes out big time, or ends up with equity that's worth nothing. In fact, over the years many companies have borrowed money and used the proceeds to pay a fat one-time dividend to common shareholders, which usually resulted in the bonds dropping in price, a credit rating downgrade, or both.

For bondholders, however, the options are a little more nuanced. If the firm ends up bankrupt but bondholders escape with 90 cents on the dollar, they'll be in O.K. shape. If the company recovers only 10 cents on the dollar, the bondholders are in much worse shape. "Debt is critically different from other instruments as it is sensitive to the value of assets in bankruptcy," the study notes. However, a CEO who's paid only in equity has little incentive to worry about the differences.

This fact prompted Edmans' curiosity, given how much attention has been paid to equity compensation. "It didn't make sense," he says. If executives really didn't care about bondholders, they'd find it hard to attract them, or at least any willing to buy bonds at less than punitive rates.

As Edmans dug into companies' financial statements, particularly those issued since 2007, when new SEC disclosure rules required the release of more info on executive compensation, he found that many firms actually were paying their execs in ways that were similar to debt. For instance, executives' pensions - what Edmans calls "inside debt" - are similar to unsecured credit in that if the firm goes under, pensioners stand in line with other creditors to see just how much they'll recover.

For about 13 percent of CEOs, in fact, their debt-like compensation is worth more than their equity stakes. 

The idea of tying executive pay to debt-like instruments is slowly gaining attention. In June, AIG announced that it would pay its top executives with what the company is calling "long-term performance units," consisting of a mix of about 80 percent debt and 20 percent common stock, according to this report.

The optimal split between debt and equity in executives' compensation plans will vary from one firm to another, Edmans says. Often, it will mirror the financial structure of the firm itself, with compensation packages that tilt toward equity in smaller, growing firms that have greater growth opportunities, and greater percentages of debt in mature firms that are growing at a more measured pace. The goal is to motivate execs to keep in mind the interests of both sets of investors.


Comments (1)Add Comment
Jack Henrie
written by Jack Henrie, July 16, 2010
True "good to great" Level 5 leaders, as I believe that Jim Collins would put it, would intrinsically act to maximize long-term stakeholder (i.e., holders of equity and debt, employees, customers, suppliers, and community) wealth. Since, however, most CEOs are not truly Level 5 leaders, it is suboptimal to align executive compensation only with shareholder wealth, better to tie it to a combination of debt and equity more aligned with a risk-related long-term return on investment, and better yet to align the compensation with the stakeholders as a whole (if the right combination could be unlocked). In any case, I would agree with Alex Edmans that this approach is a step in the right direction.

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