applied corporate finance applied corporate finance

V O LU M E 2 7 | N U M B E R 3 | S U M MER 2 0 1 5

Journal of

APPLIED COR PORATE FINANCE

In This Issue: Activist Investors and the Future of the Public Corporation Ernst & Young Roundtable on Activist Investors and Their Implications for Corporate Managers

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Lucian Bebchuk, Harvard Law School; Paul Clancy, Biogen; Don Chew, Journal of Applied Corporate Finance; John Cryan, Fortuna Advisors; Shyam Gidumal, Ernst & Young; Paul Hilal, Pershing Square Capital Management; Patrick Lally, Red Mountain Capital; Greg Milano, Fortuna Advisors; Damien Park, Hedge Fund Solutions; Richard Ruback, Harvard Business School; and David Silverman, Blue Harbour Group. Moderated by Jeff Greene, Ernst & Young.

In Search of Unicorns: Private IPOs and the Changing Markets for Private Equity Investments and Corporate Control

34

Revisiting “The Fruits of Genomics”: How the Biopharma Industry Lost But Is Now Regaining its Productivity

49

A. Rachel Leheny and Eric W. Roberts, Valence Life Sciences

Be Your Own Activist

61

Gregory V. Milano and John R. Cryan, Fortuna Advisors

A Long Look at Short-Termism: Questioning the Premise

70

Michael J. Mauboussin and Dan Callahan, Credit Suisse

The Activist Investor Process Model: Phase One of a Successful Campaign—Identifying a Target

83

Damien Park, Hedge Fund Solutions, LLC and

The Hazards of Growth

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Kevin Kaiser and S. David Young, INSEAD

The Value of Reputation: Evidence from Equity Underwriting

96

Chitru S. Fernando, University of Oklahoma; Vladimir A.

Keith C. Brown and Kenneth W. Wiles, University of Texas at Austin

Troy Marchand, Foundry Capital Group

Gatchev, University of Central Florida; Anthony D. May, Wichita State University; William L. Megginson, University of Oklahoma

CEOs, Abandoned Acquisitions, and the Media

113

Baixiao Liu, Florida State University, and John J. McConnell, Purdue University

How Much Do Expatriate Earnings and Repatriation Taxes Matter to Shareholders?

122

Robert Comment

Shrinking to Grow: Evolving Trends in Corporate Spin-offs

131

Marc Zenner, Evan Junek and Ram Chivukula, J.P. Morgan

Creating M&A Opportunities through Corporate Spin-Offs

137

Mieszko Mazur, IESEG School of Management

Multiples, Forecasting, and Asset Allocation

144

Javier Estrada, IESE Business School

The Hazards of Growth by Kevin Kaiser and S. David Young, INSEAD*

he number 29 seems harmless enough, but it got General Motors into a heap of trouble not too long ago. In 2003, GM’s North American market share dropped to 28.3 percent. This was down from 28.7 percent the previous year, the first such decline the company had experienced in three years. So what did the GM executives in their wisdom choose to do? Did they take a closer look at the value drivers within the company in order to figure out where greater value-generation could be achieved? Did they adopt a fresh perspective on the way in which they judged the NPV of the projects they invested in, or on their day-to-day decision-making? No. They started wearing lapel pins in the shape of the number 29. The purpose of this move was to challenge and encourage employees to push GM’s market share back over that figure. When an indicator falls, how do most companies react? Set it higher as a target for next time. The president of GM North America was quoted as saying, “29 will be there until we hit 29. And then I’ll probably buy a 30.”1 We don’t need to tell you how things turned out at GM, but we will anyway: value-destroying growth investment, a slow death resulting in bankruptcy, and a massive bailout from the U.S. government. A growth strategy can be an inspirational thing, but it can also be dangerous. Nowhere does indicator-driven management manifest in a more noxious way than in obsession with growth and market share.2 We suspect that if you could somehow observe the growth targets set by senior managers in every publicly traded company in Europe, North America, and Japan, and then weight the targets for firm size, the result would be a lot greater than the 2% annual growth that one should reasonably expect for the entire global economy. The conclusion is that many corporate growth plans are doomed to destroy value. Why? To understand better how an undue focus on growth can cause companies to derail, recall the simple rule of

value creation: projects with an expected Return On New Invested Capital (RONIC) above the Opportunity Cost of Capital (OCC) are value creating, and those with an expected return below the OCC are value destroying. Now imagine what happens to the number of available projects with expected returns above the OCC. As time passes and the effects of competition are felt, along with the ever greater demands of customers, employees, and suppliers, expected returns and profits will almost certainly erode. If you are a company focused on gaining market share, you must woo customers from your competitors. To make potential customers aware of your existence, you will need to expend resources. And to make it worthwhile for those customers to switch—by improving the product, say, or lowering the price—you will need to expect still more. As long as the expected return from pursuing these customers exceeds the OCC, your investors will be happy to provide the needed funds. Then again, industry rivals might conspire to limit competitive forces before the RONIC is driven all the way down to the OCC. As an example, if we assume the OCC is 8% and the average RONIC 12%, it wouldn’t surprise you if your competitors were to form a cartel to stave off the threat of you entering the fray. Will it work? For a while, maybe—but eventually, economic forces—or what we refer to in our book as “nature”—will assert themselves and bring the cartel down. The market, in its instinctive wisdom, will pave the way for new entrants with value-creating ideas. The incumbents will not be able to ignore this new attack; they will respond to the pressure by driving the RONIC to 8% in spite of their initial efforts, along with those of their fellow colluders, to keep it higher. It isn’t only consumers who will take a stand against the scheme. Employees, too, witness the attractive returns delivered to investors and speak up, wanting their fair share of

* This article is a slightly edited version of a chapter in our recently published book, The Blue-Line Imperative, John Wiley & Sons 2014. It is printed here with the permission of the publisher. 1. H. Simon, F.F. Bilstein and F. Luby, 2006, Manage for Profit, Not for Market Share, Boston: Harvard Business School Press, p. 1. 2. Organizations of all types rely extensively on key performance indicators (KPIs) to define and evaluate success. To motivate performance, target outcomes for these indicators are often linked to management bonuses. In a previous article in this journal (Managing for Value 2.0, Winter 2014), we argued that such practices are usually counter-

productive. Instead, companies are better served by using KPIs as instruments for organizational learning. To make these arguments, we introduced a concept called “blue-line management,” an approach in which all decisions of consequence are made with one aim in mind: to create value. This approach stands in stark contrast to the more common practice of “red-line management” in which value creation may be the stated goal, but the business is managed to deliver on specific indicator targets or other objectives, to the detriment of value creation.

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Journal of Applied Corporate Finance • Volume 27 Number 3

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the pie. They demand pay increases, further driving down the RONIC. And what about suppliers? Will they not want to increase their own profits if they know how much money the company is generating? Why, certainly they will. The RONIC takes another hit and is pushed further downward. In understanding and embracing the value creation imperative, you must always remember the lesson from the first chapter of our book, The Blue Line Imperative: whenever you manage to achieve a rate of return greater than the OCC, you may as well paint a target on your chest, because nature does not share your idea. It will always respond by trying to take profits from you. And nature will again adjust. The normal result is a combination of consolidations (mergers and acquisitions) and liquidations until the forces have balanced out again and the RONIC is driven back up to, or above, the OCC. This explains the frequent phenomenon of “roll-ups” in declining industries. The continuous interplay of the various forces of nature means that the steady state outcome—one that balances the demands of customers, employees, suppliers, and investors—is one where the RONIC equals the OCC. The Lesson of Competitive Advantage If every element in nature is trying to maintain balance toward the OCC, how can any company consistently earn expected returns above it? We’ve just said that any returns your company generates above the OCC will inevitably be taken back by nature in order to restore the value-creation balance. Aren’t we contradicting ourselves? The answer lies in SCA, or Sustainable Competitive Advantage. When your company establishes this, it creates the possibility—not a guarantee, but a possibility—of earning returns that consistently exceed the OCC. Companies that routinely earn RONICs higher than their OCC have developed some trait or attribute that enables them to push vigorously back against the competing forces and keep them at bay while still creating value. A company with no discernible SCA will inevitably see its RONIC fall to the level of the OCC or below it. Not many firms in an industry or given market can have an SCA at any point in time. If only one or two companies in a given market can have an SCA that allows investments where the RONIC is greater than the OCC, then logically for the other companies in the industry, expected earnings fall below the OCC. Otherwise, the average RONIC for the industry average would exceed it. For most companies, in other words, the only way to achieve “growth” is to invest in negative-NPV projects. 3. T.J. Peters, and R.H. Waterman, R. H., 2004, In Search of Excellence. London: Profile Books. “Authors’ Note: Excellence 2003.” 4. R.R. Wiggins and T.W. Ruelfi, 2002, “Sustained Competitive Advantage: Temporal Dynamics and the Incidence and Persistence of Superior Economic Performance,” Orga-


Let’s say it another way. If your company does not have a competitive advantage, it has no access to positive-NPV projects. Therefore growth can come only from value-destroying projects. Since any additional investment is going to necessarily destroy value, the obvious move is for the company to stop investing—and, ideally, to divest and shrink. The managers in your company are going to be pretty reluctant to take this course of action, naturally, but if they don’t, nature—that is, your customers, your competitors, and your investors—will surely compel them to. But if your company has unlocked some type of SCA, that is, it has created access to ongoing positive-NPV investments, valuecreating growth is possible. It still depends on a blue-line mentality, however. Sustainable Competitive Advantage doesn’t last forever. That’s why we call it sustainable and not permanent. When Sony’s Walkman portable audio cassette player came out in the 1980s, it took the industry by storm and was spectacularly profitable for its maker. However, no one could predict how long the trend would last. Certainly even the best market prognosticator couldn’t have told you in 1986 that the device would eventually come to be replaced by the MP3 player. New ideas come along, technology progresses, and preferences change. The rule holds not just for products, but at a company level, too. Tom Peters and Robert Waterman, the authors of In Search of Excellence, famously pointed out that they “weren’t writing Forever Excellent”3 in their note to the 2004 edition of their best-selling book. Studies by Robert Wiggins and Timothy Ruelfi4 reported finding that a staggering 95% of the authors’ sample of 6,772 companies failed to hold their position of advantage for 10 years. Less than half a percent stayed the course for 20 years, and just three were still out-performing their rivals after 50. The researchers discovered another, equally interesting fact. Not only was competitive advantage difficult to sustain, it became progressively more difficult as time went on. The more recent the observations, the lower the average time companies were able to retain their competitive advantage, and the higher the chances of their being overtaken by competitors. In short, sustaining competitive advantage has become a tougher test than ever. Rather than defining competitive advantage in quite the same way as Wiggins and Ruelfi, we choose to employ a more rigorous standard represented by a single question, which will come as no surprise: Is the company creating value or not? This question is one that should be self-directed. Many companies make the fundamental mistake of defining competitive advantage according to a comparison against nization Science 13, no. 1: 81-15. R.R. Wiggins and T.W. Ruelfi, 2005, “Schumpeter’s Ghost: Is Hypercompetition Making the Best of Times Shorter?”Strategic Management Journal 26: 887-911.

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Table 1 Claringdon Glassworks

Past 3 Years

2012

Revenues

2013

2014

864

907

952

Cost of Goods Sold

(432)

(454)

(476)

Selling, General & Admin

(130)

(136)

(143)

Depreciation

(143)

(150)

(157)

EBIT

160

168

176

Taxes on EBIT

(56)

(59)

(62)

NOPAT

104

Depreciation

115

143

150

(5)

(6)

(6)

(177)

(189)

(199)

64

64

66

Increase in working capital Capital Expenditures

109

Free Cash Flow

157

other firms within the same industry. Throughout the strategy literature we come across statements such as, “An attractive position is one where the company has a sustainable competitive advantage enabling it to earn greater profits than its industry peers.”5 This definition is deeply misleading and potentially dangerous. Value creation does not occur because we outperform our competitors. If an industry is filled with companies pursuing negative-NPV investments—that is, collectively destroying value—there is still going to be some company at the top of that list—the company doing the least bad. Merely doing better than one’s peers says nothing about whether future investments will create value or destroy it.

Growth versus Value So should your company simply ignore growth as an objective? Should it be summarily discarded as a tool of evil and disaster? Not at all. The issue is that most firms, even those in mature sectors, express growth as a major performance objective—whether defined in terms of revenues, market share, profits, cash flow, total assets, or some other indicator—in a self-contained way. Setting growth as a target in isolation will indeed lead to problems. The question must be reframed: It should never be simply, “How much can we grow?” but rather, “How much can we grow without destroying value?” The answer depends entirely on the expected returns you can deliver on new investment, which in turn depends on the strength of your sustainable competitive advantage. Consider the situation of a company we will call Claringdon Glassworks, a firm that, as can be seen in Table 1, established sufficient competitive advantage over the past few years to generate value-creating revenue growth of 6% per year: In the current year, however, Claringdon’s competitive advantage is beginning to erode, and this backslide is starting to show up in the numbers. The first noticeable impact is that growth in future revenues, profits, and cash flows has declined even though previous levels of capital expenditures (CapEx) have remained unchanged. A typical response to this loss of competitive advantage is to invest even more in the hopes that it can be restored. As we see below in Table 2, this can be a big mistake. As you can see in the above forecast, the returns on investments delivered in the past three years were 13.2%, 12.2%, and 11.9%.6 By 2015, Claringdon’s RONIC drops

Table 2 Forecast – Income Statement/Balance Sheet/Cash Flows

Past 3 Years

2012

2013

Revenues

Explicit Forecast Period 2014

2015

2016

2017

2018

2019

2020

864

907

952

1,000

1,040

1,082

1,125

1,170

1,217

Cost of Goods Sold

(432)

(454)

(476)

(500)

(520)

(541)

(562)

(585)

(608)

Selling, General & Admin

(130)

(136)

(143)

(150)

(156)

(162)

(169)

(175)

(182)

Depreciation

(143)

(150)

(157)

(165)

(172)

(178)

(186)

(193)

(201)

EBIT

160

168

176

185

192

200

208

216

225

Taxes on EBIT

(56)

(59)

(62)

(65)

(67)

(70)

(73)

(76)

(79)

NOPAT

104

109

115

120

125

130

135

141

Depreciation Increase in working capital Capital Expenditures Free Cash Flow

146

143

150

157

165

172

178

186

193

201

(5)

(6)

(6)

(10)

(10)

(10)

(11)

(11)

(12)

(177)

(189)

(199)

(209)

(217)

(226)

(235)

(244)

(254)

64

64

66

67

69

72

75

78

81

5. E. Beinhocker, 2006, The Origin of Wealth. Boston: Harvard Business School Press, p. 324. 6. The historical RONICs were calculated by dividing the incremental NOPAT (yearon-year change) by the incremental invested capital. For example, the incremental

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NOPAT from 2012 to 2013 is (109.1 - 103.9), or 5.2, while the incremental invested capital is (173 + 5 – 143), or 39, which yields, after adjustment for rounding error, 13.2%.

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Table 3 Claringdon’s RONIC Scenario:

Growth rate by year

RONIC

2015

2016

2017

2018

2019

2020

2021

0

9%

4.0%

4.0%

4.0%

4.0%

4.0%

4.0%

4.0%

1

10%

3.0%

3.0%

3.0%

3.0%

3.0%

3.0%

3.0%

2

8%

4.0%

5.0%

6.0%

7.0%

7.0%

7.0%

7.0%

3

11%

1.5%

1.5%

1.5%

1.5%

1.5%

1.5%

1.5%

Scenario:

2015

2016

2017

2018

2019

2020

CAGR

0

120.3

125.1

130.1

135.3

140.7

146.3

4.0%

1

120.3

123.9

127.6

131.4

135.3

139.4

3.0%

2

120.3

125.1

131.3

139.2

148.9

159.4

5.8%

3

120.3

122.1

123.9

125.7

127.6

129.5

1.5%

Table 4 NOPAT

NOPAT

Scenario:

Free Cash Flow 2015

2016

2017

2018

2019

2020

CAGR

0

66.8

69.5

72.3

75.1

78.2

81.3

4.0%

1

84.2

86.7

89.3

92.0

94.7

97.6

3.0%

2

60.1

46.9

32.8

17.4

18.6

19.9

-19.8%

3

103.9

105.4

107.0

108.6

110.2

111.9

1.5%

to 9%, which means that its investments are now—at least on average—destroying value. What will happen if, in the face of this new, lower, growth rate, management decides to ramp up investment with the aim of maintaining the same growth rate as before or even increasing it? As an alternative, what if, in acknowledgement of the new reality, they scale back growth plans in an attempt to refocus and rebuild competitive advantage? The answer can go a few different ways. Below are four different scenarios that define the average RONIC the company can earn on its future projects, including a target growth rate: • In scenario 1, which is shown in Table 3, Claringdon grows at 4% per year, slightly lower than the 5% average annual growth it achieved over the past few years. This growth rate, however, is still above that allowed by the company’s SCA, assuming that it limits investment to positive-NPV projects. The average RONIC (the average of the positive-NPV and negative-NPV projects which together provide the 4% growth) is 9%. The resulting value of the company is 1,177. • In scenario 2, management recognizes that Claringdon’s competitive situation has changed. Any growth beyond 3% requires investment in negative-NPV projects, which management has the discipline to avoid. It settles on Journal of Applied Corporate Finance • Volume 27 Number 3

a targeted growth rate of 3%, with neither value creation nor value destruction resulting from the new investments. The consequent value of the company is 1,203. • In scenario 3, management fails to recognize the loss of competitive advantage and senses that the decline in growth is having a negative impact on morale, perhaps because bonuses, promotions, and overall employment fall as profits decline. It elects to focus on growth without regard to value creation. The strategy delivers rising growth rates, from 4% to 5%, then 6%, and, finally 7%. Except it requires investment in a growing number of negative-NPV projects. The average RONIC is driven down to 8%, and Claringdon’s value declines to 1,115. • In scenario 4, recognizing the loss of competitive advantage, management eschews ambitious growth targets and instead decides to re-group and refocus. Based on a careful assessment of the company’s competitive situation, growth targets are lowered to 1.5%. The new strategy is successful in rebuilding competitive advantage, to the point of obtaining an average RONIC of 11%. Because the OCC is 10%, the average investment creates value such that, even with the lower growth rate, the value of the firm is 1,210— higher than in any of the other scenarios. Table 4 shows NOPAT and free cash flow, by year, for each scenario: Notice that while scenario 3 has the highest growth rate in Summer 2015

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NOPAT (and revenues), it has the lowest level of free cash flow and, ultimately, the lowest overall value because of the need to invest heavily to support a high growth-rate target in the absence of competitive advantage. The next lowest level of free cash flow is scenario 1, which again suffers from the need to invest heavily because of growth targets that exceed the company’s ability to identify and execute positive-NPV investments. To understand why the investment needs to be higher when the RONIC is lower, think about the following expression: NOPAT × g = NI × RONIC, where NOPAT is net operating profit after tax, g is the growth rate for NOPAT, NI is net investment, or the investment beyond that required for maintenance purposes, and RONIC is the return on new invested capital. More precisely, NI is the sum of additional investment in the Working Capital Requirement7 and Capital Expenditures (CapEx) after deducting depreciation (which is used as a proxy for maintenance investment).8 Thinking slowly through this expression, we see that the NI needed to deliver growth in profit of g% depends on the RONIC to be earned on the new investment. The lower the RONIC, the more investment is required to deliver the desired growth. As this example shows, then: • If RONIC is less than the OCC, growth destroys value. • If RONIC is greater than the OCC, growth creates value. • If RONIC equals the OCC, growth has a neutral impact on value, because all future investments are zero-NPV. • If growth equals zero, there is no investment (beyond maintenance levels) and therefore no return on new investment, so the impact on value is nil. A different way to think about it is this: When growth targets are disconnected from true value creation, growth itself may lead either to value creation or value destruction, but it’s usually the latter. When a target is focused on growth for its own sake, whether in the form of revenues, operating profits, or market share, delivering on the target often requires value destruction, for the simple reason that access to valuecreating growth is strictly limited by the nature and extent of the company’s SCA. The human factor plays a key role in this. Sensing the importance of delivering on the growth target to keep their jobs, managers will fight to deliver it, even while many of them will feel it isn’t right thing to do. 7. The Working Capital Requirement is the sum of operating cash, trade receivables, inventories, and prepaid expenses, net of the sum of accounts payable, advances from customers and accrued liabilities such as unpaid taxes and salaries. This investment can be viewed as the additional investment required to get fixed assets (i.e., property, plant, and equipment) to work. For example, a new retail store cannot increase company sales and profits unless it is stocked with inventory.

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It’s the system that needs fixing, not the particular decision-maker. If your only chance to get a nice bonus and a promotion depends on hitting the target, and your family’s well-being depends on your getting that nice bonus and promotion, there you have it. This is the reason it is so easy to find evidence of companies that set growth targets and then aggressively pursue them until they destroy the firm, or at least until painful restructuring is needed. Value-destroying Growth: A Cautionary Tale In the 1990s, while the global oil industry was consolidating and facing record low prices for petroleum, one major player found it hard to keep up because of its unique ownership structure. Nevertheless, the company sought to retain its industry ranking for a number of reasons, some valuebased, like economies of scale and scope or negotiating power, others decidedly separate from value, like ego and vanity. To keep pace with its rivals, the company set ambitious organic growth targets at a time when oil prices were low. The effect, of course, was to make value destruction a virtual certainty. The intended growth took hold and continued. After several years of this progress, the newly hired head of strategy decided to analyze performance for a large number of projects from a blue-line perspective. That is, she decided it would be a good idea to assess outcomes of this initiative relative to expectations at the time of the investment decisions. What she found was deeply distressing. In nearly all cases, the delivered performance was demonstrably below that of expectations, at least the expectations reported in capital budgeting documents. Because the company had been using rigorous NPV planning tools for years, and its senior managers had a well-deserved reputation for being among the most competent and knowledgeable in the industry, the head of strategy suspected that the systematic error could be explained by only one factor: a lack of honesty in the projections. In other words, the reported expectations of future cash flows far exceeded the true expectations held by the managers requesting the capital. When the head of strategy confronted the offending parties with her suspicions, several managers admitted that they knew there were simply not enough positive-NPV projects to deliver on the company’s growth targets. But the targets had to be met, so they re-worked the assumptions on negative-NPV projects, disguising them as positive. The dual outcome was the same one we’ve observed in too many companies to count. The targets were hit. And billions of dollars in value were destroyed.9

8. The idea here is that depreciated assets must be replaced by the company to maintain its physical stock of assets. Therefore, depreciation is a proxy for required capital expenditure. Expenditures above this amount are considered “Net Investment.” 9. Senior managers from the company revealed the estimated losses to us, but asked us not to reveal the figure.

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If Growth Is So Bad, Why Are Companies Obsessed with It? Marketing consultants Hermann Simon, Frank Bilstein, and Frank Luby claim that what they call the “market share movement” can be traced back to two main intellectual influences.10 First is the “PIMS study,” a famous research report published in 1987 that reported a strong correlation between market share and profit margin.11 The market leader in a given industry was found to enjoy profits (measured by pre-tax return on investment) that were roughly three times greater than the fifth-largest competitor. An obvious conclusion drawn from such a finding is that if you want more profits, you need to grow, and the faster, the better. The second important source for this growth obsession is the so-called “experience curve.” As Simon et al. explain, “This concept says that a company’s cost position depends on its relative market share.… The higher this position, the lower that company’s unit costs should be. The market leader automatically has the lowest costs in the market and therefore the highest profit margin.”12 The implication is that companies with higher market share enjoy economies of scale and pricing power not available to their smaller competitors. Again, the apparent lesson for corporate leaders would seem to be to drive market share as high as possible and leave it at that. In the 1970s, the Boston Consulting Group became one of the main promoters of this idea. Subsequent research has chipped away at both concepts, but the growth fixation has never lost its appeal at the highest rungs of the corporate ladder. Simon et al. point out that “business schools initiated thousands of MBA students into the market share cult. Those who earned their MBA degrees in the 1970s and 1980s—and who soaked up the philosophy in its freshest, most concentrated form—now hold C-level positions.”13 Indeed, one of our motives in writing The Blue Line Imperative, the book this article is based on, was to conquer the market share obsession and replace it with the obsession to create value. While the factors identified by Simon et al. have certainly played a part in promoting value-destroying growth, other factors may be more important still. For example, an additional reason for the staying power of the “grow at all costs” philosophy is the way in which popular measures associated with business growth, such as sales volume, revenue growth, and market share, are indeed excellent indicators of whether a company has created SCA through innovation.

After all, successful innovators, all else being equal, deliver greater volume and revenue growth than their competitors. The problem is that managers too often interpret cause and effect backwards, assuming that if the company achieves high growth and increases market share, it must mean that it was “successful,” when in fact the causality is frequently in the opposite direction. Genuine innovation, and the competitive advantage that logically follows from it, translate into growth. Too many firms have been managed into oblivion because senior management failed to understand this critical distinction.

10. See H. Simon, F. Bilstein and F. Luby, 2006, Manage for Profit, Not Market Share, Boston: Harvard Business School, pp. 8-10. 11. PIMS stands for “Profit Impact of Market Strategy,” and was designed to determine, based on rigorous empirical testing, which business strategies lead to success in particular industries. The data were drawn from thousands of business units in hundreds of companies. The “PIMS study” cited by Simon, et al. is The PIMS Principles: Linking Strategy to Performance, by R.D. Buzzell and B.T. Gale, New York: Free Press, 1987, and was based on data gathered in the 1970s and early 1980s.

12. Simon, et al, p. 9. 13. Ibid., p. 14. 14. Most of this section is based on the work of one of the authors of this article (Young) and Stephen F. O’Byrne of Shareholder Value Advisors, Inc. 15. A 1936 study by future Harvard Business School dean John Baker found that 18 of 22 companies analyzed gave management a share of economic profit or profit above a specified dollar threshold. 16. Also, option pricing models such as Black-Scholes were not available before the early 1970s. The lack of a credible pricing model would have rendered any attempt to charge a single bonus pool with the value of option grants problematic at best.


The Problem with Executive Pay14 All of the reasons above are significant contributors to the obsession with growth and the value destruction that so often results. But perhaps the most significant reason for the persistence of growth-driven strategies is the compensation many senior executives receive for delivering on them. You may be surprised to hear that executive pay practices, at least in the U.S., were often more value-driven in the first half of the 20th century than they are now. In 1922, General Motors adopted a bonus plan that awarded management 10% of the profit in excess of a 7% return on capital. This approach was a simpler (and, as we will see later, a better) version of the EVA (Economic Value Added) based compensation practices that became popular in the 1990s. Since value is a function of a company’s ability to generate returns above the cost of capital, paying bonuses directly linked to how much profit the company earns above this threshold is an effective way to align management and shareholder interests. In effect, the GM plan was a comprehensive bargain between management and shareholders, covering all incentive compensation, both cash and equity-based. Moreover, given their long-term tenure, senior managers had little incentive to boost earnings in the short term at the expense of long-term value creation. This type of approach wasn’t exclusive to GM at the time. Such formulae were common among large American companies before World War II.15 Sadly, comprehensive incentive formulas started to wane in the 1950s, due primarily to two factors. First, changes in tax laws encouraged more companies to grant stock options, but almost no companies charged option values to the bonus pool.16 They created a separate bonus pool instead. On its own, the growing use of options was not problematic. If used more judiciously, in fact, it might have strengthened

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wealth-creating incentives. But because there were now two separate formulas, one for cash bonuses and the other for equity incentives, companies gradually abandoned the discipline that came with a single comprehensive formula. Under the old GM system, senior managers received bonuses only to the extent that the cost of capital had already been covered. In addition, there was a single sharing percentage, so everyone knew management’s cut of the value created. The system was simple, tidy, and fair. But the GM approach of giving managers a percentage of economic profit was compromised by the widespread adoption of stock option programs, because the value of the option grants was not directly linked to economic profit earned. It could have been, but few companies bothered to make the effort. A significant portion of management rewards had been disassociated from value creation. The second, and more direct, reason for the gradual abandonment of comprehensive incentive formulas was the new focus on “job value” and “competitive pay” and the correspondingly reduced attention to an individual manager’s contribution to value. After World War II, the human resources movement fundamentally altered the way everyone in business would be paid, including those at the very top. In 1950, the American Management Association conducted its first survey of U.S. executive compensation and the Hay Guide Chart for job evaluation was standardized the following year. The early compensation surveys used profit as a measure of size, soon switching to revenue. Henceforth, benchmark pay would be defined in terms of revenue, not profit or value creation. Meanwhile, over the ensuing years a large industry of compensation consultants emerged, with the benchmarking of pay serving as the “bread and butter” of their practices. Through these consulting firms, compensation practices in the U.S. gradually found their way into European and Asian companies. IBM provides a good example of the transition to modern human resource practice and its effect on compensation at the senior managerial level. When Tom Watson joined Computer Tabulating Recording Company as CEO in 1915, he had a salary and a 5% share of after-tax profits, net of dividends. As late as 1960, IBM had 90 executives with well-defined individual shares of corporate profit. In the mid-1960s, a major consulting study led to a new compensation program that eliminated individual profit shares, introduced formal job evaluations, and established target compensation levels. By the 1970s, the comprehensive shareholder-management bargain embodied in the GM approach of the 1920s was all but finished. Competitive pay policies gradually became the norm just about everywhere you looked. The practice begins with the identification of a peer group for each management post.

Peers are usually found among other companies, including competitors, with adjustments made for size. In most sectors, size is defined in terms of revenues. Imagine a manufacturer of small household appliances that generates revenues of $3 billion. With the help of compensation consultants, a peer group is defined, consisting of CEOs of similar companies having similar revenues. After the consultants determine the distribution of pay among the CEO’s peers, a target is then set—for example, 50th percentile pay. This means that if about half of the peer-group CEOs make more than $2 million while the other half make less, the target level of total annual compensation for our CEO is $2 million. The consultant will also advise the company, based on the practices of comparable firms, how to divvy up the $2 million among salary, annual bonus, deferred bonus, stock and stock option grants, and pension benefits. Competitive pay policy decreases the chances of losing good people to poaching competitors while ensuring that pay is also not too far above market, therefore limiting shareholder cost. Corporate boards then try to create strong incentives by putting a high percentage of pay at risk. That is, a significant portion of pay in any year is tied to performance, with performance most often defined as some measure of profit. But as reasonable as it might sound, this practice has serious flaws. First, percentage of pay at risk is not a good measure of incentive strength. Most of an executive’s pay package can be at risk even while financial incentives for wealth creation are weak or nonexistent. Second, a competitive position target (for example, target pay at the 50th percentile for a manager’s peer group) is not a sensible retention objective. It is not needed to retain poor performers, and is usually insufficient to retain superior performers. Another problem with competitive pay is that it rewards CEOs for value-destroying growth. CEOs increase their level of competitive pay as the revenues (not profits or even economic profits) of the firms they manage increase because the standard is set by a new group of larger companies. It is much easier for a CEO to increase revenues by reinvesting free cash flow at inadequate rates of return and by overpaying for acquisitions than it is by actually creating value. But perhaps the biggest problem with competitive pay policies stems from one of its most common features—the “recalibration” of targets and rewards each year to ensure competitive pay in the following year—a practice that explains why even pay systems based on EVA17 or economic profit usually fail to deliver the promised results. For example, if profit targets aren’t met in the current year, the board may simply lower the target for next year to ensure that managers can expect compensation equal to peers at other companies. Or, if the share price falls, managers might be given larger option grants. Again, the aim is to ensure target compensa-

17. EVA is a registered trademark of Stern Stewart & Co.

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tion is maintained, independent of prior performance. Since peer-group pay estimates are largely unaffected by company performance, annual recalibration to competitive pay levels creates systematic and bogus “performance penalties.” These benchmarking and recalibration practices also explain why the percentage of pay-at-risk says almost nothing about the effectiveness of wealth-creating incentives for senior managers. A CEO might have 80% or more of her total compensation at risk—a typical percentage among CEOs of publicly traded companies—yet still her actions can destroy huge amounts of wealth. Summary Not all growth is good for shareholders, not even growth in earnings. It depends on how much investor capital is used to achieve that growth. When a company fails to earn a competitive return on invested capital, it is destroying value for its shareholders. The corporate obsession with growth results in part from a confusion of cause and effect. In most cases, successful companies have also experienced above average growth in revenues and earnings. But so have many unsuccessful companies, at least for significant periods of time. And this means that the direction of cause and effect between earnings growth and value is critical: Is the company growing profit


because it has a sustainable competitive advantage (SCA) that it is exploiting to grow market share, revenue and profit by investing in the positive NPV projects made available by the SCA? If so, then value is being created. However, the fact that a growth in market share, revenue, profit or other indicator is generally the result of a company possessing and exploiting its SCA, does not imply that the reverse is true. If the value of the new profit is less than the price that must be paid to obtain it (neither market share nor profit are typically “free”—each comes at a cost), then obtaining this new profit will destroy value. What’s more, when companies destroy value by pursuing unprofitable growth, there are opportunities for activist investors to add value simply by cutting investment. Kevin Kaiser is Professor of Management Practice at INSEAD. He can be reached at [email protected].

S. David Young is Professor of Accounting and Control at INSEAD. He can be reached at [email protected]. They are co-authors of The Blue Line Imperative: What Managing For Value Really Means (Jossey-Bass) which can be purchased on Wiley.com. http://www.wiley.com/WileyCDA/WileyTitle/productCd-1118510887.html.

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ADVISORY BOARD

EDITORIAL

Yakov Amihud New York University

Carl Ferenbach High Meadows Foundation

Martin Leibowitz Morgan Stanley

Laura Starks University of Texas at Austin

Editor-in-Chief Donald H. Chew, Jr.

Mary Barth Stanford University

Kenneth French Dartmouth College

Donald Lessard Massachusetts Institute of Technology

Joel M. Stern Stern Value Management

Associate Editor John L. McCormack

Amar Bhidé Tufts University

Martin Fridson Lehmann, Livian, Fridson Advisors LLC

G. Bennett Stewart EVA Dimensions

Design and Production Mary McBride

Michael Bradley Duke University Richard Brealey London Business School

Stuart L. Gillan University of Georgia Richard Greco Filangieri Capital Partners

Michael Brennan University of California, Los Angeles

Trevor Harris Columbia University

Robert Bruner University of Virginia

Glenn Hubbard Columbia University

Christopher Culp Johns Hopkins Institute for Applied Economics

Michael Jensen Harvard University

Howard Davies Institut d’Études Politiques de Paris

Robert Merton Massachusetts Institute of Technology Stewart Myers Massachusetts Institute of Technology

Sheridan Titman University of Texas at Austin

Robert Parrino University of Texas at Austin

Alex Triantis University of Maryland

Richard Ruback Harvard Business School

Laura D’Andrea Tyson University of California, Berkeley

G. William Schwert University of Rochester

Steven Kaplan University of Chicago

Alan Shapiro University of Southern California

David Larcker Stanford University

Clifford Smith, Jr. University of Rochester

Robert Eccles Harvard Business School

Ross Watts Massachusetts Institute of Technology Jerold Zimmerman University of Rochester

Charles Smithson Rutter Associates

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