Last week was a great week – only 4 days of work and then a 4 day long weekend. During the week, I went to a meeting this week which changed my perspective on events in the financial community on the past 6 months dramatically. Our outside investment adviser did a report on the portfolio he manages for us. We need to be extremely financially conservative in this group, so our directives to him are very simple – 1st: “preserve the capital value of the funds”, and 2nd: “earn us some income”. He’s pretty good at “preserving wealth”, and perhaps not as good at “making money” as some of the other members of the group would like. The capital value of our funds has stayed solid, although our anticipated income has gone down.
I think he is the right choice as an investment adviser for us. But I guess he was feeling that some of my peers had wanted more income, because he was fairly defensive when he presented his results. At the end, he sensed the positive mood around the table. He relaxed and started to “wax decisively” on the state of the world.
He started off with: “It’s a strange world. I don’t get it. You know US banks on average were leveraged 30 to 1. That’s great as long as the market is on your side. You make money and look really good. You earn the big bonuses, especially if they are based on short term results. But look at the down side. All you need to make is a 3% mistake and you are insolvent. What happened to the people who ran these places? Just think of it in personal terms. You are worth a million bucks. You go out and borrow 30 million based on that. You invest in an up market and you predict that you will earn great returns. But just make a little mistake, and you are completely insolvent and that state of affairs lasts a long time. What happened to common sense? How did we get to a place where it was missing in so many of the folks in the executive suites and on the Boards of the Banks and insurance companies? I guess what let them think that taking this kind of risk was o.k. is that they were not playing with their own money. They were not running the risk of going down personally. But where is the decency in what they did? Cripes, they were supposed to be business leaders, not card sharks and gamblers!”
I thought about that as I drove back to the office from the meeting. How did so many well intentioned, law abiding, smart people get it wrong? How did we get involved in this kind of collective confusion about numbers? Most of us in business took stats in college. We understand probabilities. How did we collectively go so wrong? We have had to mortgage our childrens’ future to pay for our mistakes. That is what we are doing when we turn to the government to put money into the banks and other business to keep them from going insolvent. Taxes will rise to pay for all of this. We may some part of this increase ourselves, but it is more likely that our children will end up paying the majority of the increased taxes. That means that we are taking from our children, never a sound moral choice.
There are lots of reasons for our collective confusion. The events in the North American financial industry will no doubt become a fruitful source for Master’s and PHD dissertations to come. But I believe that at least part of the answer has to be with the fact that we got confused about the basic role of the executive management tier in our enterprises. We started to believe that their job was to meet the needs of only one group among an enterprise’s stakeholders.
This schematic, like all models, is simpler than the real world. But it also allows us to ask an insightful question. If this picture depicts the complex and often conflicting pressures on an enterprise, what is management’s role in dealing with them? The answer is straightforward to articulate and difficult to do: work through the competing and dynamic pressures coming from all the stakeholders in the environment in a way ensures that the enterprise survives now and into the future.
In a for profit enterprise, that means making money this year, but doing it in a way that ensures that the enterprise is still there to do it next year, and the year after that, and the year after that. Management has to be focused on the now and the future at the same time. Making money this year in a way that risks survival in the future is clearly a foolish MANAGEMENT thing to do.
But that is exactly what happened in our financial institutions. How did this come about? Our executive compensation practices of the last 20 years have something to do with this. The compensation gurus have argued that senior management should have “skin in the game”, that their compensation packages should be aligned with the interests of the shareholders and investors in the enterprise. In doing so, they have forgotten that the task of management is not simply to create benefit for external shareholders and investors. Bonus plans that focus on Earnings per Share, and compensation schemes that reward executive with share ownership, do exactly that. They distract management from its fundamental job.
Executive management must work through all of the competing external demands from the environment, and create strategic plans and executive tactical solutions that allow the enterprise to survive in a balanced way in both the short term and the long run. Our executive compensation practices have lost sight of this. They too closely align executives with external investors, who are only one of the external stakeholders who depend on the survival of the enterprise. So we have the consequences: group of extremely well compensated executive who were not committed to the long term survival of the enterprises they run. Short term results for both themselves and their investors became their primary focus. They took risks that could create tremendous short term financial results. But while doing so, they lost sight of their responsibility to ensure long term enterprise survival.
This is not the only reason for our collective lack of common sense. But it was one. It needs correction now. Executive compensation practices need to reflect management tasks. Some part of an executive’s pay need to reflect current profit. But other parts of an executive’s compensation package needs to be tied to profits that are yet to come: next year and conceivably over the next 10 years. Shares which executives come to own and can sell in their own right do not accomplish this. We need an executive compensation structure that is tied to the stream of profits that are actually experienced by a for profit enterprise over a 5 to 10 year time frame. This mechanism must work even if the individual executive has retired or moved on. Golden parachutes, short term bonuses and share ownership plans have not done the job. It is time for the executive compensation gurus to put their long term conceptual hats on, and come up with something better.
