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Vampire CEOs Continue To Suck Blood

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As the economy continues to struggle in the seventh year of its supposed recovery after the Great Recession--despite unprecedented amounts of free government money from the Fed--CEO compensation continues to soar.

“The party goes on,” writes David Gelles in the New York Times, with a horrifying list of examples of corporate greed and value extraction. At the top of the list is a coven of four CEOs associated with John Malone at Discovery Communications who received some $350 million in 2014. Not bad for a year’s work, at a time when median compensation for workers has not increased significantly in decades.

Bloomberg calls it “gluttony.”

Harvard Business Review calls it “the biggest financial bubble of them all.”

The New Yorker says, that the effect of reforms such as say-on-pay, aimed at containing excesses in CEO salaries, has been “approximately zero. Executive compensation…is now higher than it’s ever been.”

Shareholder votes “have done little to curb lavish executive pay,” writes David Gelles. Greater public disclosure based on the view that somehow the companies would be ashamed and change their ways ”hasn’t worked.” He quotes Regina Olshan, head of the executive compensation practice at Skadden, Arps , Slate, Meagher & Flom: “I don’t think those folks are particularly ashamed. If they are getting paid, they feel they deserve those amounts. And if they are on the board, they feel like they are paying competitively to attract talent.”

“At root, the unstoppable rise of CEO pay,” says James Surowiecki in the New Yorker, “involves an ideological shift. Just about everyone involved now assumes that talent is rarer than ever, and that only outsize rewards can lure suitable candidates and insure stellar performance…CEO pay is likely to keep going in only one direction: up.”

A Macroeconomic Problem

The problem today is that the super-sized executive compensation isn’t a regrettable but tiny sideshow. It has grown exponentially and is now macro-economic in scale. It has become almost the main game of the financial sector and the main driver of executive behavior in big business.

When money becomes the end, not the means, then the result is what analyst Gautam Mukunda calls “excessive financialization” of the economy, in his article, “The Price of Wall Street Power,” in the June 2014 issue of Harvard Business Review.

Even as the members of the C-suite are delivering less and less return on assets and on invested capital, the poor performance has yet to register in their paychecks. In the period 1978 to 2013, CEO compensation increased by an astonishing 937%, while the typical worker’s compensation have declined. These executives are administrators masquerading as entrepreneurs. As Bill Lazonick has documented in his recent HBR article, these executives are “takers,” while posing as “makers”: they are extracting value, not creating it.

Thus between 2004 and 2013, publicly-listed firms in the S&P 500 used a colossal amount of their earnings—$3.4 trillion—to buy back their own stock. These firms are engaged, Bill Lazonick’s article showed, in “what is effectively stock-price manipulation.” The consequences of these share buybacks are an economic and social disaster: net disinvestment, loss of shareholder value, crippled capacity to innovate, destruction of jobs, exploitation of workers, windfall gains for activist insiders, rapidly increasing inequality and sustained economic stagnation.

No Rational Basis

There is no rational basis for these phenomena

“A major study by the economists Xavier Gabaix and Augustin Landier, who happen to believe that current compensation levels are economically efficient,” writes the New Yorker, “ found that if the company with the 250-most-talented CEO suddenly managed to hire the most talented CEO its value would increase by a mere 0.016%.”

“After all, paying someone $10 million isn’t going to make that person more creative or smarter. One recent study, by Philippe Jacquart and J. Scott Armstrong, puts it bluntly: ‘Higher pay fails to promote better performance.’”

We are not dealing with facts or rational decision-making. We are dealing with an ideology. Shareholder value theory is harming shareholders. Cronyism among CEOs is taking advantage of it. Institutional investors are complicit. Regulators play at reforms that have no prospect of having a positive effect.

“So the situation is a strange one,” writes the New Yorker. “The evidence suggests that paying a CEO less won’t dent the bottom line, and can even boost it. Yet the failure of say-on-pay suggests that shareholders and boards genuinely believe that outsized CEO remuneration holds the key to corporate success.”

The Ideological Roots Of The Excesses

The ideological source of excessive executive pay is clear: it’s what even Jack Welch has called “the dumbest idea in the world,” that is, the notions that the purpose of a firm is to maximize shareholder value as reflected in the current stock price and that CEOs must be compensated in stock to keep them focused on that goal.

These notions—still pervasive in big corporations—have paradoxically resulted in the systematic destruction of shareholder value, by encouraging a focus on short-term cost-cutting, curtailing in investment in innovation, encouraging the pursuit of “bad profits” and the extraction, rather than the creation, of value. The phenomenon is supported by cronyism in boards of directors and disinterest by regulators in fixing systemic issues.

“The cronyism of major corporate boards is a travesty,” writes Barry Ritholtz in Bloomberg:

These rubber-stamp directors, often like-minded corporate peers, use shareholder money to enrich the CEOs who appointed them. The conflict of interest isn't hidden; it's right out in the open. Nor do the compensation committees of these boards serve shareholders well. That might be because they rely upon a class of outside advisers whose job it is to devise novel ways of fattening executive paychecks. Compensation consultants give boards cover for these ridiculous compensation packages. They offer no real analysis of intrinsic value, but instead devise models that feed off of and reinforce the upward spiral in pay.

The Emergence Of Vampire Talent

How did America—a country once dedicated to the proposition that all men are created equal—become one of the most unequal countries on the planet? Why do the nation’s leaders now spend so much of their time feeding at the trough and getting ever more for themselves? Why has public-mindedness in our leaders given way in so many instances to limitless greed?

The C-suite has become "vampire talent" in the sense that they suck value from their organizations, their customers and from society, rather than creating it. They include:

1. Super-managers are people who hold administrative positions in the C-suite of private-sector bureaucracies but are masquerading as entrepreneurs. They are, to use Thomas Piketty’s slyly ironic term, “super-managers.” As such, they have been able to extract extraordinary levels of compensation. They have been lavished with stock and stock options and have been able to “manage” the share price of their firms with massive share buybacks and other financial engineering so that they receive massive bonuses. As Bill Lazonick documented in the September 2014 issue of HBR, the net effect of their activities is to extract value, rather than create value. A prime example is Sam Palmisano’s $225 million payout for his stint at IBM , while systematically extracting value from the firm for himself and the major shareholders over a period of years.

2. Hedge funds act as gamblers, speculating with other people’s money, for instance in the $700 trillion derivatives market.

Modern market structures enable hedge funds to trade like this by borrowing stock in large amounts, which means they can take short positions as well as long ones. In fact, hedge fund managers don’t care whether companies in their portfolios do well or badly—they just want stock prices to stay volatile. What’s more, they want movement in prices to be large: The more prices move, up or down, the greater the earning potential on their carried interest. They aren’t like their investment management predecessors, long-term investors who wanted companies to succeed.

3. Tollkeepers, or what Charlie Munger calls "rats in the granary." They extract rents or baksheesh, simply by reason of being able to do so. Examples include high speed trading, dark pools and some facets of banking. Martin cites one of the notorious examples: “James Simons, the founder of Renaissance Technologies, ranks fourth on Institutional Investor’s Alpha list of top hedge fund earners for 2013, with $2.2 billion in compensation. He consistently earns at that level by using sophisticated algorithms and servers hardwired to the NYSE servers to take advantage of tiny arbitrage opportunities faster than anybody else. For Renaissance, five minutes is a long holding period for a share.” Simons is not an isolated example.

Vampires Only Part Of The Time

Keeping the activities of the “vampire talent” in perspective is complicated by the fact that not everything these characters do is bad. CEOs head organizations that provide real goods and services to the economy. The financial sector, in addition to these questionable activities, serves a useful social function in funding the real economy of goods and services and providing citizens and businesses with financial security. The issue is: where do the “value-adding activities” end and the “value-extracting activities” begin?

“The real problem for the economy,” says Roger Martin in HBR,

is that hedge fund talent and executive talent both have an incentive to promote volatility, which works against the interests of capital and is damaging to the cause of labor…stock-based compensation motivates executives to focus on managing the expectations of market participants, not on enhancing the real performance of the company.

The move from building value to trading value is bad for economic growth and performance. The increased stock market volatility is bad for retirement accounts and pension funds…talent is being channeled into unproductive activities and egregious behaviors.

These imbalances, says Martin, cannot endure for long:

The income gap between creativity-intensive talent and routine-intensive labor is bad for social cohesion…In a democratic capitalist country, it is not sustainable to leave the members of the largest voting bloc out of the economic equation.

A Wider Set Of Issues For Society

It’s possible that investors will awaken from their illusions and refocus investment on creating long-term real value. But this is only likely to happen if it is part of a much wider societal transformation.

The current situation is one of fundamental institutional failure across the whole of society. The behavioral breakdown is mutually reinforcing. Hedge funds are gambling risk-free with other people’s money. "Rats in the granary" are raking in baksheesh in massive amounts. CEOs are extracting value from their firms, rather than creating it. CFOs are systematically enforcing earnings-per-share thinking in decisions throughout their organizations. Business schools are teaching these people how to do it. Institutional shareholders are complicit in what the CEOs and CFOs are doing. Regulators pursue individuals and offer placebos but remain indifferent to systemic failure. Rating agencies reward malfeasance. Analysts applaud short-term gains and ignore obvious long-term rot. Politicians stand by and watch. In a great betrayal, the very leaders who should be fixing the system are complicit in its continuance. Unless our society as a whole reverses course, it is heading for a cataclysm.

Thus change in behavior is needed in a whole set of institutions and actors: CEOs, CFOs, investors, legislators, regulators, rating agencies, politicians, analysts, thought leaders and business schools—all need to think and act differently.

The intellectual foundation of all this behavior is the notion that the purpose of a firm is to maximize shareholder value. Unless we do something about this intellectual foundation, the problem will remain. Changes in a few regulations or the tax code won’t make much difference. "Vampire talent" will find ways around them.

A Different Way Of Managing

Fortunately, a consensus is emerging around a better idea. The idea isn’t new. It’s Peter Drucker’s foundational insight of 1973: the only valid purpose of a firm is to create a customer. It’s through providing value to customers that firms justify their existence. Profits and share price increases are the result, not the goal of a firm’s activities

In the last few years, more than a score of books have been written about this better idea, including notably Roger Martin’s own book, Fixing The Game. The language, terminology and emphases differ somewhat from book to book, but there is a great deal of common ground on the overall direction of change.

Increasingly, forward-looking CEOs are speaking out in favor of change.

Moreover in a report from the Aspen Institute, which convened a cross-section of business thought leaders, including both executives and academics, the most important finding is that a majority of the thought leaders who participated in the study, particularly corporate executives, agreed that “the primary purpose of the corporation is to serve customers’ interests.” In effect, the best way to serve shareholders’ interests is to deliver value to customers.

CEOs, institutional investors, legislators, regulators, politicians, analysts and particularly business schools must join in the effort to focus organizations on their true purpose. To be sure, there is still plenty of room for substantive debate on the details of implementation but the emerging consensus of the way forward is now becoming clear. What is needed is the courage and wisdom to pursue it.

A Vast Societal Drama

We are thus at a critical point in a vast societal drama. We have reached that key moment, which Aristotle famously called “anagnorisis” or “recognition.” This is the theatrical moment in a drama when ignorance shifts to knowledge. Just as King Lear in Shakespeare’s play eventually recognized that his apparently virtuous daughters, Goneril and Regan, were a really bad lot, and that his apparently disrespectful daughter, Cordelia, truly loved him, so society is learning that much of ‘the talent’ it thought was adding value have in fact been extracting value for themselves.

As usual with anagnorisis and the shock of recognition at a disturbing, previously-hidden truth, there is a disquieting sense that the accepted coordinates of knowledge have somehow gone awry and the universe has come out of whack. This can lead to denial and a delay in action, even though the facts are staring us in the face.

If the recognition of our error comes too late, as in Shakespeare’s Lear, the result will be terrible tragedy. If the recognition comes soon enough, the drama can still have a happy ending. We are about to find out in our case which it is to be.

And read also:

Why IBM Is In Decline

From CEO Takers To CEO Makers

How Hedge Funds Transfer Wealth

Why another financial crisis is inevitable

The five big surprises of radical management

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Follow Steve Denning on Twitter: @stevedenning

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