What Babcock & Brown teaches us about executive pay

While Babcock and Brown shareholders might not agree, the infrastructure house’s implosion may have a small silver lining. That is, the catastrophic share price collapse might just lead to a dramatic rethink in how executives are valued and remunerated. And by rethink we don’t mean reduce by 5% or provide executives with a few more options and less fixed pay, but rather a drastic redefinition of the contribution of executives to shareholder value.

Some of the remuneration received by leading executives last year is, even without the benefit of hindsight, appalling. None have been worse than Babcock’s Phil Green, who for the year ending 31 December 2006 took home around $15 million in cash (none of those pesky performance hurdles for Phil) — on the back of Babcock’s fantastic shareholder return (which has since been erased). Sadly, while Green is the high watermark for “value destroying” executives, he is not alone. Other leading examples of remuneration gone wild include:

The current system, which has resulted in Phil Green collecting $50 million over three years as his company disintegrates or John Stewart earning more than $8 million while NAB loses billions on CDOs, is clearly broken. Shareholders end up paying executives a significant proportion of earnings to deliver occasional short-term gains, but over the longer term, receive negative real returns.

Given companies appear to perform well in boom times and badly in downturns — and the lack of specialised skills required to be an executive — has our society got it completely wrong in valuing public company executives? Leaving all preconceptions aside (most notably, that the most senior staff by implication must earn more than anyone else in the organization, regardless of their actual contribution to value) how much should a manager/decision maker be paid?

When an independent expert values a company during a takeover, one methodology often adopted is a comparison of peers. That is, to value BHP one can compare it to similar mining companies like Rio Tinto. Taking the same approach with executives, consider that:

• Leading QCs earn around $3 to $4 million annually (charging around $20,000 per day). A junior barrister would earn less than a million. To become a silk, upwards of five years of tertiary and a multi-year apprenticeship is required, as well as appointment by the court. Further, senior counsel earn money directly by billing clients — poor performance would lead to fewer briefs and less income;
• Top surgeons/medical specialists in fields like plastics or dermatology can expect to earn upwards of $2 to 3 million. However, the apprenticeship is grueling — six years university followed by residency then another five years of specialty training. Not only that, a surgeon will live and die on his own skills — poor performance doesn’t lead to a generous remuneration. Rather, it leads to lawsuits, personal legal liability and skyrocketing insurance premiums; and
• State Premiers will oversee multi-billion dollar economies and tens of thousands of staff receive around $300,000 annually. The Prime Minister receives only slightly more.

Top investment bankers may earn even more — some upwards of $10 million. But bankers, unlike executives, earn their income from billing clients. Bankers are required to market themselves and face an uncertain income level during market downturns. By contrast, executives require little formal education, often an undergraduate degree and possibly a two-year general MBA will suffice. Unlike a neurosurgeon, executives don’t rely on a particular specialty or skill — their job ultimately requires making decisions, usually based on advice from expensive bankers, consultants and lawyers.

Further, while there is nothing wrong with incentivisation, executives appear to be one of the few categories of employees who receive bonus payments for simply undertaking their primary responsibility (that is, making decisions). Moreover, the incentives paid to executives are often poorly designed, as the Phil Green example shows. Most CEOs receive bonuses for short-term performance, with instruments like options performance rights which provide those executives with unlimited upside and no downside.

The Babcock fiasco has shown that paying celebrity CEOs massive short-term cash payments alongside already significant fixed remuneration is not in shareholders’ interests. Hopefully, institutional shareholders and independent directors recognize and remunerate executives for the value they create, rather than the position they hold.