Investors must take note of how company chiefs are paid, as it appears the managements of many firms are no longer ‘on our side’, says portfolio manager Sean Peche.
Three listed US banks have been ‘saved’ so far this year, and at the time of writing, PacWest is ‘reviewing strategic options’.
These banks have combined assets of $576bn supported by shareholders’ equity of only $16bn if you deduct the $21bn of unrealised losses on held-to-maturity securities at the last reporting date. None was closely regulated because they each have less than $250bn of assets.
Things could get worse: there are almost 100 listed regional banks in the US that fit this description, holding a combined $3.4tn of assets.
According to Bloomberg data, the CEOs of these four banks received combined executive compensation of $131m in the last three years, of which roughly 10% was salary and 90% was share-based compensation (SBC).
Bad thinking
Conventional thinking is that granting executives SBC ‘aligns’ their interests with shareholders but, as we’ve seen, this can encourage risky behaviour that isn’t in the long-term interests of shareholders – nor indeed those of any other stakeholders.
The problem is that when your incentives are so geared to the share price, there’s a game to be played: divert analyst attention away from GAAP accounting to higher ‘non-GAAP’ numbers, carefully manage the non-GAAP estimate, then beat it and cash in during the rally.
It’s a game many US companies have played. You may think this is a cynical view, but we see it often so are constantly on guard for this kind of behaviour when analysing companies for inclusion in our portfolio.
Taking a bath
Houseware group Bed Bath & Beyond (BBBY) filed for bankruptcy last week, having paid former CEO Mark Tritton $47m over the past three-and-a-half years. And like the banks, such compensation was largely share-based – Bloomberg data tells me only 7% of his total was basic salary.
In keeping with common industry practice, and presumably the recommendations of their ‘remuneration consultant’, Tritton’s primary performance target was adjusted Ebitda.
The ‘i’ in Ebitda is interest expense, so that target was before interest payments. If interest expense doesn’t matter, that means debt doesn’t matter. And if compensation is mainly share-based, then the message to the CEO is that it’s the share price that really matters. And since their non-execs also received SBC (unlike common practice in Europe and Japan), the share price really matters to them too.
Buy now while stocks last
So the BBBY board focused on the share price and spent $836m buying back shares in the past three years, even though the company was experiencing consistent operating losses and free cash outflows totalling $1.2bn over that time.
Some of these buybacks were even announced as ‘accelerated’. If you want to pay a high price, announce to the world you’re in a hurry to buy back your shares. The weak balance sheet and cash outflow meant this was all funded by debt.
This now bankrupt company spent nearly $12bn buying back shares since 2004. And they didn’t go bust because they sold obsolete products like DVDs – they went bankrupt because of gross mismanagement. What an indictment of the board who approved such aggressive buybacks under the guise of ‘returning value to shareholders’.
And who suffers from this gross mismanagement? Shareholders, suppliers, BBBY’s 37,000 employees and the real estate companies that own their stores, and the banks that lent money to those real estate owners.
But read the company’s 142-page proxy statement and its complicated SBC schemes and you’ll read about long-term incentive plans, short-term incentive plans, performance stock units, restricted stock units, multiple performance targets, ever-changing peer benchmarks, and so on.
You’re sure to conclude that remuneration consultants have an interest in making the reward scheme as complicated as possible – there’s not much money to be made from recommending a simple salary and discretionary bonus.
All gain, no pain
You’ll also conclude the previous CEO isn’t suffering. Quite the opposite. He was paid every which way – from ‘make whole’ payments to join to his very generous remuneration while the company imploded. And then his ‘termination without good cause’ meant he cashed in twice his salary and bonus and got immediate vesting of all stock awards.
If bankruptcy 10 months after leaving isn’t ‘good cause’, what is? In 2020 he was paid 859 times the median employee’s salary. Is this what corporate America has become?
We fear so because we don’t encounter the same level of excessive CEO remuneration in Europe or Japan. The CEO of Japan’s largest bank, Mitsubishi UFJ Financial Group, received less than $2m last year – a fraction of the US regional bank CEOs cited above – for running a bank with $3tn in assets.
And yet the MSCI World index has 70% in North America, almost three times the combined weighting of Europe and Japan.
Why would you want 70% of your money invested in North America? ‘Because that’s the weighting in the index’ would be the common response.
We don’t. Our exposure to the US market was 19% at the end of April. Some asset allocators will wince and tell us that’s too risky because of the high tracking error. Thankfully, our clients care more about growing their wealth in real terms than tracking errors.
A key part of identifying investments is assessing whether management is ‘on our side’. All too often in US companies, that is no longer the case.