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The recent financial crisis, triggered primarily by bad bets in the financial sector, has brought the reality of corporate failure to the fore, adding momentum to the idea that executive compensation should be tied more closely to corporate debt rather than equity. Last month, for example, American International Group (AIG), after being bailed out by taxpayers, announced that it will link incentive pay to the value of the troubled insurer’s bonds.
For decades, companies have tied executive compensation to equity, such as stocks and options, but the idea of adding debt-like instruments to the mix — such as pensions or deferred compensation paid to executives from inside the firm (known as “inside” debt) — is gaining new attention. “[This] is a positive move which should hopefully prevent future financial crises and more closely align managers with all investors, both shareholders and bondholders,” says Wharton finance professor Alex Edmans.
In a new paper titled, “Inside Debt,” Edmans and doctoral student Qi Liu contend that these types of incentives protect bondholders’ interests and the value of the firm, particularly when a company’s solvency is in question. The paper will be published by the Review of Finance.
Edmans notes that when companies run into difficulty, executives with compensation packages that are based largely on equity, rather than debt, may decide to take on large levels of risk to salvage the enterprise — and their portfolios — even though they may be placing the value of the firm and its bonds in even greater jeopardy. Since the value of managers’ equity would be close to zero at this point anyway, Edmans says, managers in this position might be tempted to “gamble for resurrection.” If their gamble fails, executives who are compensated heavily with equity have nothing more to lose. The remaining loss in the value of the firm is borne by the bondholders and other creditors, who may need to take a sharp reduction in the value of their investments if the firm goes into bankruptcy.
For managers at companies close to bankruptcy, equity compensation is a “one-way bet,” Edmans points out. “If the risk pays off, the value of the equity shoots up. If the risk doesn’t pay off, the worst their equity can be is zero.”
Some executives are able to save their equity — and their firms — with a bold move. Many others, however, fail spectacularly. Edmans points to Lehman Brothers and Bear Stearns, whose outsized bets on derivatives led to their collapse during the financial crisis that unraveled across global markets in the fall of 2008. Outside the financial sector, Enron is another example of a company where executives took excessive risk by moving away from their core business into derivatives trading, he notes. When those gambles failed, the managers’ actions brought down the firm. “In the example of Enron, the thing to do would have been to ‘fess up and disclose to investors that there were problems. Instead, they tried to conceal the problems, hoping that one of their gambles would pay off before the problems became noticed. But they only became worse,” Edmans adds.
For 30 years, the vogue in compensation theory has been to show that CEOs should own equity to align themselves with shareholders. According to Edmans, the long-standing emphasis on trying to justify pure equity compensation grew out of a belief that, in practice, managers do not hold much debt in their firms. He says this is a myth brought about because management shareholdings were widely disclosed, while pensions and other types of debt-like compensation have been more difficult to monitor. However, the U.S. Securities and Exchange Commission (SEC) disclosure rules that took effect in March 2007 are now providing new data showing that, in practice, companies offer substantial compensation in debt-like forms, such as pensions and deferred compensation. The paper notes that Roberto Goizueta, the former CEO of Coca-Cola, had more than $1 billion in deferred compensation when he died in 1997. It also cites other research showing that 13% of CEOs hold a larger stake of debt than equity in their companies.
According to Edmans, some commentators concluded that the use of debt compensation must be an inefficient way to reward managers because no existing theory advocated it. In their paper, the Wharton authors show that debt can in fact be part of an optimal compensation package. Indeed, after the change in SEC rules, Edmans says, “people started realizing that not only do executives hold debt in pensions and deferred compensation, but companies like AIG are saying this is a sensible way of paying CEOs.”
Remedy for Risk Taking
In their paper, the authors lay out a theoretical understanding of how debt can motivate corporate leaders. In developing their model, they explore how inside debt can be a superior motivating tool over other remedies to excessive risk-taking — such as giving the manager a bonus for avoiding bankruptcy — when it comes to managers selecting which projects to take on. The model then factors in an element of management effort to determine which levels of debt and equity are best, depending on the characteristics of the firm.
The model predicts that young, growing firms tend to rely on high-risk strategies to build value. At these companies, it makes more sense to weight compensation toward equity rather than debt. Edmans notes that this pattern is well-established in start-ups and other firms breaking new ground.
According to the model, adding inside debt to the compensation packages of top management is a better approach in companies with a high risk of bankruptcy, and where investment decisions and managerial effort are likely to have a big effect on the liquidation value of the firm. The paper cites leveraged buyouts (LBOs) as an example of this scenario. LBOs are usually targeted toward mature firms suffering from excessive investment in which the manager — often a private equity firm — steps in and takes control of operations while holding debt and equity positions. “Where debt has the strongest effect is when the firm’s solvency is threatened,” says Edmans. The model also suggests that companies with more debt should use more debt compensation in their executive pay packages.
AIG this summer adopted a compensation structure that pays bonuses in the form of what it calls “long-term performance units.” Eighty percent of the value of these instruments is based on the value of AIG’s junior debt and the rest is keyed to the value of AIG common stock. The new compensation plan helps reduce the volatility of equity-based compensation during the company’s restructuring. The restructuring is being overseen by the government, which put up $102 billion to save the company and has approved the new debt-based bonus plan.
Edmans notes that AIG’s decision to add more bonds to executive pay is a more clear-cut way of tying compensation to bondholders and the liquidated value of the firm, as opposed to promoting other forms of inside debt, like pensions. Pensions might pay out slightly differently than the company’s secured debt, reducing the effect on management.
Avoiding Bankruptcy vs. Maintaining Value
According to the authors, other studies indicate that paying executives a bonus for avoiding bankruptcy could be enough of an incentive to make debt-like compensation unnecessary. However, the authors state that such an incentive only encourages managers to avoid the occurrence of bankruptcy rather than manage the firm in such a way that it maintains as much of its value as possible if a bankruptcy petition becomes inevitable. When given a bonus for avoiding bankruptcy, this bonus is lost regardless of whether the bondholders receive 80 cents on the dollar or 10 cents on the dollar during bankruptcy proceedings. As a result, the manager is insensitive to the firm’s recovery value, and so will not fully protect bondholders’ interests.
While it is the shareholders who determine management pay, they also stand to benefit if managers are more aligned with bondholders and motivated to preserve as much of a firm’s value in a crisis, Edmans says. Bondholders who believe management is incentivized to protect their interests will demand a lower return on their bonds, he adds, which will drive down overall expenses and enhance the equity value of the company.
Despite the emphasis on equity compensation and growing interest in models built around debt, salaries will always remain a part of executive compensation, according to Edmans. The new research findings “complement the existing arrangements that people have known about for some time.”
Adding debt to compensation schemes is a simple way for corporate boards to balance the interests of shareholders and bondholders when times are good and when they are bad, potentially muting the volatility of economic cycles, the research suggests. If an executive receives a balance of equity and bonds, equity will rise in good times and so become much greater than the value of the manager’s debt. This is efficient, the authors argue, because debt is less necessary when the firm is far from bankruptcy. In contrast, when a firm is troubled, the value of its equity declines and debt makes up the bulk of the manager’s incentives — precisely at the time when he or she should be most concerned about bondholders’ interests and not take excessive risks or avoid tough decisions, such as closing plants. “The nice thing about compensating with debt and equity is that it is self-balancing,” says Edmans. “It runs on auto-pilot.”