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How to Revive Animal Spirits in CEOs

Jeff Ubben - Wall Street Journal - 11/29/2012

Jeff Ubben, Founder, Chief Executive Officer and Chief Investment Officer of ValueAct Capital, wrote an op-ed piece in Friday’s Wall Street Journal, entitled “How to Revive Animal Spirits in CEOs.” In our first edition of Director’s Cut, below is the version prior to WSJ editing, and annotated by 13D Monitor (13D Monitor annotations are in bold and bracketed).

Corporate America is stuck in a rut, and it is holding back economic growth. Despite record-low financing costs, capital expenditure plans at large firms are down, R&D is being cut, and mergers and acquisitions are at a virtual standstill. This corporate age of austerity is a failure of governance—not just in Washington but in public company boardrooms.

In the name of risk management, corporate boards have lost the “owner” mentality they need in designing management compensation. Too many CEOs are now better off being caretakers instead of value creators. Surprisingly, the solution may entail more compensation for CEOs, not less—but only if CEOs create long-term,sustainable value for shareholders. There is a “better mousetrap” for longterm incentives that is simple and can help bring back growth.

My partners and I have served on 28 public company boards of directors and 18 compensation committees since our investment firm was founded in 2000. [In the 22 13D situations where ValueAct has taken a Board seat, they have averaged an annualized return of 22.65% versus .20% for the S&P500 over the same time periods] We have watched the corporate appetite for risk swing from recklessness to trepidation. At the turn of the century, speculators were hyperventilating in favor of absolute growth, and company managements and boards fell into line. This “new economy” era saw a tremendous misallocation of resources towards blind pursuit of market share, volume, capacity, “eyeballs,” new products, and acquisitions. But firms were building paper empires, not sustainable value. In this era’s wake, our strategy was often to support companies “getting smaller to get better,” a strategy that worked well when the dominant corporate mentality was “growth for growth’s sake.” [Jeff Ubben and ValueAct were instrumental in “deconglomerizing” Sara Lee Corp. and realizing an 18.8% return during a period when the S&P500 was down .40%]

Now corporate America has become far too cautious when it comes to growth, at the wrong time, and for the wrong reasons.

A misguided shift in compensation design is a crucial reason. In the name of reining in corporate risk-taking, boards have disconnected CEO pay from the enhancement of equity value across all industries—and not only in the banking sector, where excessive risk is truly systemic. Equity compensation for executives has shifted dramatically from “appreciation awards” (stock options), which pay out only if the stock price increases, toward “full-value awards” (restricted stock units) that usually pay out regardless of future stock performance.

The shift away from stock options matters. Even when granting “performance- based” restricted stock units, boards have coalesced around shortterm performance metrics that are recommended by managements to their boards’ compensation committees.

Thus, more than ever before, long-term equity grants are triggered by meeting short-term budget goals framed by CEOs themselves. And with their equity plans not tied to exceptional future stock-price gains, executives have adopted the psychology of a bondholder— managing risk to protect their “coupon” of cash and equity. Why budget long-term investment when the reward doesn’t justify the risk? Unfortunately for both stockholders and truly outstanding managers, executives are now paid more for mediocrity and less for excellence than they deserve.

There is a simple solution: Boards can reorient management to maximize value for stockholders by paying CEOs a percentage of the equity value they create above a minimum rate of shareholder return, or “hurdle.” [Putting his money where his mouth is, Jeff Ubben’s compensation at ValueAct has a similar structure. Most of investor capital is subject to a hurdle before Ubben and his partners receive any incentive compensation, which they only receive at the end of the lockup period for the applicable investor]. Traditional stock options, it is said, both encourage risky behavior and reward CEOs for stock-price increases even if caused by temporary market volatility rather than long-term value creation. But if hurdles are set high enough and required holding periods are long enough, CEOs won’t be rewarded for temporary stock-price increases. They will “own” the long-term outcome of risky investments.

This simple concept—sharing the gains with managers once the gains exceed a hurdle rate of return—exists in many private companies. It is the “better mousetrap” of compensation design.

Unfortunately, the “Say on Pay” shareholder vote, mandated by the Dodd Frank financial-reform legislation in the hope of increasing alignment between owners and managers, has backfired. [Activist investors are generally more concerned with “executive competence” than they are with “executive compensation.” To paraphrase Carl Icahn: If the New York Yankees hired me and paid me $0 in salary and $1 million for each home run I hit, I still would not be able to hit any home runs] Say on Pay has led directors to triangulate compensation to what will receive popular approval. But most shareholders are not equipped to judge compensation plans case by case. Overwhelmed with the task of evaluating thousands of Say on Pay votes, outsourced proxy advisers and large institutional shareholders have resorted to one-size-fitsall formulas to guide their votes: the future value of equity grants is quantified using forced math and benchmarked against contrived peer groups.

Perversely, we have watched boards make compensation awards that are contrary to their better judgment but will “carry the vote.” Boards become servants to formulas and solve for the dollar amount to be delivered, losing focus on desired outcomes and the design of incentives. This is backwards. It is incentives that can incline managements away from cash-hoarding and toward desired outcomes. In 2009, this newspaper published an article praising a public company’s CEO-compensation plan that incorporated the “better mousetrap” model (“Valeant CEO’s Pay Package Draws Praise as a Model,” Aug. 24). One of our firm’s partners, Mason Morfit, chaired the compensation committee that designed CEO Michael Pearson’s incentive plan when he joined Valeant in February 2008. [Mason Morfit has been on the Boards of five ValueAct 13D Companies, and ValueAct’s annualized average returns on those investments is 36.40% versus -.29% for the S&P500 during the same time periods.]

Since then, Valeant has taken advantage of low interest rates to invest over $8 billion in M&A, R&D and capital spending. [Ubben is a little modest here. The detailed financial modeling and analysis done by activists on Boards, particularly ones with the experience of Mason Morfit, can often mean the difference between accretive acquisitions and poor acquisitions. In Valeant’s acquisition of Medicis Pharmaceutical, Valeant’s stock rose 15% on the news. In contrast, around the same time, IDTI acquired PLX Technology, Inc. prior to Starboard getting its Board seat and upon the news, IDTI’s stock dropped by 9.6%.] The company has introduced an innovative and efficient operating model in the pharmaceutical industry while driving sales growth (excluding the impact of acquisitions) to 9%, or more than double the growth rate of global GDP.

Credit some of Valeant’s success to the design of the CEO’s compensation. During Mr. Pearson’s tenure, shareholder value has increased tenfold, the annualized return to shareholders has been 60%, and Valeant’s market value has grown to $17 billion.

For their gains, stockholders have rewarded Mr. Pearson with more than 3% of the value created—but, crucially, had he not achieved his hurdle rate, he would have shared the pain of stockholders and earned far less than his peers.

This is the model that can bring a healthy appetite for risk back to the boardroom and help get corporate America growing again. [This compensation package was completed prior to Say on Pay and Ubben worries that the creativity that went into his package will get sniffed out in this Say on Pay world]

Mr. Ubben is the founder and CEO of ValueAct Capital, a long-term activist investment fund.


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