Worth Every Last Million

By Roy C. Smith
Sunday, January 21, 2007

Tell me if I'm wrong: You think America's top corporate executives are obscenely overpaid. You think recently ousted Home Depot chairman Robert Nardelli was just the latest in a long line of high-flying CEOs to negotiate himself an overinflated severance package and to waft out the door thumbing his nose at us all. You think it's about time that the Senate started considering, as it did last week, closing some of the tax loopholes that have made it possible for these corporate scalpers to get away with highway robbery for so long.

I say, think again.

Executive compensation today isn't the sinful overindulgence of greedy executives that it's made out to be. There may be some abuse among the 7,500 publicly traded corporations in the country, but most of the CEOs who receive those huge pay packages not only earn them but also, yes, deserve them.

Most have increased their companies' value and improved their performance far more quickly than was common in the 1970s and '80s. Yes, corporate compensation has gone sky high, but the result is better-run, better-performing companies than the United States has ever had. And most of us -- from shareholders and investors to average consumers -- are reaping the benefits.

If you want to blame anything for today's inflated compensation packages, blame the hostile takeovers and the leveraged buyouts of the 1980s. Remember the days of the corporate raiders? Twenty years ago, those guys were everywhere, cruising the market for likely takeover targets and offering hostile bids, at premium prices, on well-known but poorly performing companies. The raiders would claim that management had failed to perform its basic duty to the companies' shareholders, which was to increase the value of their investment. These bids put management on the defensive, forcing it to justify both past performance and future plans.

The takeover effort led to a prolonged legal struggle to determine what managers could and could not do to defend themselves against hostile offers. But in the end, investors supported the bidders. And in doing so, they revolutionized corporate boardrooms, establishing the principle that if boards and managers did not create shareholder value, then shareholders would seek others who would.

By the mid-1980s, leveraged buyout (LBO) firms joined the pursuit of large underperforming companies using borrowed money. The LBO operators, however, believed that if certain management principles were followed, the risk of carrying all that debt could be greatly reduced. One of these principles required all-out managerial attention to increasing the company's operating cash flow so that debt could be repaid as quickly as possible. This in turn would improve profitability and increase the value of shareholders' equity.

Another principle was that the firm should retain the most effective managers it could find. That meant providing powerful compensation incentives. Managers who succeeded in meeting the LBO firms' performance benchmarks would be paid handsomely in company stock or options.

On the whole, the LBO management principles worked. The average LBO returns in the later 1980s were well into the double digits -- so the principle of exceptional pay for exceptional performance soon migrated to the public company arena.

From 1985 to 1990, there was more than $1 trillion worth of mergers in the United States, 25 percent of them hostile and 18 percent done through LBOs. In the 1990s, mergers continued at a record pace, but both hostile deals and LBOs decreased. One reason? There were fewer underperforming companies remaining.

The most famous takeover of the era was the landmark $25 billion buyout of RJR Nabisco in 1988. This began with a $75-per-share bid by the company's own CEO, F. Ross Johnson, supported by an investment bank. Johnson was frustrated that the stock market didn't value the tobacco and consumer goods company as highly as he thought it should. He also, admittedly, thought that if he could upgrade or break up the business, he could make much more money than if he remained CEO of an unleveraged RJR Nabisco.

"Greed in America," Time magazine blared on its cover in response to news that Johnson's management group would receive 8 percent of the stock in the LBO. But then the bid was exceeded by a higher one from the investment firm of Kohlberg Kravis Roberts. The two bidders slugged it out until RJR Nabisco's independent directors finally selected KKR's $109-per-share bid as the winner.

When it was over, KKR had to find someone to manage the debt-laden company. It chose Louis V. Gerstner Jr., then president of American Express. But to reel him in, it had to offer a generous pay-for-performance package similar to the one that Johnson had proposed for himself and his management team. Gerstner was not about to give up his lucrative future at American Express, where he was heir apparent to the CEO's job, without a gold-plated contract that would reward him for success and cushion him against failure. The contract also sent a message to American Express and other large American companies: Watch out, or you'll find your top managers picked off to follow an alternative career path in LBOs.

By the time a troubled IBM, impressed by Gerstner's work at RJR Nabisco, decided to recruit him to be its CEO in 1993, Gerstner had perfected the art of negotiating employment contracts. In his seven years as chief executive of IBM, he turned the company around and increased its stock price tenfold. Stockholders didn't complain about his compensation, which was closely tied to the stock price and represented a tiny percentage of IBM's total market value.

Sometimes, however, things go wrong even for the best of reasons. In 2000, Home Depot, facing the aging of its legendary founders, Bernie Marcus and Arthur Blank, needed a succession plan. That year, General Electric CEO Jack Welch was due to retire; Jeffrey R. Immelt was selected over two other top GE executives to replace him. Home Depot, acting quickly and with an appropriately generous package, was able to attract one of the passed-over executives -- Nardelli -- to become its new chief executive when he left GE (the other, W. James McNerney Jr., became CEO of Boeing).

The media bashing he has endured notwithstanding, Nardelli proved to be a powerful and effective manager -- the company's bottom-line net income per share of stock grew at an average rate of 20 percent during his six years as CEO. But the stock price, which had quintupled in the three years before Nardelli's arrival, began to sink almost immediately -- along with the rest of the stock market. Home Depot was no longer the darling it had been, and no new shareholder value had been created in the Nardelli years. Meanwhile, the company's major competitor, Lowe's, managed to add shareholder value.

Disappointed investors stirred and forced the board to replace Nardelli. But on exiting, he was able to rely on the contract he had negotiated when he joined the company. It had anticipated such an eventuality and enabled him to leave with severance arrangements valued at $210 million (more than half of which was in previously earned grants of deferred stock -- the kind of compensation that the Senate is considering restricting). These arrangements attracted a great deal of complaint -- "All that pay for no performance" was the general gripe -- but if Home Depot's stock price had followed its earnings, it would have tripled, adding $18 billion to the company's value, and there would have been far less fuss.

It's true that CEOs have a lot of power inside their companies and that some have milked their boards for more compensation than they deserved. Most boards are fairly passive -- they want their chief executives to be paid competitively and to own significant amounts of company stock, but otherwise they tend to go along with whatever their compensation consultants tell them.

But the boards do have to disclose what they do, and that information is available for scrutiny by investors and by regulators, especially since the attention to corporate conduct after the Enron debacle. Nevertheless, most boards would prefer to pay too much rather than too little, because they accept the two important principles of governance established in the 1980s: that CEOs are responsible for creating shareholder value (and will be replaced, as Nardelli was, if that doesn't happen) and that the best and perhaps only way to attract top CEOs in a competitive marketplace is through LBO-like pay-for-performance incentives.

Today's compensation packages have become highly complicated, but the essence remains rewarding a CEO, predominantly through company stock or stock options, for meeting certain goals. Options were extremely valuable in the 1990s, when stocks were rising rapidly, and they did not have to be accounted for until they were exercised. But they haven't been worth nearly as much since 2000, when the markets went flat and the accounting rules changed.

The best chief executives have proven track records demonstrating management ability in large, complex corporate situations. Such people are always in demand. But most get only one shot at being a CEO, and they want to make the most of it. They also know that the rate of CEO turnover at large corporations has increased significantly in recent years, and that 50 percent of departures are the result of mergers or performance issues. If things go wrong, their contracts may be all they have to hang on to, so they negotiate the best ones they can going in. No doubt you'd do the same.

Today's CEOs are paid well when they deserve to be (and sometimes when they don't), but most corporate directors will tell you that over the past 20 years, public companies have become better managed, with increased profit margins, productivity and returns on investment. And those that haven't have become the targets of mergers or buyouts or have replaced their CEOs. Isn't that the way we want it to be?

Roy C. Smith, a professor of finance at New York University, is co-author of "Governing the Modern Corporation" (Oxford University Press).