Incentives Factor Big in Business Issues

Whether the issue is CEO pay, middle management coordination, or family-run businesses, incentives play a role, according to a panel of GSB professors at the 2007 Conference on Chicago Economics November 10 at the Charles M. Harper Center. The conference was put on by the Becker Center on Chicago Price Theory and the panel was moderated by Austan Goolsbee, Robert P. Gwinn Professor of Economics.

When Robert Gertner, Wallace W. Booth Professor of Economics and Strategy, was an MIT grad student in the 1980s, he sat in on a Harvard class about contract law. “At the time whenever the professor or anyone in the class used the word “incentives,” people would hiss and sometimes even bang their feet,” Gertner said.

“My guess is the world has changed a fair amount,” he said. “I think what’s happening is there’s been growing realization of the importance of incentives.”

Gertner cited research on middle managers, specifically how they coordinate with one another for the benefit of the entire company rather than working to ensure their individual units perform well.

“If you think about why this coordination problem is difficult, it’s that managers of units tend to have incentives that are weighted very heavily towards the unit’s performance relative to the performance of the entire organization,” Gertner said.

Even with a component of pay relative to company performance, “individual managers of units care more about their own unit than the company as a whole,” he said.

Partly this occurs because managers can control what’s going on in their own unit, but not what’s happening throughout the company, Gernter said.

A case study of a Swiss coffee and confectionary firm showed what happened when the company went from 19 plants down to six. General managers lost control of manufacturing but maintained control of sales and marketing. They had to discuss and coordinate product design with the manufacturers.

“The problem was each of the individual general managers didn’t have a big incentive to make concessions that were in the interest of the company as a whole,” Gertner said.

He said incentives should be given on both sides of “a fundamental trade-off” that exists between performance within a division and coordination, cooperation, and communication within the whole organization.

This trade-off offers insight into the failed merger of Time Warner and AOL, Gertner said. One supposed benefit of the merger was coordinated ad sales across media. Rather than hiring a new manager, the company said “everybody get together and cooperate,” Gertner said. “And surprise, surprise. Everyone had narrow incentives. They had no reason to cooperate. And they didn’t.”

In family-run companies, there are a few incentives for a company founder to pass control on to a family member rather than someone unrelated. Doing so makes sense if the reputation or brand of the company is tied to the family name, said Marianne Bertrand, Fred G. Steingraber/A.T. Kearney Professor of Economics. Also family leadership may have long-term interests at heart, she said. And, especially in countries that lack good legal institutions, a family company founder may want to pass control to a family member who can be trusted, she said.

Founding family members hold officer or director positions in about a third of S&P 500 firms, Bertrand said.

Return on assets comparisons show that companies with unrelated leadership fare better than those with family succession. That is, unless the son who takes over has a top education, statistics showed.

“Appointing your son as CEO really does nothing bad for business, as long your son was smart enough to make it to one of those 200 top colleges,” Bertrand said.

Steven Kaplan, Neubauer Family Professor of Entrepreneurship and Finance, discussed CEO pay. High levels of CEO pay packages have drawn criticism in the media recently, with boards of directors being chastised for awarding them.

“Are the critics right?” asked Kaplan. “The answer is no.”

He said the typical CEO is paid for performance, and boards of directors “actually seem to be doing a better job” than they were in the past. Estimated average pay of S&P 500 CEOs, or what boards think they are awarding, has declined since 2000, Kaplan said. Estimated pay differs from realized pay because of the unknown value of stock options at the time a compensation package is formulated.   

Average estimated CEO compensation has stood at about $10 million a year, and median compensation at about $8 million a year, Kaplan said. Realized average CEO pay has been about $12 million and the median is about $6 million.

Kaplan has compared realized CEO pay with stock performance.

“The firms where the pay is the lowest, the stock returns are the lowest. In the quintiles where the pay is the highest, performance is the highest.”

CEO turnover is higher than it’s been any time during the last 35 years, Kaplan said. CEO tenure has dropped to six years from ten, where it stood 20 to 30 years ago. In addition, research indicates that CEOs are being penalized for poor performance, he said. So evidence shows “boards have performed better in their monitoring roles in the last eight or ten years.”

First-year student Joao Guillaumon said he was most interested in what he had learned about CEO compensation, its link to performance, and how boards were firing ill-performing CEOs, contrary to press reports. CEOs “should have incentives very well aligned with the shareholders’ interests,” Guillaumon said.

- Mary Sue Penn