Monday, July 29, 2013

Bosses with moneybags.

Muting “freedom fighters” at the heart of their “struggle”.

There was a popular caricature in years gone by of the “fat-cat capitalist” boss leaving work with his briefcase stuffed with money that had been gathered from the efforts of exploited workers.

Thys, the mine manager at one of the first sites I consulted at, and I used to have precious moments of levity at his casual safari-suit dress code and absence of a brief case to counter that caricature. Indeed, my presence there was part of that effort, more specifically to set up some form of comprehensible sharing of information that would disabuse the belligerent mobs of their misguided musings.

In all of my work at the time and at many different sites, I could never convince clients of the need to be transparent about pay differences. Even the most belligerent workforces never argued for “equal pay” – only, and then not too convincingly for “equal pay for equal work”. What was even more tragic was that the pay difference cover up was exacerbating misconceptions. Employee suspicions were far worse than the reality. Full and credible disclosure, I argued, would in fact ameliorate the murmurings.

But it all fell on deaf ears, even at one large retail site where we extrapolated an average differential of about 7 to 1 between the top-paid 10% per cent and bottom paid 10%. Of course that was before the introduction of other executive pay magician’s capes such as share options and convoluted bonus schemes. (Latest U.N. statistics puts that calculation for South Africa as a whole at 33 to 1). But at that time, I vehemently championed disclosure, pointing out that it was a differential that even the most radical unions could accept, against the background of a relatively mild prevailing South African Gini co-efficient of less than 5 compared with today’s 6.7.

What I could not achieve in those years was later done by the stroke of a Mervyn King pen. The King III governance requirements has forced executive pay disclosure at a time when the differential has been exponentially burgeoning, not only catapulting the issue into the heart of serious labour ferment, but adding to the frenzy by igniting comparisons and adolescent envy as a motive for increasing executive rewards.

What changed in a span of less than 20 years, that could turn modest, yet covert pay differentials into excessive, now embarrassingly overt gaps? -- certainly not sudden and massive changes in supply and demand for executives. That alone should confirm that the so-called executive market is thoroughly broken, and the price for executives is nothing short of fiction.

It has perhaps been forgotten that the explosion in executive pay has happened in less than 20 years, more specifically as an unintended consequence of American President Bill Clinton’s efforts to curb what was then already becoming obscene levels of executive remuneration. His executive pay tax proposals in the early 1990’s set off a wave of tax avoiding remuneration initiatives that compounded the gap many fold.

South Africa, with its 50-60 times pay differences in a highly emotionally charged environment, simply cannot escape the global soul-searching on executive pay. Switzerland for example is looking at enforcing a 9 times differential cap, on the back of a recent referendum for executive pay reforms.

One of the world’s thought leaders on executive pay, PwC has been challenging executive pay models for a number of years, concluding in its latest Executive Remuneration report that “there are few who would argue that executive pay models have produced better performance over the last decade”. The case against long term incentive plans, it says, may be based on:

  • Poor track record of aligning reward with shareholder returns;
  • Volatility of performance being rewarded rather than strong sustained performance;
  • Impossible to calibrate reliably;
  • Perceived as a lottery by participants; and has led to irrational discounting by executives, so valued at a fraction (in many cases only 25%) of their economic cost.

PwC believes that simplification and with it greater certainty will lead to a reduction in executive gross pay, simply by reducing the extent to which executives discount the real value of these incentives. It has proposed a new model to capture

  • Financial performance (but with a long-term view on underlying trends),
  • Customer,
  • People, and
  • Risk, compliance, and behaviour.

It says performance assessment criteria should be based on (1) Revenue; (2) EBITDA (earnings before interest, tax, depreciation, and amortisation); (3) Operating free cash flow and (4) Return on capital.

It is beyond the scope of this article to give all the details of the proposed model, let alone a critique of all of its elements. Encouraging as it is simply in challenging the current dysfunction in executive remuneration, my main concern is that it is still deeply rooted in profit maximisation and shareholder value criteria and will do little to effectively counter short-termism and a squeezing out of other social constituents, including labour. The model falls back heavily on elements of the Triple Bottom Line and the Balanced Scorecard, which have been around for decades with no effect on pay disparities or more balanced national economic growth globally.

Ultimately the real value of any business should not only be to one specific group such as the owners, but to all of its constituents, the most important of all being customers or the market that that business serves. Accommodating those constituents as merely co-incidental beneficiaries of the grand purpose of maximising profit is skewed, inappropriate and indeed has led to their neglect.

If, as Bill Kellogg once remarked, the real purpose of a business is to add value to people’s lives and profit is only one consequence (albeit a very important one) of that, then the real issue is to challenge the mother of all measurements, the income statement itself.

The only metric that appropriately captures the very essence of what companies should be about is wealth creation or value added. This is simply income less outside costs. I believe, however, that real wealth creation is more accurately represented as cash Value added, which means that interest, depreciation and amortization should be deducted from the commonly used value-added metric.

If used as the primary incentive criterion, it forges common purpose and common fate within an organisation and will be by far the most powerful tool in countering ever increasing pay disparities. It is the one measurement that will encourage executives to emulate entrepreneurial behaviour while reconciling shareholder and customer interests.

Of course, there are such powerful vested interests cemented in conventional accounting that one cannot expect any serious move towards something else, particularly from the accounting profession.

Indeed, giving credit where it is due, PwC’s challenge to current formulae is a laudable proposal in addressing pay disparities, one of the great distortions of our time. It is such a powerful weapon in the hands of malcontents such as our so-called economic freedom fighters that any hint at its invalidity has to be seriously explored.

PwC’s difficulty will be to reassure a sceptical audience that any tinkering with executive remuneration that implies a reduction in their gross pay, will lead to an exodus of much needed talent.

I used to be an avid poker player. Let’s call their bluff!

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