Final 2006 Thoughts on CEO Pay

The Hoover Institute’s Thomas Sowell is an economist who usually makes a lot of sense. And in his latest blog, he touches upon some uncomfortable truths about the media’s obsessive objections to high executive pay. He first points out data which show that 99% of people “can’t understand” how any executive can make $50 million in total compensation. Sowell’s response is: So what? He asks: “Do you understand how your automobile's transmission works? Could you repair it if something went wrong? Do you understand how aspirin stops headaches? How to make yogurt?” If we accept these gaps in our knowledge, says Sowell, why would we be troubled by not understanding complex economic processes which yield huge compensations for working executives? Sowell, in fact, goes further, arguing that the politically correct solution to this knowledge gap--more government oversight-- is economically unjustifiable. He notes that the typical solution is “that politicians should impose policies based on your ignorance of what is going on. Can you imagine anything more dangerous than allowing politicians to decide how much money each of us can earn?” And he correctly notes that when politicians replace free markets in determining pay, there is an inevitable rise in government corruption, bureaucracy, and intrusion, not to mention the ever-growing definition of who is “rich” and ought to be taxed heavily—all in the name of socially engineered “justice” which has had a terrible historical track record in other countries. All true. And yet, I think Sowell is missing something important. Another economist, Irwin Stelzer of the Hudson Institute, points out that the reason that the political atmosphere vis-à-vis “fair” pay has moved leftward is that “voters feel that the middle class, or the average worker, has not shared in the economic growth of recent years. Wages have not risen as fast as profits, and the recent spate of multi-million dollar Wall Street bonuses has caused many workers to figure that some financial high flyers make as much in an hour as they make in a year…..(And then) throw in tales of rigged corporate compensation through pervasive backdating of options.” Stelzer is right, and it doesn’t even have to be rigged. To quote the Wall St. Journal, even legitimate stock options have become simply “an additional form of pay slathered on top of already generous packages.” That leads me to one other factor. In my November 3 blog “Grotesque Thoughts About Grotesque Pay”, I noted the persistently lousy correlation between executive pay and corporate performance. When people read about CEO’s raking in millions while their companies lose billions, those peoples’ perceptions about executive pay sour, even if they—to use Sowell’s words-- “don’t understand” complex economic theory. Never underestimate the voice of the marketplace. Managers, consumers, investors and just plain citizens often form opinions without fully understanding all their underlying dynamics. That’s life, that’s democracy, that’s capitalism. Messy and unruly, but effective. When it comes to CEOs’ pay, I believe the good ones deserve every penny of their millions, the bad ones ought to be ashamed of their obscene contracts (and shamed publicly), and the rest of us shouldn’t be afraid of analyzing, commenting, and evaluating on the subject. With that in mind, as 2006 comes to an end, I hope you’ve had a great Channuka and Christmas, and I hope that your compensation will rise in 2007.

Lessons From a Disappointing Merger

Last week I described a company which did an acquisition that looked great on paper but failed in practice, and the CEO wanted to know why, and what he could learn to avoid the same mistake in the future. My partners and I discovered that the acquisition made sense logically and financially. It didn’t make sense culturally. The cultural "fit" was awful. We proposed several recommendations which are applicable to any company. In the interests of space and confidentiality, I’ve selectively chosen and then condensed them to form the following list: • In any acquisition, do not underestimate the cultural integration challenge. • What happens after the deal is inked can make or break the strategic and business logic behind it. • The acquiring firm must develop a realistic and specific plan for the integration challenge before inking the deal.• Before a deal is finalized, due diligence should include the “fit” for cultures, values, management styles, how business is conducted, and the personal and professional goals of the key players in the acquired firm. The investigation should include a checklist for data and evidence to look for. • If, after all this work is done, there is serious reservation about the cultural fit between the two companies, don’t do the deal, even if the numbers look attractive and even if the deal looks sexy on paper. (This, by the way, is the “M.O.” of companies like Cisco Systems and Washington Mutual, which have a higher-than-average success rate with their acquisitions). • If, after all the above is done, the acquiring company still has screwed up and purchased a company with a lousy fit, then it’s time for the leaders in the acquiring company to make tough decisions. One decision is to cut bait and divest the acquired company before the inevitable bleeding progresses. The other is to ratchet up the controls: unapologetically define the values, behavioral, and performance expectations for everyone affiliated with the firm (including the people that were acquired), accelerate cultural training, development and formal coaching/mentoring initiatives for members of the acquired firm, launch regular “cultural exchanges” between members of the two firms, prominently reward those who get on board, and prepare clear management directives to resistors and skeptics to either change or move on—and make sure those directives have “teeth”. The worst thing to do is to sit back and hope that the problem will somehow resolve itself over time. Had Company X taken the above steps, it would have substantially improved the odds of success for the deal. It would have been much more likely to have realized the projected gains which seemed so reasonable and exciting when the deal was originally done.

"A Disappointing Merger"

I just wrapped up an interesting project with colleagues from an investment bank. We were asked by a CEO of an able and healthy company to analyze why an acquisition which looked so good on paper five years ago bombed so badly in practice. Apart from protecting confidentiality, I want to assure you that the name of the company in question, and the financial specifics of the deal, are irrelevant to the learning points that my colleagues and I unearthed. As it turns out, the economics of the deal were sound. The price was good, the legal and structural issues were handled well, and the strategic rationale was solid. No problems before the documents were signed. The problems began afterwards. It turned out the gross cultural mismatches between the two firms pretty much overwhelmed and negated the financial and strategic advantages underlying the acquisition. Basically, what happened was that the key players in both companies had vastly different perspectives on how they ran their businesses, how they managed for growth, how they dealt with customers, and what they defined as appropriate corporate values. Even though the acquisition was not ever called a “merger of equals” (no acquisition ever is, regardless of the spin), the acquiring firm simply could not dislodge the cultural legacies and resistances within the acquired firm. How could Company X, which acquired Company Y, not have seen this train wreck coming? The reason is that the capable people on both sides who originally put together the deal were primarily “numbers” people. They focused their due diligence and preliminary analysis almost entirely on the financials and “big picture” strategy. Though they wouldn’t admit it, some of them ignored the cultural integration issue altogether, and the others naively assumed that things would somehow work out or that "staff" would figure out how to make the execution happen. Company X is certainly not unique. All too often in the M & A arena, these “soft” cultural issues are given short drift by dealmakers, and then they come back to haunt the marriage partners—in a “hard” way. Don't make the same mistake. That's the first, and most important, lesson. Next week I’ll tell you what we suggested to the CEO and the executive team.

Indigestion at US Airways

So US Airways Group is trying to take over Delta Airlines. As someone who studies mergers (and who flies a lot), why am I not reassured by this deal? Here are a few reasons:

1. US Airways Group is an amalgam of America West and US Airways, but America West and US Airways are still digesting each other. And now they want to devour another huge meal at the same time? I foresee some big competitive indigestion.

2. The America West/US Airways merger has been “successful” inasmuch as the new company has slashed costs so much that it might post a profit in Q4. But in the process of eviscerating resources, customer service problems have (unsurprisingly) multiplied. Upshot: Once the low-hanging fruit of obvious excess costs has been fully harvested, how are the leaders going to profitably grow the company when more customers are unhappy?

3. The answer to question #2 seems to be: Hell, I don’t know, so let’s buy another airline and use synergies to slash more costs. But the track record of companies whose growth strategy revolves primarily around serial acquisitions is pretty poor. Without a solid “organic” grounding of cutting edge services, brand uniqueness, and customer loyalty—none of which seem to be in abundance at US Airways Group-- it’s unlikely that serial acquisitions will, long term, yield much more than a house of cards.

4. I get the sense that the leaders behind the deal confuse “being the biggest” (and the new company would be the biggest U.S. airline) with “being the best.” If being biggest was the magic secret, you’d want to have invested in GM rather than Toyota, or in Albertson’s rather than Whole Foods Market—or in Delta and US Airways rather than Southwest Air and Jet Blue. Wrong.

5. It’s a hostile bid, in a business that requires resources and employee commitment to cost containment, quality enhancement and face-to-face customer care. Enough said.

6. Most important, let me quote from my book Break From the Pack, the subtitle “The Dinosaurs Mating Syndrome”:

“Perhaps the greatest delusion executives have about mergers is the belief that somehow, two bureaucratic, backward-looking corporations will join forces and spawn an impregnable giant. The underlying assumption is that two companies that have individually managed to generate flat earnings and declining share will be able to magically continue their comfort-zone strategies by jumping into bed together… Ultimately, a merger might temporarily prop up any two beasts by providing them better scale and better marketing, but the end result is still extreme vulnerability, if not extinction.”

Well, as the holidays approach I don’t mean to sound like a Scrooge, but I do believe I’ve answered my original question.